Technical Analysis: Features, Objectives, Limitations and How It Works

Whether you trace the origin to the 19^th century American Charles Dow, who created the DJIA Index, or the 18^th century Japanese Homma Munehisa, who invented the candlestick Pattern chart, technical analysis has got a rich history. And traders will continue to use it in their quest to get an edge in the market.

Technical analysis is an analysis method where traders analyze recurrent patterns in the price of a security, in order to know when to enter and exit the markets. Technical analysis covers a broad spectrum of methods, including commonly known methods like technical trading indicators, like the RSI and ADX, and chart patterns, like wedges and triangles. 

Technical analysts use technical analysis to track human psychology in the market and how it affects the price of a security. Owing to the importance of technical analysis in trading, we have created this comprehensive guide to teach you all you need to know about the subject.

What Is Technical Analysis?

Technical analysis is a method of analyzing a financial asset, such as a stock, commodity, currency pair, options, or futures, to identify trading opportunities. It is used to predict where the price of an asset will go in the future, based on what is happening in the market now and what has happened in the past. Followers of this method use various charts and market data to study the activities of investors in the market in order to forecast future price movements.

Simply put, technical analysis is a way of analyzing a market by using charts to study market action. The term market action implies all the metrics used to indicate the activity in the market, such as price, volume, and open interest. Open interest is used in the options and futures market to denote the total number of outstanding contracts that are yet to be settled.

Technical analysis is based on the idea that all you need to analyze a security — and make a fairly accurate prediction of the future price of that security — is the historical trading activity in that security, expressed in price, volume, and open interest (where applicable).

Any security that has historical market data can be analyzed with technical analysis methods. So technical analysis can be used on stocks, exchange-traded funds, bonds, currencies, futures, options, commodities, and even the volatility index.

The Importance of Price Action for Technical Traders

Unlike a fundamental analyst, who tries to evaluate a security’s intrinsic value, a typical technical trader would only study the chart to identify price patterns and changes in volume. Technical analysts believe that the price of the security and the volume transacted are the most reliable predictors of future price direction. They believe that the price and volume data can show the imbalance in supply and demand of the security, which is what determines the direction of price movement in the future.

Some technical traders (pure technical traders) make their trading decisions solely on their analysis of chart patterns and volume, without any consideration of fundamental factors. However, many technical traders still consider fundamental factors when buying or selling a security — at the very least, they stay away from the market during major news releases.

The official group that trains and certify technical analysts is the Market Technicians Association (MTA). Although any trader can learn technical analysis on his own, advanced technical analysts are examined and awarded with the Chartered Market Technicians (CMT) certification by the MTA.

Related reading: Does Technical analysis work?

Brief History of Technical Analysis

In the Western world, it is believed that technical analysis was first introduced by Charles Dow when he teamed up with his friend in 1896 to create the equity market index named after their names — Dow Jones Industrial Average. Through his regular stock market editorials in The Wall Street Journal (a financial publication he founded), Charles Dow also laid the early foundation of what later became known as the Dow Theory — the basis of technical analysis.

However, many aspects of technical analysis have been in existence in Japan more than a century before Charles Dow was born. The Japanese believe that Homma Munehisa invented technical analysis when he developed a method to track the price of rice coupons in the 18^th century — what would later become known as the candlestick chart.

Uses of Technical Analysis

Technical traders have different ways of using technical analysis, and no two traders have the same approach to technical analysis, even the certified ones. So both the analysis and how it is used are quite subjective, as individuals try to modify several aspects to suit their perceptions and personalities.

However, despite the variations in methods and styles, there are some common grounds. Certain things are generally accepted, although individual traders may use different technical tools to achieve them. For the most part, technical traders use technical analysis to:

• Identify the price trend
• Mark important price levels
• Know when to enter a trade
• Estimate profit targets
• Place stop losses
• Decide when to exit a trade

Price Trend

Technical analysis can be used to identify, firstly, if the price is in a trend or just moving sideways. And if in a trend, it can show the direction. To know if the price is in a trend or not, traders check their price charts to see if the highs and lows of price swings remain at the same level or are moving in a particular direction.

If the price swings are moving up, with higher highs and lower lows, the price is said to be in an uptrend. Conversely, if the swings are moving lower, with lower lows and lower highs, the price is in a downtrend. Technical traders would often attach a trendline on the successive swing highs or swing lows to help them easily identify the direction through the slope of the trendline.

Alternatively, some traders use technical indicators to decipher the trend direction. The most common indicator for this purpose is the moving average indicator. A flat moving average line indicates sideways movement. If the line is sloping upwards, the price is in an upward trend, and if it’s sloping downwards, the price is trending downwards.

Important Price Levels

There certain levels where the price tends to get to and reverse or temporarily pause. They are often called support (if they are below the price) and resistance (if they are above the price) levels. Traders use technical analysis to identify such levels in advance so as to take advantage of the potential price reaction there.

Technical traders often look at the previous swing highs and lows to map out the resistance and support levels. Some may use certain technical tools, such as the pivot lines and Fibonacci retracement and extension or expansion tools, to identify potential levels, while others use indicators to do the same. Indicator users mostly use long-period moving averages, such as the 200-day moving average, as potential a support or resistance level, depending on where the price is in reference to it.

Below is an example of how a previous high acted as a resistance level!

If you want to learn more about how to use support and resistance in your trading, be sure to check our article on support and resistance!

Trade Entry

Another important use of technical analysis is to determine when to enter a trade. Some traders, who predominantly use fundamental analysis to evaluate a security, still make reference to technical analysis to identify the best possible time to enter a trade.

For pure technical traders, however, technical analysis is used to define what constitutes a tradable opportunity — a trade setup. In addition to using the analysis to guess the future direction of price movements, they also use it to develop some rules about when to enter (or not enter) a trade.

For technical traders, trading becomes a rule-based game, where a trade is entered only when all the criteria for a trade setup is met. If the criteria are not met, the trader stays on the sideline and wait for the setup to complete.

So technical analysis simplifies the process of entering a trade, and this has led to the creation of many software programs that execute the trades or, at the very least, alert the trader when the setup is complete.

Profit Targets

Profit targets simply are levels where you decide to exit a trade and take profit.

There are many ways that technical analysis can assist you in finding the appropriate profit target level. For example, you could use the Average True Range indicator to place the profit target at a distance from the entry that accounts for market volatility. Another example is to use support or resistance levels and exit a trade once the market hits one of them, depending on if you are long or short.

When it comes to chart patterns,  they have often have a measurable projected price movement. For instance, when the price breaks out of a triangle pattern, it is expected to make a move that is approximately the size of the base of the triangle.

Below you see how a breakout from a triangle leads to a move upwards that measures the same distance as the base of the triangle.

Similarly, a head and shoulder pattern is expected to move a distance that is equivalent to the size of the head. So a trader may know, beforehand, how far the price will move in a particular direction and use it to estimate where to lock in profit and get out of the trade.

However, in our experience typical chart patterns like the ones above simply don’t work. Still, they are worth mentioning, since they are so popular and common among traders!

If you want to learn more about profit targets, be sure to read our guide on how to use a profit target!

Stop Loss

Experienced traders know when to get out of a trade if it’s not going fine, and it is technical analysis that they use to make such calls. The same way it tells when there’s a trade setup, technical analysis can tell when an already-established setup has been invalidated so that the trader, who placed a trade when the setup initially appeared, can get out of the trade with as little loss as possible.

Most commonly, traders use technical analysis to know how far they can allow the price to move against them before they can accept the loss and move on. Technical analysis helps them to establish a level beyond which their trade setup has been made invalid, and this would be the place to place their stop-loss orders.

This level could be beyond an important support or resistance level, a round number, or a long-period moving average.

The image below is an example of a trade, where the stop loss is $20 away from the entry.

Here you can read more about stop losses and how to use them!

