Investors can sometimes use historical data when predicting what will happen to an asset in the future. To do this, they will use various technical analysis techniques to identify previous trends that might have occurred.
While it can be an important tool, it is essential to understand that these methods do have their limitations. Past performance is not always indicative of future trends, so you should always use other sources of information, in addition to technical analysis, when placing your trades.
Here are the basics of technical analysis:
What is your trading style?
When you start your investment career, the first thing you should decide is for how long you are like to keep your positions open. Will you open and close your trades in short timeframe, or hold onto your assets for days, or even months?
Deciding this will determine which trends you will monitor to carry out your analysis. There are usually three timescales to choose from – short term, intermediate term and long term.
Intraday (such as hourly) or daily charts will suit investors who like to trade quickly, while those who prefer to take their time will most likely refer to monthly or weekly charts.
Resistance and support levels
The use of support and resistance levels has become so popular that it has made these technical indicators appear to be self-fulfilling prophecies. This is because so many investors believe that these metaphorical lines will signify a change in trend, that their cumulative ‘take profit’ orders will be enough to send an asset’s price in the opposite direction.
For an upward trend, investors will be looking for resistance levels to plot when an asset price will reverse. In a downward trend, traders will expect an asset to reverse once it hits a support level.
Sometimes an asset will break through these levels and carry on its current trajectory. If this occurs, investors will look at the next support or resistance level, and expect the asset to bounce off that.
Once a support level has been broken, it will act as a new resistance level if the prevailing downward trend suddenly starts to reverse. The same will happen in upward trends, meaning that a resistance level that has been broken will become a new support level.
A prevailing trend, whether upward or downward, will never continuously move in the same direction. Instead, you will notice a number of peaks and troughs throughout the trend line. These corrections are known as retracements.
Traders will use a series of techniques, such as Fibonacci, to estimate where they believe a retracement will occur, and how far it will carry on for. They will then use this information to work out additional ways to make a profit, or prevent a loss. Retracements are always expressed as a percentage, with common values being 50% and 100%.
What are trend lines?
Investors will use a trend line to predict how an asset will perform. They are created by drawing two diagonal lines that connect consecutive peaks and troughs.
As long as a trend keeps between these two lines, traders are more confident that the trend will continue. If an asset breaks through the lines, then the trend is deemed to be over.
Traders will watch the price of an asset extremely closely if it tests these trend lines numerous times. If this happens, a trend will be expected to last for a long period of time.
It is also worth knowing that an asset price must touch a trend line at least three times to be considered a valid trend.
These are tools that will let investors know if a particular asset has been overbought or oversold by the market. If this occurs, then a prevailing trend will mostly likely reverse, due to a lack of available buyers or sellers. If an oscillator indicates a period of overbuying or overselling, traders can be more confident that a reversal will happen soon.