The practical application of Technical Analysis in trading

Core Points Overview

• Technical analysis (TA) is a method of predicting market trends using historical price data and trading volume.
• Technical analysis methods include a combination of various tools such as support and resistance levels, moving averages, RSI, MACD, and Bollinger Bands.
• Trading signals can help identify buy and sell opportunities, but may produce false signals in short-term or low liquidity markets.
• Risk management and multi-faceted data validation are crucial.

What is Technical Analysis

Technical analysis is a trading method that infers future price trends by observing the historical price movements and trading volumes of an asset. Unlike fundamental analysis, which focuses on various influencing factors, technical analysis only concentrates on the historical records of price movements and chart patterns.

Traders use technical analysis to identify market trends, find support and resistance levels, and discover potential entry and exit points. This method assumes that all known information is already reflected in the price, and therefore, by studying price patterns and trading volume, one can predict future price movements.

The Historical Evolution of Technical Analysis

The earliest form of technical analysis appeared in Amsterdam in the 17th century and Japan in the 18th century. The founder of modern technical analysis is financial journalist Charles Dow, the founder of The Wall Street Journal.

Dow was the first to discover that individual assets and the entire market generally follow specific trend movements, which can be broken down and analyzed. His research ultimately formed the Dow Theory, which further promoted the development of the discipline of technical analysis.

Early technical analysis relied on hand-drawn charts and manual calculations. With technological advancements, technical analysis has been widely applied and popularized, and has become an important tool for many investors and traders today.

How Technical Analysis Works

The core logic of technical analysis is: all known information is reflected in asset prices. By analyzing the patterns of price movements and changes in trading volume, one can predict the next direction of prices.

Essentially, technical analysis studies the balance of supply and demand, and this balance reflects the overall sentiment of the market. In other words, asset prices reflect the confrontation of forces between buyers and sellers, which is closely related to the emotions of traders and investors—particularly the fluctuations of fear and greed.

Technical analysis works best in markets with high trading volume and high liquidity, which operate under normal conditions. Markets with large trading volumes are less affected by price manipulation and abnormal external shocks that may distort the results of technical analysis.

Method Technical Analysis: Main Indicator Tools

Traders use various technical indicators to analyze price movements and identify potential trading opportunities. Here are some of the most commonly used methods:

Moving Average (MA)

The moving average is one of the most basic tools in technical analysis, divided into two types:

Simple Moving Average (SMA) calculates the average price over a specific period, smoothing out short-term price fluctuations.

Exponential Moving Average (EMA) gives more weight to recent prices, making it more responsive to new information.

The moving average helps determine the direction of the trend and potential support or resistance levels. A common trading strategy is to observe the crossover points of short-term and long-term moving averages to determine buy and sell signals.

Relative Strength Index (RSI)

RSI is a momentum oscillator that measures the speed and magnitude of price movements on a scale of 0 to 100. Traditionally, an RSI above 70 indicates that an asset is overbought, while below 30 indicates that it is oversold.

Bollinger Bands (BB)

The Bollinger Bands consist of two lines that are positioned above and below the moving average line. This indicator helps assess market volatility and determine when an asset is overbought or oversold.

MACD indicator

MACD is a momentum indicator that shows the relationship between two exponential moving averages. It consists of the MACD line, the signal line, and a histogram, which helps to identify potential buy and sell signals.

Practical Application of Trading Signals

Technical indicators are not only used to determine the overall trend but can also generate specific trading signals that indicate potential entry and exit points.

Overbought/Oversold Condition: Indicators such as RSI can signal when an asset is overbought (a possible sell signal) or oversold (a possible buy signal).

Moving Average Crossover: When the short-term moving average crosses above the long-term moving average (golden cross), it generates a bullish signal; when it crosses below (death cross), it generates a bearish signal.

MACD Signal: When the MACD line crosses above the signal line, it may indicate a bullish trend; crossing below indicates a bearish trend.

It is important to note that technical analysis signals are not always accurate. Especially in short-term trading, technical indicators can generate a large number of false signals. To reduce the risk of loss, technical analysis indicators should be combined with other methods and risk management strategies.

Questions About Technical Analysis

Many experts claim that technical analysis is an unreliable tool, referring to it as a “self-fulfilling prophecy.” This term is used to describe events that occur simply because most people believe they will happen. Although technical analysis is widely used, it does have some limitations:

Self-fulfilling prophecy: Critics argue that technical analysis is effective because many traders use the same indicators, leading to predictable market reactions.

Subjectivity Issues: The interpretation of charts and patterns may be subjective, and different traders may draw different conclusions.

Market Anomaly: The effectiveness of technical analysis may decline during periods of high volatility or in markets affected by unexpected events.

Despite these doubts, many traders still believe that technical analysis is a valuable tool, especially when combined with other analytical methods. Proponents of technical analysis point out that each trader has their own unique way of analyzing charts and indicators. From this perspective, given the diversity of data, it is unlikely that a single market strategy will form among the numerous traders.

Comparison of Technical Analysis and Fundamental Analysis

Technical analysis focuses on historical price data and patterns, while fundamental analysis assesses the intrinsic value of an asset based on financial statements, economic indicators, and other qualitative factors.

Technical Analysis: The most suitable for short-term trading strategies, helping to determine the optimal entry and exit points.

Fundamental Analysis: More suitable for long-term investment decisions, assessing the overall condition and potential of assets.

Many investors combine two methods to make more informed decisions.

Suggestions for Comprehensive Application

Considering the advantages and limitations of both technical analysis and fundamental analysis, many professionals recommend a combination of the two methods. This way, fundamental analysis can be used to develop long-term investment strategies, while technical analysis can provide real-time information about short-term market conditions that traders and investors can use to optimize their strategies. In actual trading, the application of a multi-tool combination of technical analysis methods, along with strict risk management, can significantly improve the accuracy of decision-making.