Exiting a Trade

Apart from being used to place your protective stop loss, technical analysis is also used for the main exit method. There really is no limit to the conditions that you could use to exit a trade, but here are two simple methods that we use a lot:

• Time Exit- You simple exit after a certain number of bars or days
• RSI Exit – for our mean reversion strategies we often use an oversold RSI reading as the exit signal

As you see, these are really simple methods, and often times they work surprisingly well!

Related Reading: Indicators for Technical Analysis

Criticisms of Technical Analysis

Technical analysis is not without some criticisms, just like everything in finance. Although technical analysis has not received as much academic scrutiny as fundamental analysis a lot of questions have been asked about whether previous price data can actually tell anything about the future price direction.

Some of the common criticisms of technical analysis are based on the following:

• The market is efficient
• Price movements are random
• Technical analysis is just a self-fulfilling prophesy

Efficient-market hypothesis

Some academic financial experts believe that the market is efficient and reflects all available information about a security, so there’s no way to identify imbalances in pricing from past market data and take advantage of it. This idea of the market is what is referred to as the efficient-market hypothesis.

Fundamental analysts and the proponents of the efficient market idea don’t believe that technical traders can find an edge in the market from analyzing price patterns and volume data. However, this theory presupposes that market participants always act rationally — which can’t be further from the truth.

Random Walk Hypothesis

Another set of economists think price movements are random and cannot be predicted by any price patterns or volume changes. This group argues that history doesn’t repeat itself because if a price pattern is known to work in a particular way, the market participants will act in such a way as to prevent it from working in the future.

But just like the efficient-market theory, the random walk hypothesis doesn’t consider the irrationality of market participants. Most of the market still is random, but there exist recurrent patterns that traders can make use of in their trading. These are what we call Edges.

Self-fulfilling Prophesy

The third criticism is that technical analysis is only a self-fulfilling prophecy when it works. In other words, many traders know the technical patterns and act the same way when the pattern appears, thereby creating a buying or selling wave in response to the pattern.

So the traders effectively fulfill their expectations of the market but may not be able to do that for long. While it may be true that the concerted actions of a large number of traders can move the market, it is simply the market forces — demand and supply — at play.

The History of Technical Analysis

While many traders, especially from the West, think it all started with the Dow Theory, the history of technical analysis can be traced to the Amsterdam market of the 17th century and Japanese rice trading in the early 18th century. However, the Dow Theory contributed a lot to explaining this way of analyzing the markets.

Why Technical Analysis Works

Despite the criticisms, evidence abounds of traders who have made a lot of money using technical analysis methods. The major reason technical analysis works is that it simplifies the process of trading. Technical analysis makes it easy for us to define what constitutes our edge in the market — trading becomes a rule-based game where you create your own rules and play by them.

It is possible to identify and define an edge in the market through technical analysis because:

• Price moves in trends and can form recognizable patterns
• History repeats itself
• Market action discounts everything

Price Moves in Trends and Forms Recognizable Patterns

The first reason we analyze price data is that price can trend in one direction or the other. There are different types of trends, depending on the duration and the timeframe you’re using to analyze the price. Long-term trends can last for several years, and you can analyze it on the monthly and weekly timeframes. Medium-term trends can be appreciated on the daily timeframe, and they tend to last from a few weeks to a few months. Short-term trends last from a few days to a few weeks, and you can analyze them on the 4-hourly and hourly timeframes.

The second reason is that price can form recognizable patterns that can help us identify when a security is likely to move in one direction. There are many small edges (patterns) that go undiscovered by the large masses, that can indicate, for example, an imminent turnaround in the market!

Technical analysis helps us to identify those price pattern directly from the price data or through an indicator. Chart patterns, such as the head and shoulder pattern, are known to occur at trend reversals. Similarly, there are technical indicators like the ADX, which can tell when a new trend is forming — more on these later.

Once again it is worth pointing out that we have not had any success with commonly used chart patterns such as head and shoulder pattern. In fact, we don’t believe in them, but choose to include them just for the sake of completeness!

History Repeats Itself

Market activity has a lot with human psychology, and moreover, humans constitute the market participants. Since humans tend to repeat their actions time and again, those price trends and patterns will keep repeating in the future. Technical analysis shows that if you want to understand what price will do in the future, you need to study what it has done in the past.

Not only do the trends and patterns repeat themselves, but the market also has memory and can remember previous important price levels (support and resistance levels). This is the reason those price levels are respected in the first place. Technical analysis helps you to identify those levels and take advantage of them.

The Market Discounts Everything

Technical analysts believe that all possible factors (fundamental, political, sentiment, climate, natural disaster, terrorism) that can affect the price of a security is already reflected in the market action. So by studying the activity in the market, a trader can identify an imbalance in the demand and supply of the security and profit from it.

Although this premise may appear similar to the efficient-market hypothesis, it doesn’t. In fact, they are miles apart. The technicians’ idea of market action discounting everything acknowledges the fact that market participants can be irrational, and this irrationality creates an imbalance in demand and supply, which is what gives rise to price trends and patterns — the very footprint technical analysis tries to find.

The efficient-market hypothesis, on the other hand, denies this aspect. It believes that the market participants are rational, and there can never be an imbalance in demand and supply, so the market is forever in equilibrium — how wrong they are.

How Technical Analysis Is Different from Fundamental Analysis

Technical analysis and fundamental analysis are the two main approaches to participating in any financial market. While with technical analysis a trader tries to use patterns and changes in the security’s price and volume, to predict the future direction of price, with fundamental analysis, an investor evaluates a security by trying to measure its intrinsic value, using such factors like economic conditions, quality of management, earnings, and revenues.

Fundamental analysis and technical analysis appear to be at the opposite end, and traders often classify themselves as either technicians or fundamentalists. But the truth is, the two approaches overlap. Some fundamental followers have a basic knowledge of technical analysis and use it to time their entry in the market. Similarly, technical traders may have some knowledge of fundamental factors and consider them when making trading decisions.

Having said that, these are some of the key differences between technical and fundamental analysis:

1. Function

The two approaches differ in how they are used: while fundamental analysis is mostly concerned with investing, technical analysis is mainly used for trading. Traders rely on technical patterns to identify opportunities to make quick profits. But investors are more likely to buy and hold an asset, so they tend to use fundamental analysis to look for stocks that suit their style.

2. Time Horizon

Fundamental analysis tends to have a long-term outlook, as fundamental investors often look for stocks that will grow in value over a long time. On the contrary, technical analysis  more often is used to find short-term trades that will yield quick profits, even though they may be quite small. The belief is that these profits can compound to huge amounts over time.

3. Main Goal

The aim of fundamental analysis is to find the intrinsic value of the asset (stock), so it focuses on factors that can be used to estimate that. A fundamental analyst will often start by studying the general condition of the economy, checking things like interest rate, commodity prices, and the political situation of the country.

The fundamentalist will study the financial situation of the company behind the stock by analyzing the quarterly earnings, sales, and revenues and compare them with similar quarters in the preceding year. At this point, the analyst will study the various financial ratios — earnings per share, price to earnings ratio, projected earnings growth, price to book ratio, price to sales ratio, and others. The analyst may even compare them with those of the company’s competitors and the industry’s average. Finally, the analyst will check the quality of the company’s management and its outlook on the long-term profitability of the company.

Technical analysis, on the other hand, aims to identify the right time to enter and exit a trade with profit by analyzing the market action — price action and changes in volume.

4. Ease of Acess to Information

Finding data for Fundamental analysis is more intense and takes more time since all the data needed for the analysis cannot be found in one place — moving from government’s websites for general economic data to the company’s website and then, to the competitors’ website.

On the other hand, the data you need for technical analysis takes less time to find. All the data you need for the analysis is there with you on your screen.

It is important to note that this by no mean suggests that technical analysis is easier! Everybody can analyze the markets technically, but very few will be able to turn their analysis into money!

5. The Rationale

Technicians and fundamental analysts act on somewhat different grounds:

Technicians make money from the fact that imbalances in demand and supply will often create some recognizable trends and patterns which can indicate the next direction of price. Technicians also believe that these patterns repeat themselves, so the analysis of previous patterns can be a profitable adventure.

