Technical analysis

The basis of fundamental analysis is, unsurprisingly, the fundamental elements of an investment. They can include: market sentiment, economic indicators, and a company’s earnings reports. Technical analysis, on the other hand, uses historical trends to predict how an investment is expected to perform in the future. Here, Psi Markets will provide in-depth coverage of technical analysis.

Understanding Technical Analysis

Analysts have long known that economic performance is cyclical in nature. Viewed over a suitably broad period of time, the value of any commodity, stock, market, or economy follows a general pattern of rising or falling. There are variations caused by a myriad of factors, but certain trends emerge over the long term.

Technical analysis attempts to decipher these patterns to predict when a rise or fall will occur. With the right technical analysis, you will be able to correctly decide when to enter or exit a market.

The crucial tool of all technical analysis are the charts that monitor any price or value. They are distinguishable by their unique structures and colors.

Green parts indicate an increase in value, while red segments indicate a fall. Each green or red section is made up of a thick line called a candle. The candle shows the range between the opening and closing price. Above and below each candle there is a thinner line called a wick. The wick shows the range between the highest and lowest price for the period.

To a beginner, a technical analysis chart may look like a random series of movements. However, when paired with real-world data – such as time of day, week or year, and current events – a pattern begins to emerge. Some of these patterns can be detected easily, while others are only revealed by specialized computer programs.

It is enough to extract just one pattern from the chart. A valid hypothesis can only be formed if the boom and/or bust theory can be applied to many, or all, of the previous movements. To decide whether a theory is universal or widely applicable, we use a “back test”.

Back testing takes the proposed theory and tests it against factual data. For example, a trader might suggest that the price of the US dollar weakens against the euro every Friday before the foreign exchange market closes. The back test will look at the weekly USD/EUR numbers as far back as possible to verify the hypothesis.

If the test confirms the theory, a trading company can automate your trades based on the verified indicators. Using the example above, they can set a schedule to buy USD on Friday and sell it for EUR before the following Friday.

What are the bases of technical analysis?

The famous Dow Jones Industrial Index (DJIA) was founded and partly named by technical analysis pioneer Charles Dow (1851-1902). He established what we know today as the Dow Theory, which states that the price of any commodity or stock is guided by three (3) principles:

Averages

Regardless of fluctuations, the average value is a reflection of all factors that affect it.

Tendencies

A trend emerges when there is a consistent movement in a particular direction, up or down. It consists of three (3) parts:

• Primary – The maximum point of increase or decrease.
• Secondary – A correction in the primary movement, which is a reversal of direction, typically by half, but usually in the range of one-third to two-thirds.
• Minor – Minor fluctuations in secondary motion.

Phases

Primary trends have three (3) distinct phases:

• Accumulation – Shrewd investors identify a trend and enter the market.
• Public participation – The trend becomes popular and a large number of traders enter the market.
• Distribution – The widespread adoption of the trend, which is followed by a huge increase in trading volume.

How are technical analyzes used?

Recognizing a trend early is critical to the success of any technical analysis. The period does not matter: it can be an indicator of price changes that occur daily or fluctuations over the course of a year.

A trader who correctly recognizes a trend when it starts can invest in bonds, futures or CFDs (Contracts for Difference) with a small investment and maximize his profits by exiting the market before the trend changes.

Technical analysis can also be used to offset losses. For example, consider an investor who bought a stock that fell and suffered a loss.

If technical analysis shows that the downward trend will continue for another 3 months, he can invest in a CFD by entering that position. If the analysis is correct, he will profit from falling share prices. Consequently, when the trend changes within 3 months, he can sell the stock and also profit from this transaction.

Technical analysis x fundamental analysis

We previously explained that technical analysis focuses on trends, while fundamental analysis focuses on companies, sectors, and market fundamentals.

An investor using fundamental analysis does not look for large data sets of market movements. Its primary focus is on the “here and now” that directly impacts value. They use this information to decide whether the value is likely to rise or fall.

In this sense, it may happen that fundamental analysis reaches a conclusion diametrically opposed to technical analysis.

For example, technical analysis may indicate that the value of a stock is at the beginning of a downward trend due to the time of year. On the other hand, fundamental analysis may look at the company’s new CEO, new product launches, and government guarantees as indicative of upward pressure on stock prices.

The best investment approach is not to pit one analysis against another, but to make them complement each other.

Advantages and disadvantages

The biggest advantage of technical analysis is the first principle of the Dow Theory: averages are the key. Regardless of minor fluctuations, the average value of any variable becomes equal over a period. If your technical analysis correctly identifies a trend, you can profit instantly and in the long term.

The most obvious disadvantage of technical analysis is uncertainty. There is simply no guaranteed formula for identifying a trend: even market movements that perfectly fit historical trends are susceptible to unpredictability. In other words, if your technical analysis misidentifies a trend, then you could suffer losses.

A perfect example is the COVID-19 pandemic of 2020: it completely contradicts, by a wide margin, any previously acceptable prediction.

At Psi Markets, we understand the strengths and weaknesses of technical analysis, and apply them to our investment decisions.