Technical Analysis For Beginners – 101
Since the turn of the 19th and 20th centuries, technical analysis has become an integral part of financial market analysis. Based on the studies of Charles H. Dow, the co-founder of the Wall Street Journal, the technical analysis does not focus on the fundamental characteristics of a market or a company, but derives its forecasts for the markets from price trends (chart analysis) and mathematical-statistical indicators (indicator analysis). The basic assumption of chart analysis is that historical price courses repeat themselves. Technical analysts chart the price development based on significant points in the chart.
The trend is your friend
“The trend is your friend” is the basic rule of technical analysis. In essence, this means that a stock or index will maintain the direction until a marked move signals a turning point in the price. Trends can basically have three directions: up, down and sideways.
Methodically, a trend in the chart technique is determined by connecting different extreme points (namely highs and lows) in the historical price trend to a trend line. An upwards trend – represented in this graph by the example of the Apple stocks – consists of a series of consecutive high points, each of which is higher than the previous one. A downwards trend corresponds to a series of lower and lower values.
A sideways trend occurs when the price shows the same peaks and valleys over an extended period of time. The straight line connecting the individual highs and lows is called the trend line. It is important if you want to determine how long a trend is valid. Roughly speaking, this is the case until the price chart breaks through this trend line, with prices below (during the downwards trend) or above (during the upwards trend) the trend. It is important that the “outbreak” is sustained.
It is not enough for the price to be quoted briefly beyond the respective trend during the course of the day. According to the prevailing opinion of chart technicians, the outbreak must be at least closing price based, and some analysts see a trend as finished only when the price closes two or three percent above or below the existing trend line.
The chart technique
Supports for highs and lows in the price trend in charting not only serve to define trend lines. When it comes to setting price targets for a stock, for example, supports also provide important clues. If the chart marks a low in a downward movement and turns up from here, this low assumes the function of a “support” afterwards.
True to the fundamental conviction that price movements are repetitive, chart technicians assume that a mark on which the price has once turned will continue to be difficult to break. Support is all the stronger, the more it serves as a turning point over time – be it high or low.
The criticism of the technical analysis
Really important things always need to be repeated and there is hardly any area where there are so many misunderstandings and so much is operated on with half knowledge as in technical analysis. The reputation of technical analysis is therefore not always the best, “hocus-pocus” is one of the nicer characterizations of those who don’t really understand technical analysis.
This is not completely unfounded, because charts may be used to spread all kinds of mischief, since anyone can quickly draw a few colorful lines, without even understanding what technical analysis is all about and what should be avoided.
The real achievement that good market technicians provide are not a multitude of colorful lines, but the interpretation of the current state of the market from the available data.
But back to the misunderstandings. First of all, we have the widespread misconception that technical analysis – such as a chart – would map the future course of the market. If you like, charts are taken as something like a crystal ball with which you may see into the future.
Long scientific papers should demonstrate that technical analysis is not valid.
But looking at the evidence to the contrary – in terms of the benefits of alternative methods of analysis, science fails to come up with proof. Technical analysis is like all other analysis methods just a tool that may be used if a trader is so inclined.
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The here and now counts in technical analysis
Good technical analysis reflects the state of the market in the present, in the here and now. And it can work out typical developments of the past.
However, good technical analysis knows as little about the future as any other methodology, including economic forecasting models!
However, if one has really penetrated the state of the market in the here and now, one can derive assumptions and probabilities. Because the self-referential market consisting of the expectations of millions of market participants is by no means so erratic to changes fashions, trends and structures every two hours like a pair of underpants.
It is quite possible to derive opportunities and risks for the future from understanding the market state in the “here and now”, but these are always just probabilities and never certainties.
That's what good technical analysis is all about. Incidentally, even fundamental data and analyzes do not provide a crystal ball into the future unless you really have insider knowledge. Anything publicly known about fundamental data is public and has been seen by others, and has therefore become part of the expectations and thus of the price performance.
Good technical analysis tries to feel the pulse of the market in the “here and now” in order to derive tendencies and scenarios for future developments, all in the awareness that even the best technical starting position produces only probabilities, because at any given time a new, previously unknown message or development might change the overall picture.
This may not seem like much at first glance, but it is more than a normal investor can get as a head start with fundamental analysis – because this is so onerous that a normal investor has no chance of getting an edge on the market.