Fundamental analysts, on the other hand, make money from that even though the price may not agree with the prevailing fundamental realities in the short term, over time, the market will correct itself. Thus, it’s profitable to buy and hold an undervalued stock or a stock with huge growth potentials.

6. Type of trader

Investors and long-term position traders tend to mostly make use of fundamental analysis, while short-term traders like swing traders, day traders, and scalpers make use of technical analysis. However, most of the market participants often use a combination of both.

The Common Types of Trading Charts

Charts are graphical representations of market activity. Most of the time, charts are used to represent price movements but can also be used to represent volume. Some common charts are time-based, and they include:

• Candlestick chart
• Line chart
• Bar chart
• Heiken Ashi chart

Others are not time-based, and they include:

• Tick chart
• Volume chart
• Range bar chart
• Renko chart
• Point and figure chart
• Kagi chart
• Three-line break chart

Let’s now cover all of them!

Candlestick chart

Also called the Japanese candlestick chart, the candlestick chart originated from the 18^th-century Japanese rice traders. The chart is color-coded, so the price action can easily be seen. Each candlestick shows details of price movement during a single trading session. A candlestick consists of a body, an upper, and a lower wick, and it clearly shows the:

• Opening price
• The highest price
• Lowest price
• Closing price

Below you see a candlestick chart where some candlestick patterns have been marked as well! We will have a closer look at candlestick patterns soon! If you can’t wait, we recommend that you have a look at our massive guide to candlestick patterns!

The Benefits of Candlestick Charts

Apart from showing the details of the price movement in each trading session, the candlesticks can take different shapes, which can give clues about future price movements. A few consecutive candlesticks can form patterns that are even more significant than the individual candlestick shapes.

Another interesting benefit is the customizable color-coded bodies which make the chart very visible. So you can easily see when the price gaps.

Bar chart

A bar chart is similar to the candlestick chart, and it is sometimes called the OHLC (open, high, low, and close) bar chart because each bar also shows the:

• Opening price
• The highest price
• Lowest price
• Closing price

But it differs from the candlestick chart because the bars do not have easily visible bodies.

The benefits of the bar chart

The bar chart shows some important details about the price movement. Just like the candlesticks, you can see how the highs, lows, and closes of nearby bars are related, and this may have some predictive value. For example, the bars can form patterns, such as the inside bar that you can see in the image above

Line chart

The line chart is a very simple chart and one of the earliest charting technique known. It is constructed with only the closing prices of each trading session. If you mark out the closing prices of the different sessions and connect them with a line, you have a line chart — it’s just that simple.

The benefits of the line chart

Although the line chart doesn’t provide us with much details of the price movement in each trading sessions, it may be very useful for observing the long-term trends. In addition, since the chart is cleaner, it may be easier to see certain chart patterns, such as triangles, double tops, and wedges.

Heiken Ashi Chart

This is a smoothened candlestick chart. The term Heiken- Ashi is a Japanese phrase for an average bar. So the chart is constructed to smoothen price action by using the average values of the corresponding price data. The formula for calculating each Heiken Ashi bar is:

Open = ½(Previous bar’s Open + Close)

Close = ¼(Open + Close + High + Low)

High = highest of [High, Open, or Close]

Low = lowest of [Low, Open, or Close]

The benefits of Heiken Ashi chart

Although it doesn’t show the real-time price levels, the Heiken Ashi chart reduces noise and makes it easy to identify the main trend. With its color-coded bodies, you can easily see if the price is rising or falling. It helps traders to confirm when the trend has reversed.

Tick Chart

Tick charts are charts that present a specified number of ticks per bar. In other words, each bar on the tick chart represents the OHLC of a specified number of ticks, and a tick represents a trade. A 144-tick chart means that each bar represents 144 trades.

A bar closes when the specified number of trades is reached, irrespective of how long it takes. So unlike the candlestick chart, a tick chart is not dependent on time. But there’s no limit to how far the price movement in a bar can be. Setting the number of ticks per bar is often dependent on the market’s volatility. Some also use Fibonacci numbers.

The Benefits of the Tick Chart

Since each bar represents the same number of transactions and not the number of transactions per time unit, you know that each bar is as significant as the other in terms of volume.

Volume Chart

Similar to the tick chart, the volume chart directly displays market activity. While a tick represents a trade, the volume is the number of shares or contracts traded. Just like in the tick chart, a bar in the volume chart represents the OHLC of a fixed volume, so a 500-volume chart means that 500 contracts/shares are transacted for each bar.

The Benefits of the Volume Chart

The main benefit of the volume chart is that the rate the bars are being printed depends on the activity in the market. When the market is sluggish, fewer bars are printed, so it can smoothen the price waves, making the direction of the trend more obvious.

Range Bar chart

In this type of chart, only the price is considered. Each bar represents a specified range (between its low and high) of price movement in either direction. When the price complete the specified range, it opens a new bar. Therefore, every bar has the same range and closes either at its low or high.

The Benefits of the Range Bar Chart

Because a bar doesn’t close until the specified range is completed, the range bar chart can reduce the noise that occurs as price bounce back and forth at a support or resistance level. So it can show when the price has truly broken out of a consolidation level.

Renko Chart

Renko is a Japanese word for brick, and with the Renko chart, the bars are referred to as “bricks”. Just like the range bar, the brick size must be specified. In the Renko chart, each brick is printed only when the price has moved more than a brick size away from the preceding brick. Thus, consecutive bricks cannot occur beside each other, and the chart doesn’t show the exact price action.

The Benefits of the Renko Chart

It filters out whipsaws that are smaller than the brick size in the trend direction and two bricks in the opposite direction. So it simply shows the direction of the main trend and could be good for trend-following purposes.

Point and Figure Chart

The point and figure charts plot price movements by marking columns of “X” and “O” to indicate rising and falling prices respectively. The “X” and “O” are placed in separate columns, and each X or O represents a box, whose value must be specified. In addition to the box value, the number of boxes that represent a reversal must be specified.

The Benefits of Point and Figure Chart

The chart can be great for trading price breakouts, but you will need a lot of practice to understand how it works. Also, the point and figure charts have some specific chart patterns that can give trend signals.

Kagi chart

Unlike the point and figure chart which uses boxes, the Kagi chart uses a continuous line to represent the price movement, with the direction of the line showing the direction of the price.

So the Kagi chart doesn’t need a box size, but the reversal amount must be specified. When price moves in the opposite direction by the specified reversal value, the chart line will change direction.

The line has different colors, depending on whether the price has made a higher or lower swing than the preceding swing high or low.

When the price moves above the preceding swing high, the line changes color, and it’s called the Yang line. When it falls below the preceding swing low, it’s called the Yin line.

The Benefits of the Kagi chart

The Yang and Yin lines indicate price breakout and breakdown, which can provide profitable trading opportunities in a trending market.

Three-line Break Chart

The three-line break chart plots a series of lines in accordance with the closing prices of the underlying time chart. It draws a new line in the same direction if the underlying time-based chart closes beyond the preceding line in the same direction. A line is plotted in the opposite direction (price reversal) if the underlying time-based chart closes beyond the last three lines — the reason it is called the three-line break chart.

The Benefits of Three-line break Chart

It is very helpful in spotting trend reversals. The chart is also great for analyzing support and resistance levels.

Now that we have covered the various chart types, let’s have a look at the two main distinctions within technical analysis, namely price action trading and indicator trading. Once we’ve done that, we will cover each separately!

Price Action Trading V.S Indicator Trading

As said, the most common distinction in technical analysis is the one between price action trading and indicator trading.

Price action trading is a type of technical trading where the price data is directly analyzed without the help of an indicator, so the price itself becomes the indicator. This is in contrast to another form of technical trading where traders use one or more indicators to analyze what price is doing — indicator trading.

