Technical analysis is a technique used to evaluate markets or individual securities using only data generated by market activity. Technical analysts, or technicians, rely on charts or indicators created using price and volume data. Sentiment data based on surveys of traders to determine their market opinions is also used by technicians. In the futures markets, additional data is provided by the Commitment of Traders reports and open interest.
Technical analysis is based on the belief that history tends to repeat itself and past market action can provide clues about how the price action should unfold in the future. Technicians believe that human nature is the underlying cause of price moves and since human nature is largely unchanged over time, the responses of market participants can be anticipated from what has been seen in the past and recorded on price charts.
Technical analysis is used to create market forecasts and build trading strategies based on how the market is acting. A technician creates an objective set of rules to analyze price action and minimize the role of their own emotions on trading.
Technical analysts will usually only study what prices are doing rather than analyzing the business and financial statements of a company. Technicians can also ignore economic news. Using only the past trading action, technical analysts will evaluate the future potential of an investment.
The chart below offers an example of the tools a technical analyst could apply to the markets. In very general terms, this chart shows a promising long trade set up. Price is moving higher and an uptrend is in place. The current price action could be considered a triangle consolidation pattern and traders would be looking for an upside breakout in price.
The pattern offers a price target of $116 a share, which represents a potential gain of 17%. A stop-loss could be entered at the lower line in the pattern, near $90, setting the trade's risk at about 3%.
The indicator shown measures the momentum, or speed, of the price move, and that is confirming the price action showing a consolidation. Since the indicator is positive, the odds favor an upside breakout in the pattern. The narrowing of the bands around the indicator, the red and green solid lines in the chart, would lead a technician to believe that an expansion in volatility is possible. This means the breakout from the triangle pattern could be followed by a rapid price move and traders would want to be ready for that.
Why It Matters To Traders
There are a number of technical analysts actively trading the markets and the price action often responds as expected at important technical trading points. Applying the rules of technical analysis offers traders an opportunity to profitably trade the markets.
An additional benefit of technical analysis is that no specialized expertise about a company or sector is required. The technician uses only price charts and does not need to study financial statements or economic reports to develop a trading strategy.
(This article originally appeared on ProfitableTrading.com.)