Technical analysis is used by traders to predict future market behavior based on the prior price action. The underlying assumption of this type of analysis is that the development of the price action is not random as the historical trends and patterns repeat over time. It can be applied across all time frames, as well as across all financial markets.
In this article, we will talk about technical indicators you can use to design your trading strategy, and guide you to your first trade.
The chart represents a graph of data points, which shows the historical price of a specific asset. To this chart, traders and analysts add different technical indicators to draw specific lines and objects to identify price patterns and market trends. Hence, the basic idea of charting is to first prepare your trades before you get started with the trading process. To this end, let’s have a brief look at some of the most popular indicators used by technical analysts.
In the sea of different indicators available to traders today, the moving average (MA) represents
one of the most common indicators out there. It calculates the average price of an asset over a
specified period. The most popular periods to calculate the MA are 50-period, 100-period, and
200-period. Arguably the key strength of this indicator is its applicability across all time frames.
Moving Average Indicator (Source: TradingView)
We added the 200-period (the red line) and 100-period MA (the blue line) to the chart above to
demonstrate their applicability. As you can see in the chart, two moving averages are
moving upwards since the price action is moving higher as well. The blue line is catching up
faster with the price action as it is based on the lower number of periods than the red line.
Similarly, volume is regarded to be one of the simplest indicators. It shows the amount of
an asset that was traded over a specified period of time. Many traders use volume to measure the relevance of a specific move – the higher the volume behind a certain move, the higher the relevance.
Volume Indicator (Source: TradingView)
The volume indicator is added to the chart above (the red and green bars at the bottom of the chart). You can see that the bigger moves to the upside or downside are almost always followed by higher volume.
Contrary to MA and volume, the Bollinger Bands is a more complex technical indicator used by
traders to gauge the market’s current sentiment. Bollinger Bands is comprised of three lines – a
simple moving average (SMA) is a line in the middle and two trading bands above and below it.
In general, the wider the bands the higher volatility of the market and vice versa.
Bollinger Bands Indicator (Source: TradingView)
Bollinger Bands indicator is added to the chart above to illustrate how it works. When the two
opposite bands converge, it is called a “squeeze”. As a result of low volatility, the squeeze
shows the potential sign of future-increased volatility and possible trading opportunities.
Once you analyzed the charts, you can move to the extraction of trading signals. The technical analysis should provide you with an answer to the most basic question: Are you looking to buy or sell the asset?
This is where the “long” and “short” terms come into play. If you go long, it essentially means that you purchased a specific asset with an aim to sell it at a higher price and book a profit. On the other hand, shorting means you are looking to sell and then buy back at a lower price to book a profit. The moment you know if you are buying or selling, you can move to the next phase – defining three key levels.
“Entry” is the point at which you plan to enter a trade. A good and precise entry point is very important from a risk-management perspective.
“Take profit” represents a command that allows profit to be fixed to a certain amount. Of course, this command will only be applied in case you come to a situation where our trade is successful and profitable.
“Stop loss” is the opposite command of a take profit. If our trade is not going in accordance with the initial plan, you set the stop loss order at a specific price to minimize losses.
The vast majority of traders extract trading signals from the technical analysis. One of the most interesting groups of traders is the so-called “turtle traders”. Named after the experiment dating back to the 80s, when traders Dennis and Eckhardt trained a group of students for only two weeks to prove that anyone could be taught to trade, turtle traders are advised to buy an asset when the price breaks to the upside and sell when the price breaks the support.
The students were called turtles as Dennis believed that he could train new traders as fast as the farm grows turtles. Additional components of this strategy are to always rely on charts, which is a basic assumption on which technical analysis rests. Moreover, never risk more than 2% of your account on a trade, clearly define trading levels, and calculate market volatility.
There are also different types of trading. For instance, derivatives trading allows traders to speculate on when the price of a financial instrument will rise or fall, without buying the asset itself. The most common use of derivatives is to take the opposite positions in the market. There are different types of derivatives, namely swaps, forward contracts, futures, options and others.