Price Action Trading

In price action trading, traders use price patterns — such as candlestick patterns and chart patterns — to identify potentially profitable trading opportunities. Candlestick patterns refer to the patterns formed by one or a few consecutive candlesticks, such as the hammer, tweezers, evening star, and others (which will be covered soon), while chart patterns refer to those multi-candlestick structures that form on the chart. Examples of chart patterns include triangles, wedges, flags, and head and shoulder (also covered soon)

Indicator Trading

On the other hand, with indicator trading, traders use some indicators to identify trade signals. There are hundreds, if not thousands, of indicators available to traders, and each one analyzes price in a different way. Some are used to show the direction of the trend, while some others measure the price momentum. A few may lead the price, but most are lagging.

Differences

Price action traders identify trend direction by checking the direction of the impulse and corrective waves, as well as the positions of swing highs and lows. If the impulse waves are up and the corrective waves are down, the price is in an uptrend — there are successive higher swing highs and higher swing lows.

In a downtrend, there are downwards impulse waves and upwards corrective waves, giving a series of lower swing lows and lower swing highs. To make the trend clearer, price action traders often attach a trendline to the successive swing lows or swing highs.

Indicator traders, on the other hand, use indicator such as moving averages and ADX to identify a trend. While ADX can identify when the price is trending, it cannot identify the direction of the trend.

Moving averages can identify a trend and its direction — an upward sloping moving average line indicates an uptrend, a down-sloping line shows a downtrend, and a flat line indicates a range-bound market.

Price action traders are particularly concerned about price levels and often use tools like Fibonacci retracement and expansion tools and pivot lines, in addition to swing highs and lows, to identify support and resistance levels. They also take note of important round numbers.

While indicator traders also use those tools, they are more concerned about using momentum indicators to identify price momentum. Examples of the indicators they use to identify price momentum are MACD, stochastic, RSI, and CCI.

Just remember that most traders use a combination of both methods. The examples above are highly generalizing, and are made in an attempt to make the two trading styles easier to grasp!

Comparing Price Action and Indicator Trading

	Price action trading	Indicator trading
What the trader watches	Naked price action	Price data plus indicators
How to identify a trading opportunity	Candlestick pattern Chart pattern	Indicator signals
Signal timing	Current information, not lagging	Mostly lagging
Tools for analysis	Tools like Fibonacci, pivot lines, and trendlines.	Indicators like Moving averages, ADX, MACD
Nature of chart	Chart is neat	Chart is accompanied with indicators

Price Action Trading

As mentioned, price action traders watch naked price action in an attempt to gain clues about where the price is headed. In this section of the article, we will cover the most popular ways of trading price action, which are:

• Support and resistance
• Candlestick patterns
• Chart patterns

Volume is also used frequently by price action traders, and we’ve decided to put it under its own heading, later in the article. As always you can use the toggle above to navigate around the article.

Support and Resistance

Support and resistance are price levels at which price tends to stop and reverse because of the high volume of orders. Support and resistance are characterized by the price reaching those levels on several occasions without being able to break them. Support levels lie below the current price level, while resistance levels are above.

A resistance level is a price level where a price rally is expected to reverse or, at least, temporarily pause. It happens because there’s a huge concentration of sell orders (increased supply) at that level. Most often, a little beyond the resistance level lies a high volume of stop orders (which are buys orders), so when price breaks through a resistance, it can trigger those orders and rise very fast, leading to what is known as a breakout.

Conversely, the support level is where a downward price swing meets huge buy orders (increased demand), which can reverse the price to the upside or, at least temporarily halt the descent. There are often huge volumes of stop orders a little below the support level which if triggered, can lead to a downward price break (breakdown).

How to Identify Potential Support and Resistance Levels

There are many ways technical traders recognize potential support and resistance levels. The commonest way is to draw a horizontal line connecting previous swing highs and swing lows that lie at the same level. This way, you will notice that a level can act as a support if the price is above it and act as resistance if the price is below it.

Another way of identifying potential support and resistance levels is by using the pivot lines. Pivot lines are horizontal lines drawn at the pivot points — price levels calculated from the average of high, low, and closing prices of the preceding day, week, or month.

Fibonacci tools are also used to identify possible resistance and support levels. The Fibonacci retracement, extension, and expansion levels often act as important price levels. Important Fibonacci levels include 38.2%, 61.8%, 100%, 144%, and others.

Some price action traders also use a trendline to identify dynamic support and resistance levels.

Using Support and Resistance in Trading

Because of what they represent — demand and supply levels — technical traders attach much importance to the support and resistance levels when making technical analysis. Traders usually watch these levels very closely to see how the price behaves when it gets to them.

While some will be looking to take a price reversal position, others will be looking forward to a breakout/breakdown. But a smart trader should be flexible and open to both scenarios and have strategies in place to act based on what the price does.

For reversal strategies, price action traders often look for reversal candlestick patterns and relevant changes in volume. Those looking forward to a breakout/breakdown are watching for a price close beyond the level on a high volume.

Candlestick Patterns

We’ve touched on candlesticks already when we covered different chart types. However, when using a candlestick chart, you will be able to spot many patterns which quite naturally are called candlestick patterns.

Price action traders make use of many candlestick patterns in their analysis, but here, we will discuss the most common ones.

Here is a nice infographic on how candlesticks work, in case you don’t remember.

Hammer and Shooting Star

These are single candlestick patterns that may indicate potential price reversals, depending on where they occur. The hammer has a small body at its upper part, a long lower shadow that is more than twice the length of the body, and little or upper shadow. It appears after a price swing down, and it’s interpreted as a bullish reversal signal.

The shooting star is the opposite of the hammer. It has a little body at its lower end, long upper shadow, and little or no lower shadow. The shooting star occurs after a price swing high, and it’s taken as a bearish reversal signal.

Engulfing patterns

The engulfing patterns are two-candlestick patterns that indicate possible price reversals. They are classified into bullish and bearish engulfing patterns, depending on where they occur. The bullish engulfing pattern consists of a long bullish candlestick that completely engulfs the preceding bearish candlestick. It occurs during a downswing and is interpreted as a bullish reversal signal.

In the bearish engulfing pattern, a tall bearish candlestick completely consumes the preceding bullish candlestick. It is seen in an uptrend or an upward price swing and may indicate a potential bearish price reversal.

Tweezers

These are double candlestick patterns that may indicate potential price reversals. The tweezers are grouped into the tweezer top or tweezer bottom. A tweezer top pattern consists of two consecutive candles with similar highs occurring in an uptrend or a swing high in a downtrend. It is seen as a bearish reversal signal.

The tweezer bottom pattern (below) occurs during a downtrend or swing low in an uptrend. It consists of two consecutive candles with identical lows, and it’s interpreted as a bullish reversal sign. One interesting fact about the tweezers is that in a much lower timeframe, the pattern becomes a double top or double bottom chart pattern.

Piercing and Dark Cloud cover

These are another set of two-candlestick pattern that may signal a potential price reversal. The piercing pattern occurs in a downtrend or a downward price swing during an uptrend. It consists of a bearish candlestick and a big bullish candlestick that opens below the low of the first candle but closes above its midpoint. It is usually seen as a bullish reversal signal when occurring at a support level.

The dark cloud cover is the opposite and occurs in an uptrend or an upward price swing in a downtrend. The first candlestick in the pattern is bullish, while the second candlestick is tall and bearish. The second candlestick opens above the first candlestick and closes below its midpoint. The dark cloud cover is interpreted as a bearish reversal signal, especially when occurring at a resistance level.

Morning and Evening Star

These patterns consist of three candlesticks and may signal price reversals, especially when occurring at important price levels. The morning star forms in a downtrend or a price swing low in an uptrend, and it is seen as a bullish reversal signal when occurring at an important support level. The first candlestick in the pattern is bearish, the second is a small candlestick that gaps below the first candlestick, and the third candlestick is tall and bullish.

Occurring during an uptrend or a swing high in a downtrend, the evening star is interpreted as a bearish reversal signal, especially when it forms at a resistance level. The first candlestick is bullish, the second is small and gaps up, while the third is a tall bearish candlestick.

