Day Trading Guide – Chapter 9: Technical Analysis

Technical analysis refers to the process of using historical economic figures to help forecast future price movements. It is based on 3 key assumptions:

That price change is not due to a single factor but a diversity of factors like the laws of supply & demand, political crisis, economic upheaval or natural disasters.

All these factors have an effect towards influencing price movements. In the area of technical analysis, a trader is not concerned with the fundamental reasons why the political crisis or economic instability occurred. What interests a technical analyst is by how much these fluctuations will be as a result of all these external factors.

Prices have trends that are observable and as such their movements can be tracked to help price future price fluctuations.

These price fluctuations follow a certain pattern due to market sentiments which can be explained through human psychology.

With technical indicators like moving averages, like SMA, MACD, support & resistance levels among others, a chartist will be able to plot and predict roughly where prices will go.

The most commonly used technical indicators are:

Average Directional Movement Index (ADX) – are used for determining market trends (that can be either upwards or downwards). It is used to quantify the strength of a trend. If the readings show increasing values above 20, this will mean that the trend is starting and is getting stronger.

Moving Average Convergence/Divergence (MACD) – MACD shows the impetus of market and it also displays the association amid the two moving averages. When the MACD line passes or intercepts the signal line then this will denote a strong market.

Stochastic Oscillator – shows how strong or weak a market is by comparing a closing price to an average price range over a specific duration. A value above 80 will show that the asset is overbought while a stochastic oscillator value below 20 shows that the asset has been oversold.

Relative Strength Indicator (RSI): is a momentum indicator hat contrasts the extent of recent gains to recent losses in an endeavor to establish the overbought and oversold conditions of an asset. It is a scale from 0 to 100 that indicates the high and the low prices within a particular period of time. If the price increases above 70, the asset is said to be overbought whereas if the price decline below 30, it is regarded as oversold.

Bollinger Bands – These are the bands that include most of the currency prices. These bands have 3 lines:
The lower and upper lines follow the price fluctuations.
The middle line denotes the average price.

The distance between the lower and upper bands will increase when the volatility is high. If the prices are nearer towards the upper band, this will indicate a more overbought market conditions whereas the closer the prices are towards the lower band, this will show a more oversold market condition.

Although a novice trader may initially be turned off by the complexity of technical analysis, it is an indispensible tool that traders use for the formulation of trading strategy.