Before you invest in the financial markets, you need to determine how to find the best investment opportunities. Technical analysis and fundamental analysis are the two most popular types of market analysis. Let’s look at how technical or chart analysis works.
A definition of technical analysis
In trading, technical analysis is a method used to identify trading opportunities based on price action, trading volume and other statistical and mathematical information.
Technical analysis, which works on all types of assets such as Forex, stocks, indices, commodities and more, can:
- identify significant price levels;
- detect chart patterns that point to a trend reversal, indecision or continuation of the current trend;
- take advantage of relevant short-term trading signals.
Technical analysis concepts
Support and resistance
Technical analysis can identify price levels that can lead to meaningful changes in a stock’s price, in the form either of a change of trend, or an acceleration of the current trend.
- A support is a level where there is strong demand, which causes a pause in a downward movement or the reversal of a downward trend. At its contact, prices rebound temporarily or permanently. If the price breaks a support, then the downward movement accelerates lower towards the next support level.
- A resistance is the opposite of a support. It is therefore a price level that will slow down or stop an upward movement. When the price reaches resistance, it will tend to fall temporarily if this is a pause in the movement, or permanently if it is a reversal of the trend. A breach of resistance usually accelerates the upward movement.
If you’d like to see support and resistance lines in action, download this chart patterns PDF named “Chart Patterns Cheat Sheet”. It calls out 20 classical chart patterns (bullish and bearish), and allows you to explore them through interactive charts, powered by TradingView. I’ve found that reviewing price charts is the best way to learn.
Trendlines
For technical analysts, prices always move in a trend. It can be bullish, bearish or neutral. A trend line is therefore a line that links a series of prices to highlight the direction that a given asset is taking.
An ascending trendline defines an uptrend. It’s characterised by higher highs and lower lows. Prices are usually above the trendline.
A descending trendline defines a downtrend. It’s characterised by lower highs and lower lows. Prices are usually found below the trendline.
During a neutral trend, prices move sideways between support and resistance (as is the case with a rectangular pattern), or within a symmetrical triangle.
Importantly, not all trendlines are the same. A good trendline should:
- follow a normal slope;
- have at least 3 touch points;
- lead to a significant price reaction when touched.
Overbought and oversold market conditions
Some technical indicators highlight overbought or oversold situations such as the relative strength indicator (RSI technical indicator) or the Money Flow Index (MFI).
These extreme price situations represent areas in which the price tends to turn around: downward in the case of an overbought zone or upward in the case of an oversold zone. This makes it possible to identify opportunities when the buying or selling pressures have been too great, and a change in trend is likely.
However, please note that oversold conditions aren’t systematically followed by a price advance. Likewise, overbought conditions aren’t always followed by a price decline. When an asset becomes “overbought”, this can also mean that a lasting uptrend has taken hold – and vice versa when an asset becomes “oversold”. In this case, you should wait for a confirmation like an exit from the extreme zone to open a position.