How to Trade Candlestick Patterns

The candlestick patterns are often better off combined with support and resistance levels and trendlines. One of the most common approaches is to trade in the direction of the predominant trend and use the candlestick patterns to confirm the end of a pullback in that trend.

In the image below you see how we have found a rising trend, where we have connected the swing lows of the trend with a trend line. We expected the price to revert around the rising trend line, but decided to wait for confirmation in the form of bullish reversal candlestick patterns. These are arrow marked below.

If you want to learn more about candlestick patterns, make sure to check out our massive article on candlesticks!

Chart Patterns

There are numerous chart patterns a price action trader can use. Here, we will discuss the most popular ones:

Head and shoulder

The head and shoulder pattern is a well-known trend reversal pattern, which occurs after a prolonged uptrend. It shows that the price is unable to make a higher swing high, and instead of pushing higher, the price turns downwards.

The pattern consists of an initial swing high (left shoulder), a higher swing high (head), and a third swing high (right shoulder), which is lower than the preceding swing high (head). The pattern completes when the third swing turns downwards and breaks the neckline —the trendline connecting the troughs of the preceding swings.

A similar but opposite formation that occurs after a prolonged downtrend is known as the inverse head and shoulder pattern.

Double Tops/Bottoms

These are strong trend reversal patterns. The double top pattern is a bearish sign and occurs after a prolonged uptrend when the price reaches a similar level on two consecutive occasions with a moderate swing low between the two swing highs. The pattern is completed when the price falls below the line connecting the intervening swing low to the preceding swing low — the neckline.

A double bottom is a bullish reversal signal. It is formed in a prolonged downtrend when the price reaches the same low level two consecutive occasions. A line joining the intervening swing high to the preceding swing high constitutes the neckline. A price rise above the neckline completes the double bottom pattern.

Wedges

There are two types of the wedge pattern: the rising wedge and the falling wedge. The falling wedge consists of a series of rapidly falling swing highs and a gradually falling swing lows — giving the appearance of a wedge. In a rising wedge, the swing lows are steeply rising, but the swing highs are rising gradually. A falling wedge is interpreted as a bullish signal, while a rising wedge is seen as a bearish signal. So, a wedge pattern can indicate a trend continuation or a trend reversal.

A falling wedge in an uptrend is indicative of a potential uptrend continuation, but a rising wedge in an uptrend may signal a potential trend reversal. In a downtrend, a rising wedge indicates a possible downtrend continuation, while a falling wedge may mean that the downtrend is coming to an end.

Triangles

Triangles are often seen as trend continuation patterns, but the price can break out in either direction. There are three types of triangles: ascending, descending, and symmetric triangles. The ascending triangle is formed by a series of rising swing lows with the swing highs at the same level.

A descending triangle is formed when there are similar swing lows and a series of declining swing highs. In a symmetric triangle, the swing highs are descending, while the swing lows are ascending.

Flags and Pennants

These patterns are considered trend continuation patterns, and they occur in both uptrend and downtrend. The flag pattern is a rectangular pattern that occurs after an initial rapid price movement. It shows that the price is consolidating after the initial big move.

The pennant pattern is very similar to the flag except that it is a small triangular structure, instead of rectangular.

How to Use the Chart Patterns in Your Trading

To increase the odds of a trader, you can combine the chart patterns with support and resistance levels and candlestick patterns. And most importantly, observe the changes in volume.

In a head and shoulder pattern, for instance, the right shoulder should be formed on a decreasing volume, while the break of the neckline should be on a high volume. Similarly, the breakout/down of the other chart patterns should be on high volumes.

Now we are soon moving to cover technical trading indicators, but first, we will cover the difference between leading and lagging technical indicators!

Leading vs. Lagging Technical Indicators

Some technical indicators tend to show their signal before the associated price move, and they are called leading indicators; others tend to show their signal after the price has moved, and they are called lagging indicators.

Leading Indicators

A leading indicator is a technical indicator whose signal precedes the price action that it tracks. It gives a signal about price reversal before the reversal occurs. Leading indicators may be good for catching new trends early, but they can give a lot of false signals. So they can be misleading at times.

Some leading indicators are volume-based, while some are price-based. The volume itself tends to lead price. Other examples of volume indicators that are leading include on-balance volume, accumulation distribution index, demand index, and a few others. The price-based leading indicators include momentum indicators or oscillators like RSI, Stochastics, CCI, Williams %R, and others.

Lagging Indicators

A lagging technical indicator is one whose signal comes after the price action has taken place. Lagging indicators tend to show the trend after it has started. While they are not good at showing trends early, they may be good for confirming the new trend. But they often bring you late to the party.

Trend indicators like moving averages, ADX, and parabolic SAR are lagging in nature. The same is also true for some volatility indicators like the Bollinger bands.

How to Use Leading and Lagging Indicators in Trading

As you have seen, leading indicators can help you catch the entire trend but will often lead you to make wrong calls. On the other hand, if you use only lagging indicators, you will most likely enter your positions late. So the best thing is to use a combination of the two.

Furthermore, when using a leading indicator, you may look for divergences instead of the traditional indicator signal cross. (Such in the image below, where we see a bullish divergence between price and the stochastic indicator.)

By signal cross, we mean indicators that have a moving average of the indicator reading inbuilt. When the indicator line crosses the moving average it is usually seen as confirmation of a new direction. Below, you see how the stochastic indicator very well consists of two lines, where the red line is the moving average.

Let’s now have a look at some of the most popular trading indicators!

Trading Indicators 

Trading indicators are graphical representations of mathematical calculations that are used to analyze market action. Some traders base their trading decisions mostly on one or more indicators. There are many indicators and tools available to traders. Most of them are used to analyze a security’s price data, but some are used to analyze volume or a combination of both. A few others are used to check the market breadth.

Below we will Briefly cover quite a lot of trading indicators. If you are interested in finding out more about one indicator, just click the link, and you will be taken to an article that describes

Price-based Indicators 

These include indicators that make use of only price inputs, as well as other tools that can be used to analyze price levels and movements:

ADX

The average directional index is a non-directional indicator that some traders use to gauge the strength of a trend. The ADX itself cannot identify the direction of the trend, so it is always accompanied by two other indicators: positive directional movement indicator (+DMI) and negative directional movement indicator (-DMI). When the ADX line is above 25, the trend is strong, and when it’s below 20, the trend is weak. Price is moving up if the +DMI is above the –DMI.

Here you can read more about ADX.

RSI

The relative strength index is an oscillator that measures price momentum by checking the ratio of recent bullish and bearish trading sessions. It is standardized to oscillate between 100 and 0. The price is considered oversold when the indicator is below 30% and overbought when the indicator is above 70%.

Here you can read more about RSI

Moving Averages

They are used to smoothen price data by getting a continuous n-period average of the price data. There are different types, depending on the weight given to recent price data: simple, exponential, linear-weighted moving averages. A trend is up if the moving average is pointing up, and down when the slope downwards.

Here you can read more about moving averages.

Bollinger Bands

These are two lines plotted two standard deviations away (one above and below) from a simple moving average of the price. The indicator can expand when volatility is increasing and contract when volatility is reducing. It also shows how far the price is from the mean, so it can be used to trade mean-reversion strategies.

Here you can read more about Bollinger Bands.

Stochastic Oscillator

This indicator tries to measure price momentum by comparing the recent closing price to an n-period range. It oscillates between 100 and 0 and can be used to show overbought and oversold levels. A rise above 80% level is overbought, and a decline below the 20% level is oversold.

Average Directional Movement Rating (ADXR)

The ADXR measures momentum change in the ADX, so it helps to determine the trend. A rising ADXR, with the ADXR and +DMI above the –DMI, indicates a strengthening bullish trend. When the ADXR is rising and both the ADXR and the –DMI are above the +DMI, there’s a strong bearish trend.

