Technical analysis refers to the assessment of price movements of a particular financial instrument such as a currency pair. Technical analysts use price charts to assess the direction of markets in order to identify possible entry and exit points for their trades.
Although technical analysts use many exotic tools to analyze the markets, the core function of technical analysis is the study of supply and demand, as reflected in the price movements of a particular instrument.
Fundamentally, the main objective of technical analysis is to determine the future direction or trend of a currency pair.
Common Assumptions Of Technical Analysis
- The Market Is Always Right
Critics of technical analysis usually fault it for being solely focused on the price movements of an instrument while ignoring the fundamental factors that could affect the currency pair.
Supporters of technical analysis, on the other hand, would claim that technical analysis is based on the assumption that every factor that could affect a particular security is already included in its price. Technical analysts believe that the only real factors that matter are the supply of and demand for a security.
- Prices Usually Follow Trends
A core assumption of technical analysis is that prices tend to follow trends. The theory goes that if a currency pair has established a particular trend, there is a high likelihood that it will follow the same trend in future.
Furthermore, many of the technical analysis tools used by traders, such as support and resistance levels, trend lines, price channels, and moving averages, are based on the past trends of the financial instrument being analyzed.
- Historical Patterns Tend To Be Repeated
The underlying principle of technical analysis is that historical patterns in price movement tend to be repeated. Given that technical analysis largely relies on historical data about price movements, traders usually expect that under similar conditions, the identified chart patterns are likely to be repeated.
However, there are of course no guarantees that historical patterns will be repeated. The range of factors that impact the market are vast, and therefore instruments may react very differently even if some of the broad stroke factors remain the same.
Types Of Chart Patterns
Chart patterns usually fall into two categories:
- Continuation patterns
- Reversal patterns
I). Continuation patterns: these are very common and short-term in nature. The most common continuation patterns are triangles, which are usually referred to as wedges, flat-topped triangles, and pennants, among others. Triangles usually refer to a change in the prevailing trend that leads to a tightening of the trading range.
II). Reversal patterns: they are much rarer, but are also very important. They usually indicate a change in the previous pattern. A good example is the head and shoulders pattern, which usually indicates a break in the opposite direction. Another example is the double top, which typically signals that the dominant trend is about to change.
Tips On Becoming A Successful Technical Trader
There is a common misconception that technical analysts usually aim to predict the future, but this is not true. The most successful technical traders generally aim to identify existing trends in the market and then place their trades in accordance with the identified trends.
Many people also believe that successful technical traders are those who correctly identify the beginning of a trend and its end, but this is not accurate. The most successful technical traders are those who make trades once a trend has already been confirmed and exit such trades once the prevailing trend has clearly ended.
To summarize, technical analysis is an extremely wide field that incorporates the use of numerous tools to study the price movements of instruments. Over the course of this article we’ve gone through a brief introduction to the field of technical analysis, however this is just the beginning. Keep reading this blog to dive deeper into the field of technical analysis, and into other key aspects of forex trading.