Basics of Technical Analysis in Financial Markets

Key Findings

• Technical analysis is an approach to predicting price movements by examining historical price trends and trading volumes.
• Traders apply methods from basic levels of support and resistance to complex combinations of tools such as exponential moving averages, RSI, MACD, or Bollinger Bands.
• Generated trading signals can reveal promising opportunities, but technical analysis indicators tend to produce many false alarms, especially in short time frames or in low-activity markets.
• Effective trading requires consistent risk management and verification of signals through additional analytical methods.

Origin and Development of the Method

Although primitive forms of technical analysis appeared as early as the 17th century in Amsterdam, Netherlands, and later in the 18th century in Japan, the modern approach is firmly associated with the work of Charles Dow. As a financial journalist and founder of The Wall Street Journal, Charles Dow was the first to notice that assets and markets typically move in recognizable trends that can be systematically analyzed and segmented. These observations led to the creation of Dow's theory, which became the foundation for further development of technical analysis.

In the beginning, this method relied on hand-drawn charts and manual calculations. However, with the advent of digital technologies and computing, technical analysis has transformed into a sophisticated tool that investors and traders around the world use today.

Principles and Mechanisms of Technical Analysis

The basic premise of technical analysis is that all available information is already reflected in the price of a security. For this reason, experts can predict future market movements through the analysis of price trends and transaction volumes.

Essentially, it is about researching the dynamics of supply and demand, which express the overall sentiment in the markets. The price of any asset is a reflection of the balance between selling and buying pressure. These forces are closely related to the psychological factors of traders – their fear and greed.

It is important to realize that technical analysis achieves maximum effectiveness in markets with favorable conditions – with high transaction volumes and sufficient liquidity. Markets with large volumes are less susceptible to price manipulation and random external factors that could distort signals and reduce the usability of technical analysis.

Main indicators in practice

Professional traders rely on a diverse range of technical indicators to track price movements and identify new opportunities:

Moving Averages – Basic Tool

The Simple Moving Average (SMA) calculates the average price over a selected period and smooths out short-term fluctuations. The Exponential Moving Average (EMA), on the other hand, gives more weight to recent data, allowing it to respond better to new market information.

These indicators help determine the direction of the prevailing trend and identify potential support and resistance levels. The traditional strategy follows the crossing of short-term and long-term moving averages to signal potential buy or sell signals.

Relative Strength Index (RSI)

RSI is one of the momentum oscillators and measures the intensity and pace of price changes on a scale from 0 to 100. An RSI value above 70 is generally interpreted as an overbought condition, while an RSI below 30 indicates an oversold market condition.

Bollinger Bands and Volatility

Bollinger Bands consist of two bands that move around the moving average line. They are used to measure market volatility and to detect situations where an asset is overbought or oversold.

MACD – trend indicator

MACD (Moving Average Convergence Divergence) tracks the relationship between two exponential moving averages. It consists of the MACD line, the signal line, and a histogram, which together generate signals for entering and exiting positions.

Trading Signals and Their Interpretation

Technical indicators serve not only for a general assessment of the trend but also generate specific trading signals with potential entry and exit points:

• Overbought and oversold scenarios: RSI and similar tools signal when an asset is in an overbought state (potential sell signal) or in an oversold state (potential buy signal)
• Moving Average Crossovers: When the short-term average crosses above the long-term average, a bullish signal known as a golden cross is created. The opposite movement forms a bearish signal known as a death cross.
• MACD signals: When the MACD line crosses above the signal line, it indicates bullish momentum. A downward crossover points to a bearish trend.

It is essential to realize that technical analysis signals are not infallible. Indicators produce significant noise in the form of false signals, especially in short-term trading and in unstable markets. To minimize losses, it is necessary to combine technical analysis with other methods and apply disciplined risk management.

Critical Views on Technical Analysis

Technical analysis faces significant criticism and many consider it a controversial and inaccurate approach. It is often referred to as a “self-fulfilling prophecy” – a situation where events occur because a large number of market participants expect them to. The main objections to technical analysis are:

• Self-Fulfilling Prophecy: Critics argue that technical analysis works only because a number of traders use identical indicators, creating predictable patterns.
• Subjectivity of interpretation: Evaluating graphs and trends is often subjective, leading to differing conclusions among individual analysts.
• Unforeseen market turbulence: During periods of extreme volatility or when unexpected events impact the markets, technical analysis strategies lose effectiveness.

Despite these criticisms, many practicing traders find technical analysis to be a valuable tool, especially when they combine it with other analytical approaches. Proponents of TA point out that each analyst has their own unique way of interpreting charts and applying available indicators, which practically excludes a universal strategy for all traders.

Technical Analysis vs Fundamental Analysis

Technical analysis focuses on historical price data and visual patterns, while fundamental analysis assesses the intrinsic value of an asset based on financial statements, macroeconomic data, and qualitative factors.

• Technical Analysis: An excellent tool for short-term trading tactics and accurately determining optimal entry and exit points.
• Fundamental analysis: More suitable for long-term investment decisions, provides insight into the overall health and growth potential of an asset.

Most sophisticated investors prefer a combined approach that synergistically leverages the advantages of both methods to make the best possible decisions.

Final Thoughts

Despite the ongoing discussion about which approach is better, experts most often combine technical analysis and fundamental analysis. While fundamental analysis is primarily aimed at long-term strategies, technical analysis provides relevant insights into short-term market conditions, which is valuable for all types of traders and investors regardless of their investment horizon.