Commodity Channel Index (CCI)

It is a momentum indicator that traders use to identify cyclical trends. It oscillates between extreme positive and extreme negative values. Being an oscillator, it can be used to determine overbought and oversold levels. Above +100 is overbought, while below -100 is oversold.

Williams %R Momentum Indicator

Also called Williams percent range, this is a momentum indicator that oscillates between 0 and -100. It can be used to gauge oversold and overbought levels. When the indicator is above -20, the price is overbought; when it is below -80, the price is oversold.

MACD

The moving average convergence/divergence indicator measures price momentum by comparing the difference between two exponential moving averages (MACD line) with the moving average of the difference (signal line). A rising MACD line shows an upward price momentum, while a falling MACD line indicates downward momentum. A rise above the signal line even shows a bigger upward momentum and vice versa.

Here you can read more about MACD.

Coppock Curve

This measures the long-term momentum in a stock, and it’s used to identify major market bottoms. It is a 10-month weighted moving average of the sum of 11-month and 14-month rates of change for the market index. It is mostly used to analyze ETFs to determine major trends and identify future risk.

Trix

It is a triple exponentially smoothened moving average. It measures momentum and the strength of a trend. It is an oscillator that moves above and below the zero line. It can show divergence with the price, which is its most effective signal.

Ichimoku Cloud

Ichimoku Cloud is a set of overlays that show price momentum, trend direction, and support and resistance levels. It consists of five lines and is based mostly on moving averages. Two of the lines form a cloud, which shows the direction of the trend. When the price is above the cloud, the trend is up, and if the cloud is also moving up, the uptrend is very strong.

Parabolic SAR

Also known as the parabolic stop and reverse, this indicator is used to determine the direction of short-term trends. It is represented as dots: if the trend is up, the dots will appear below the price, and if the trend is down, the dots will appear above the price.

Fibonacci Lines

These are horizontal lines that act as support and resistance levels. They are based on the Fibonacci ratios and their derivatives: 23.6%, 38.2%, 61.8%, etc. There are three groups of the Fibonacci lines:

• Fibonacci retracement: Gauges how much the price has retraced from the previous swing high/low
• Fibonacci extension: Measures how much the price has extended from the preceding swing high/low
• Fibonacci expansion: Compares the size of a new swing with the preceding swing

Trendline

As the name implies, it is a straight line used to indicate the direction of the trend. It is drawn by connecting the swing lows in an uptrend or the swing highs in a downtrend. When price breaks its trendline, it might mean that the trend is changing direction.

Channel

When a line, parallel to the trendline, is drawn from the opposite swing low/high, the two lines now constitute a price channel. A break above or below the channel lines might be a sign of change in trend direction.

Pivot Points

They are points calculated from the preceding day, week, or month’s price range. They indicate potential demand and supply zones. Lines drawn at those points are seen as support and resistance levels.

Volume-based Indicators

This group of indicators makes use of volume data in their calculations. The following are some of the common volume indicators:

On-balance Volume

This is an oscillator that uses volume data to determine the potential changes in price direction. It is calculated by adding or subtracting volume from the previous value, depending on the direction of price close. Divergence from price can indicate a potential trend change.

Positive Volume Index

Also known as the PVI, the positive volume index tries to predict changes in price by computing positive changes in trading volume. It tracks when there’s herd activity by the retail investors. The PVI may be useful in gauging the strength of price trend and identifying potential price reversals.

Negative Volume Index (NVI)

The NVI is often used in combination with the PVI. It focuses on days when the volume is lower than the preceding day’s volume. It tries to understand when the smart money is quietly accumulating positions in the market.

Williams Accumulation/Distribution

Also known as accumulation/distribution index, this indicator uses volume and price changes to determine whether a security is being accumulated or distributed by institutional investors. Being a cumulative indicator, it rises and falls with price, so when there’s a divergence between the indicator and the price, it shows a potential price reversal.

Money Flow Index

This is a momentum indicator that uses volume and price data to gauge how money is flowing in and out of a security. It is the volume version of RSI. Being an oscillator, it can be used to determine oversold and overbought levels. Below 20 is seen as oversold, while above 80 is taken as overbought.

Market Breadth Indicators

Unlike the other indicators that analyze the activity in a particular stock, the indicators in this group are used to check how well the entire market is performing. They are used to measure the strength of the market as a whole:

Advance/Decline Line

The advance/decline line is used to measure how the stock market is performing. It is a cumulative indicator that measures the difference between the number of stocks that closed positively and the number that closed negatively and adds the result to the previous value. So it rises when the number of advancing stocks exceeds the declining ones and falls when the declining stocks are more than the advancing ones.

Arms Index

Also known as the Trading Index (TRIN), is an oscillator that measures the market strength or weakness by comparing the advance/decline ratio to the ratio of traded volumes of advancing/ declining stocks. A rising TRIN indicates a weak market, while a falling TRIN indicates a strong market.

McClellan Oscillator

This oscillator is gotten by subtracting the 39-day exponential moving average of Net Stock Advances from the 19-day exponential moving average of Net Stock Advances. Being an oscillator, it can form divergences. A divergence between the oscillator the stock market index (S&P 500, for example) may indicate a potential reversal in the direction of the index.

Seasonality in the Market

“There is a season to everything”, they say. And this includes the stock market. Just as businesses and the economy move in cycles, the stock market also has seasons. Seasonality in the stock market is a characteristic of the market that explains why the stock market tends to perform better during certain periods of the year.

Apart from the broad market, individual stocks tend to show some seasonality in the way they move. While some tend to perform better during the summer, others perform very great during the other seasons of the year. It is worth noting that seasonality is an issue of probability, not a certainty. Although there are some kinds of correlation between the months or seasons of the year and the stock market performance, nothing is guaranteed.

Broad Market Seasonality

The S&P 500, which measure the broad market performance, tends to perform better in certain months of the year than others. The historical performance of the S&P 500 shows that some months have been significantly bullish and some bearish.

From the picture above, which shows the average monthly returns of the S&P 500 from 1964 to 2015, you can see that the market usually perform better at the beginning of the year and towards the end of the year. This has given rise to three popular seasonality slangs in the Wallstreet:

1. January Effect: The events that lead to this effect starts from the last trading day of the year when investors try to offset losing stocks so that they can claim tax losses. Bargain hunters would move in to buy up the stocks at the beginning of the year, thereby creating a significant buying pressure that drives the market up.
2. Sell in May and Go Away: From the month of May to the beginning of October, the market tends to underperform, so the financial media coined that phrase to indicate that. This may not be unconnected to the fact that the big boys may be on summer vacations.
3. End of the Year Rally: Also known as the Santa Claus Rally, this is used to show the fact that from October to the end of the year, the market seems to perform well. One of the explanations of this pattern is that people seem to be happy around this period, so they buy more stocks.

Seasonality In Individual Stocks

Seasonality in individual stocks is related to the fact that certain businesses thrive at different times of the year. For example, a company that sells swimming suits will tend to have high sales in the summer but may not have a lot of sales during the fall and winter months. So the stock of such a company may tend to show some summer-winter seasonality.

Similarly, oil prices tend to increase in the summer when cars are used more frequently for vacations and the rest. The same may also apple to stocks in travel-related products and services. In climes that get really hot during the summer, stocks of companies that offer air conditioning solutions may also tend to do better in summer than other seasons.

How Traders Use Seasonality in Trading

Judging from the picture of the historical average monthly returns, it may appear wise to look for buying opportunities in October and try to sell in April. But you should know that past performance is not always indicative of future performance. Moreover, seasonality in individual stocks can vary widely from that of the S&P 500 Index.

As a stock trader, it’s better to study your stock picks for seasonality patterns. If you notice a high degree of seasonality in a stock, try to look for buying opportunities in the stock during those seasons it usually trends up. Another approach is to avoid shorting seasonal stocks during the seasons they normally trend; you may short them during their off-seasons.

Objectives, Features and Limitations

Technical analysis is a method used to evaluate and predict future price movements of financial assets, such as stocks or currencies, by analyzing historical market data, primarily price and volume. Its features include the use of charts and technical indicators like moving averages and relative strength index to identify trends and patterns. The main objective of technical analysis is to forecast future price trends and make informed trading decisions. However, it has limitations, including the potential for subjective interpretations and the assumption that past trading activity can predict future performance. Technical analysis operates on the principle that market psychology influences trading in a predictable manner.

Common Trading Strategies Using Technical Analysis

Technical analysis is very subjective, so each trader is at liberty to design a strategy that suits him. There are probably more technical trading strategies than there are traders, as a trader can have an almost limitless amount trading strategies.

But most of the popular technical trading strategies fall under these common types:

• Momentum trading strategy
• Breakout strategy
• Mean reversion strategy

Momentum Trading Strategy

A momentum trading strategy is a strategy that aims to buy or sell a stock depending on the strength of recent price moves. The strategy aims to pick trades in the direction of the trend — since it’s believed that the strongest momentum lies in the direction of the trend — but doesn’t just follow the trend blindly.

Traders who follow this strategy may add one or more momentum indicators to their chart. Most of them use the RSI, stochastic, CCI, or William’s %R indicator to identify oversold and overbought regions. Some also use the MACD or OsMA. The idea is to use the momentum indicators to know when a pullback is over and then put a trade in the trend direction.

Generally, the strategy involves:

1. Identifying a trend
2. Watching for a pullback
3. Using a momentum indicator to gauge when the pullback is exhausted and momentum shifting to the trend direction

Using RSI for example, if the trend if up, wait for a pullback to occur and the RSI to reach the oversold region (below 30%). When the RSI line is climbing up above the 30% line, enter long.

For a downtrend, wait for a rally (pullback) and check if the RSI has gone above the 70% line (overbought region). Enter short when the RSI begins to fall below the 70% line.

Another interesting feature of the momentum indicators that can be used for this strategy is indicator-price divergence. While divergence may be more accurate than the usual indicator signal, it doesn’t occur very often.

Breakout/down Strategy

Breakout is a very popular strategy because of how fast the price can move when the breakout is genuine. A breakout trader aims to enter a long position when the price rises above a known resistance level and enter short when the price falls below a support level. With this strategy, you’re trying to buy high with the hope that you can sell even higher, so it is premised on the greater fool theory — there will always be someone ready to pay higher for a rising stock.

Being able to identify important support and resistance levels is an important part of the strategy, so you could benefit from tools like pivot lines and Fibonacci lines. You should also be able to identify support and resistance levels by looking at the previous price swing highs and lows.

To reduce the frequency of false breakout, it is most preferable to trade breakouts in the direction of the trend, thus, you may need a moving average or the ADX to identify a trend, in addition to a trendline. Another factor that could greatly improve the odds of your trade is volume.

When you have identified the trend and the support or resistance level, wait for the price to close beyond the level with an increase in volume. Then, enter a trade accordingly.

Mean Reversion Strategy

This approach is based on the fact that stock prices tend to revert to the mean after making a sizeable advance or descent. It is a contrarian approach to trading, as it means going against the trend on some occasions.

Indicators and tools you can use to trade this strategy include:

• Bollinger bands
• Standard deviation
• Channels
• Oscillators
• volatility index

Using the Bollinger bands, for example, you look for shorting opportunities when the price has gone above the upper Bollinger band with the hope that the price will revert to the mean (the middle band). You look for buying opportunities only after the price has gone below the lower Bollinger band.

Oscillators, such as stochastic, RSI, and Oscillatory moving average (OsMA), can also be used for the strategy. Here, you look for extreme oversold and overbought levels.

How to Use Volume With Technical Analysis

Volume measures the total amount of shares or contracts of a security traded during a specified period of time. Depending on the market, it could also mean the number of times the security was bought or sold during a given time. It is a very important market data that when used correctly, can improve the quality of your trades.

Changes in volume can tell a lot about what has happened in the market. With volume, you can estimate the forces of demand and supply at play. There are different ways to use the volume data in trading, but generally, traders use volume in the following ways:

To Gauge the Strength of a Price Move

Traders often use volume to check if there’s strength in a price move. When the price is moving up, the volume should increase, or at least stay stable, to show that the move is attracting other buyers. Similarly, when the price is going down, the volume should increase or stay stable to show that the bears mean business. A significant price move without an associated rise in volume is generally a sign of weakness.

For instance, in a breakout or breakdown, traders might check to see how the volume of the breakout/down candlestick compares with the recent periods. If the volume is higher than the preceding periods, it is seen as a sign of strength, and the odds are high that the price will continue moving.

On the other hand, if the volume on a breakout/down is lower than the previous sessions or remains the same, the breakout might be more likely to fail.

To Spot Exhaustion Moves

Exhaustion moves are huge moves that occur toward the end of a trend. If it happens at the end of an uptrend, it is called a buying climax. It shows that traders and investors, who initially missed the rally, finally jumped in to avoid missing out on the move. In a downtrend, it is called a selling climax or capitulation — indicating that investors that held their positions during the decline finally gave up and sold everything.

To identify these moves, you should know that they occur after a prolonged trend. They are accompanied by high volumes, but that is not all. After an exhaustion move, there is usually a decrease in volume in the days and weeks that follow.

To Confirm a Potential Change in Trend

Volume can help traders confirm that a trend reversal is underway. Normally, in an uptrend, you expect to see the price swings making higher highs and higher lows. If the price makes a lower low and a lower high, the trend may be reversing to the downside. But you might need volume to confirm it!

If the lower low was made on a high volume while the lower high (now a pullback) was made on a low volume, the momentum may have shifted to the downside. The opposite is true for an upside reversal of a downtrend. This can help you to trade reversal chart patterns like head and shoulder.

To Recognize Possible Accumulation or Distribution

Institutional traders often take time to accumulate their positions (gradual buying) after a downtrend. In a similar way, after an uptrend, they distribute their positions in a gradual manner. When they are doing these, the market tends to stay in a tight range (consolidation).

Traders can use volume analysis to spot these activities of smart money. When the price is in a tight range (with little price movement) after a prolonged rally or decline and the volume is increasing, the smart money may be accumulating or distributing their position. Divergence in volume indicators like accumulation/distribution and on-balance volume can help you identify these activities!

How to Use VIX in Trading

The VIX is a volatility index created by the Chicago Board of Options Exchange (CBOE) to measure the implied volatility in the S&P 500 Index. It is calculated from the prices of the S&P 500 Index (SPX) options prices, so it tracks investors’ expectations by measuring the changes in option premiums.

When it comes to trading, traders use the VIX Index differently. For most traders, the VIX Index can be used to:

Gauge the Volatility in the Market

The VIX Index was created to assess the traders’ expectations about volatility in the U.S. stock market by tracking the implied volatility in the broad-market index, the S&P 500 Index. It measures investor sentiments and what they think about future movements in the S&P 500 Index.

An 18% reading in the VIX Index means that the annualized value of the change expected in the S&P 500 within the next 30 days is 18%. To get the monthly value, you divide the value with √12 — 4.24%, in this case. So in the next 30 days, the S&P 500 Index is expected to move about 4.24%.

Anticipate Major Market Corrections

Although the VIX Index is meant to track volatility in the S&P 500 Index in both directions — up or down — because of how the put and call options prices are weighted, it often tends to rise only when the S&P 500 Index (broad market) is going down.

Here’s why it happens that way: The institutional investors tend to buy more put options when they think that the market is about to turn bearish. The increased demand for put options drives the put premiums high, leading to an increase in the VIX Index. Since the rise can precede the change in the S&P Index, it can indicate an imminent market correction.

Determine When a Market Correction Is Over

During market corrections, there’s too much fear in the market, and the VIX Index spikes up, rising above 40% and more. When confidence starts to return to the market, the VIX index starts to come down gradually. This move may precede the reversal in the S&P 500 Index and can be used to time the end of the market correction.

After a major market correction, traders may want to check the VIX Index to estimate when confidence has started returning to the market so that they can start taking positions. A fall towards 20% (In VIX) after such a spike is a sign of returning confidence.

Trade S&P 500 Index Funds

Apart from using the VIX Index to gauge what is happening in the broad market, you can use it as an indicator to trade the S&P 500 index funds — both ETFs and mutual funds. Generally, when the VIX is falling, the S&P 500 index funds are going up, and when the VIX is going up, the S&P 500 index funds are falling.

Because the VIX Index is mean-reverting, when it is at the extremes (above 40% and below 10%), there’s a great chance that it will revert towards the mean.

Trade Volatility-based Securities

There are several exchange-traded products that try to track the VIX Index, such as ProShares Ultra VIX Short-Term Futures ETF (UVXY) and Path S&P 500 VIX Short-Term Futures ETN (VXX). Traders who trade these volatility-linked products often use the VIX Index to time their trades.

However, it should be noted that those products don’t track the VIX Index directly, rather, they are indexes of VIX Index futures. So they are subject to the effects of contango (covered in our VIX article).

Interested in knowing more about the Volatility Index (VIX)? Then we suggest you read our massive guide to VIX

Assumption of technical analysis

The assumption of technical analysis is that market prices reflect all available information, making historical price patterns and trends key to predicting future movements. It operates on the belief that price movements are not purely random but influenced by traders’ collective behaviors and market psychology.

Limitation of technical analysis

The limitations of technical analysis primarily revolve around its reliance on historical market data, which may not always predict future movements accurately. This method often overlooks macroeconomic factors and market sentiment, which can lead to misleading signals and potential misjudgments in volatile markets.

Importance of technical analysis

The importance of technical analysis in financial markets cannot be overstated. It provides traders and investors with tools to assess market trends and make informed decisions based on historical price movements and volume data. By identifying patterns and signals through various technical indicators, such as moving averages and relative strength index, investors can predict potential price changes and manage risk effectively. Technical analysis also enables a disciplined approach to trading, helping to mitigate emotional decision-making. Whether used alone or alongside fundamental analysis, it plays a crucial role in building robust trading strategies in both short-term and long-term investment scenarios.

Advantages of technical analysis

The advantages of technical analysis lie primarily in its ability to identify patterns and trends in market data, facilitating informed trading decisions. By focusing on price movements and trading volumes, it bypasses the need to analyze a company’s fundamentals. This approach is particularly valuable for short-term traders looking to capitalize on market sentiment and price momentum. Moreover, technical analysis offers the benefit of applicability across various markets and assets, making it a versatile tool for investors. It also provides clear, visual representations through charts, making it easier to interpret and react quickly to market changes.

Objectives of technical analysis

The primary objectives of technical analysis are to evaluate market trends and forecast future price movements by examining historical price data and trading volumes. This analytical approach helps investors and traders identify patterns and trends that suggest potential market behavior. By understanding these patterns, technical analysts aim to determine optimal entry and exit points for trades, maximizing profitability while minimizing risks. Additionally, technical analysis is used to gauge market sentiment and investor psychology, providing insights into potential shifts in market dynamics. This method is essential for making informed trading decisions in both short-term and long-term investment strategies.

Features of technical analysis

Features of technical analysis are pivotal for investors looking to gauge market sentiments and forecast price movements. This methodology focuses on studying market-generated data, primarily price and volume, through various charts and indicators. Key features include trend analysis, which identifies the direction and momentum of market prices, and support and resistance levels, which indicate where prices might halt or reverse. Additionally, technical analysis employs patterns, like head and shoulders or triangles, to predict future price behavior. Oscillators such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are also used to detect overbought or oversold conditions, providing insights into potential market turning points.

Principles of technical analysis

Principles of technical analysis delve into the intricate mechanisms of market dynamics, dissecting trends, patterns, and indicators to forecast future price movements. At its core, technical analysis operates on the belief that historical price data holds valuable insights into future market behavior. Utilizing charts, graphs, and statistical tools, analysts assess supply and demand dynamics, investor sentiment, and market psychology. Key principles include trend analysis, support and resistance levels, and momentum indicators. By interpreting these principles, traders aim to identify optimal entry and exit points, manage risk, and capitalize on market opportunities. Understanding these fundamental principles empowers traders to navigate the complexities of financial markets effectively.

Some Technical Analysis Tips

Technical analysis and trading may appear daunting at the beginning. Here are some tips on how to approach technical analysis so as to improve your trading skills:

Know the type of trader you are: The first thing is to know your temperament and the style of trading that suits you — scalping, day trading, swing trading, or maybe position trading.

Consider making your analysis on multiple timeframes: Whatever style of trading you decide, you could benefit from analysis on several timeframes — a higher timeframe for identifying the main trend, the normal timeframe for finding setups, and a lower timeframe for picking better entries. For example, if you’re a swing trader, you may identify the main trend on the daily timeframe, look for setups on the 4-hourly timeframe, and step down to hourly timeframe to pick a better entry.

Know the indicators you want to use: Be sure to study any indicator you want to include in your analysis to know what it does, how it does it, and the conditions where it can fail.

Don’t use only one type of indicator: There are different types of indicators: price-based, volume-based, trend-following, momentum, and oscillators. It is preferable you pick just one from each group, if you are going to use more than one. It seldom makes much sense to use many indicators of the same type!

Be mindful of the trend: It is advisable to avoid going against the predominant trend. In the multi-timeframe analysis, it’s better to identify the trend on the higher timeframe than the normal timeframe for your style.

Identify the major support and resistance levels: Ensure you mark the important price levels. It’s better to do this on the higher timeframe because the support and resistance levels on higher timeframes are more significant.

Plan your exit before entry: When you find a trade setup, don’t just rush to place a trade. First, identify a level beyond which the setup is no longer valid — for your stop loss. Then, from your price projection mark where your profit target will be. You should also establish when you will move your stop loss to breakeven and when and how to trail your profit.

Control your expectations: No matter how you analyze the market, you can never win 100% of your trades. A strategy with a 60% win rate is already a diamond. With a good risk/reward ratio, you’re fine.

Money management is key: Don’t put a large percentage of your trading capital in one trade.

Practice a lot with paper trading: Practice with paper trading until you’re comfortable with your technical analysis and trade-execution skills.

Conclusion

Technical analysis has been around for more than two centuries. While some people still doubt its efficacy, many have and are still making money with it.

However, remember to backtest everything before you trade it! Most concepts taught in technical analysis do not work, but are merely somebody’s conviction of what the market should do!

In our algorithmic trading course, we teach our students how they know what technical analysis that works, and turn that into profitable trading strategies. Here you can read more about algorithmic trading!

FAQ

How can technical analysis help in determining the trend direction?

Traders use technical analysis to identify trends by observing the highs and lows on price charts. An uptrend is characterized by higher highs and higher lows, while a downtrend has lower highs and lower lows. Technical analysis helps traders define tradable opportunities or trade setups. Traders follow rule-based approaches, entering a trade only when specific criteria are met.

How is technical analysis used for the main exit method in trading?

Traders use technical analysis to set stop-loss orders, determining levels beyond which a trade setup is invalidated. This level is often beyond significant support or resistance, a round number, or a moving average. Apart from setting stop-loss orders, technical analysis is also used for the main exit method. Traders may use time-based exits or indicators like RSI to exit trades.

How do Price Action Traders identify potential trading opportunities?

Price Action Traders use candlestick patterns, chart patterns, and tools like Fibonacci retracement and pivot lines to identify potential trading opportunities. They focus on support and resistance levels and pay attention to important round numbers.

How do Leading and Lagging Indicators differ in Technical Analysis?

Leading indicators provide signals before the associated price move, while lagging indicators give signals after the price action has occurred. Leading indicators, such as RSI and Stochastics, may help catch new trends early but can lead to false signals. Using both leading and lagging indicators provides a balanced approach. Leading indicators can help catch the entire trend, while lagging indicators can confirm the new trend.