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Learn

An introduction to technical analysis

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

Introduction

Technical analysis is the study of publicly available price information to predict future moves. Pure technical analysts do not use economic data, company performance, or any other background metrics to make predictions, instead they focus entirely on the price of an asset and patterns that form across sessions. The practice is essential for day traders, who look for up and down trends and either join in or trade against them in hope of a reversal. Mastering technical analysis takes years, but armed with some key information you can start your journey today.

 

Key concepts

Technical analysis relies on a couple of key concepts about markets. The first and most important is that markets are not absolutely efficient, and move based on psychological factors as well as in response to real economic conditions. This is especially important to methods of analysis based on behaviour in a single session, such as daily candlestick charts. Technical traders believe that charting analysis and technical indicators can reveal predictable market movements, known as trends. Technical analysis indicators are varied and used in all markets, with forex CFD traders and equity CFD traders using the same methods. This applicability across markets is one of the most important features of technical analysis, and fundamental methods change significantly when you trade in different markets.

 

Trends

Trends are sustained price movements in either direction. An uptrend, or bullish trend, sees price increases, while in a downtrend or bearish trend the price falls. Inside each trend will be smaller sub-trends that move in both directions, meaning there will be smaller opposite trends within the prevailing main trend. This creates a pattern of a line with waves, moving diagonally in one direction while fluctuating in both.

Trends form because of something called momentum, which gives prices a tendency to keep moving once they start. Momentum occurs as follows: when traders see an asset increase in price, they try to join the trend, and revise forecasts for its price upwards. This then creates a snowball effect where additional traders enter at the new price, driving it still higher. Eventually this trend moves too far, and traders lose confidence, closing positions or even entering opposing trades, and the trend finishes. The trend is then followed by a correction which moves in the opposite direction and may become a longer-term trend in its own right. Unlike some other concepts in technical analysis, trends are quite easy to spot, and their existence is universally accepted. Herding behaviour among investors pushes them into similar trades, and a large part of chart analysis involves following these trends.

 

Support and resistance

You might be familiar with the lines technical traders use to decorate charts – these are used to test the beginning and end of trends, and they rely on the related concept of support and resistance. When the price of an asset increases, but then falls away before crossing a certain level, that becomes a resistance level. The equivalent for a falling price is a support level. Both support and existence levels can be extended by drawing a horizontal (or sometimes diagonal) trend line forwards on the chart.

Because traders watch these key levels, they may wait to enter a long position before the price has crossed the line. The more times the price approaches the price level and falls away just before, the stronger the resistance line is considered to be. These lines then become the natural limits on a trend. When a resistance line breaks, the price moves past it and continues, and there is a flurry of new positions as traders anticipate a new, stronger trend. Conversely, a price which continually fails to break through a key level may be seen as lacking momentum, with traders watching and preparing to trim positions or even take out opposing ones.

Key technical methods

Understanding trends and support and resistance gives you the theoretical background to start technical trading but doesn’t really help you identify either. This is where technical analysis becomes important: the methods described below involve strategies and technical indicators that can produce, in some circumstances, trading signals. That means you can use them to see when a trend is about to start, continue, or reverse, and place your trade accordingly.

 

Chart patterns

Chart patterns involve candlestick patterns as well as formations you can see on line charts, such as triangles and pennants. Once you learn candlestick patterns and other chart patterns you will start to see them regularly in markets; the topic is broad and there are many possible combinations, but each pattern gives you information about the price action seen in a trading session, or across a short period of time.

 

Technical indicators

Many different technical indicators exist based on price and volume action, with the RSI (relative strength index) and Bollinger Bands two of the best known. The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements, indicating overbought or oversold conditions. RSI values range from 0 to 100, with readings above 70 signalling overbought conditions and readings below 30 indicating oversold conditions. The RSI is used regularly by mean reversion traders, which you can learn more about below.

Bollinger Bands consist of a moving average line with two standard deviation lines above and below it. They depict the volatility and potential price range of an asset. When prices move closer to the upper band, it might suggest overbought conditions, while prices nearing the lower band could indicate oversold conditions. These bands dynamically adjust to market volatility, expanding and contracting accordingly. A more volatile asset will have wider bands, and they narrow in markets with a smaller price range.

 

Moving averages

Moving averages (MA) are trend-following indicators that smooth out price data by creating a constantly updated average. They help identify the direction of a trend by filtering out short-term fluctuations. The two most common types are the simple moving average (SMA), which calculates an average over a specified period, and the exponential moving average (EMA), which gives more weight to recent prices, reacting quicker to price changes. Often multiple moving averages are plotted on the same chart, one for a shorter period and one for longer.

The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of an asset’s price. Typically, the MACD is calculated by subtracting the 26-period EMA from the 12-period EMA, but the exact periods used can be changed. This calculation results in a MACD line, which oscillates above and below zero line. Additionally, a signal line, often a 9-period EMA of the MACD, helps identify potential buy or sell signals when it crosses above or below the MACD line. The MACD histogram, derived from the difference between the MACD line and the signal line, illustrates the momentum of a trend. MACD is popular in CFD markets for all underlying assets, including equities, forex and commodities.

 

Candlestick patterns

Candlestick patterns are used in technical analysis as graphical representations of price movements within a given timeframe, offering insights into market sentiment and potential trend reversals or continuations. These patterns, which consist of a candle and protruding ‘wicks’ formed by the open, high, low, and close prices, provide an easy visual of session performance. Patterns like doji stars, hammers, and others are observed for indications of future market direction, helping technical traders identify entry or exit points for their trading strategies. Candlestick patterns can be categorised as continuation or reversal patterns.

 

Continuation

Continuation patterns are indicators that a trend is stable and likely to continue. Charting analysis involves identifying tradable market opportunities, so a continuation pattern is normally used to enter a trend-following trade. Classic continuation chart patterns include the doji star and hammer.

 

Reversal

Reversal patterns are indicators that a trend is losing momentum and likely to reverse soon. Traders look for reversal patterns when they are thinking of exiting a trend-following trend or considering trading against the market. As you can read below, trading against the market is more dangerous, so reversal trades need a thorough risk-management protocol and a clearer market signal before entry.

 

Mean reversion and trend following

Traders are agreed that trends exist, and usually that support and resistance are key factors in identifying their beginning and end. How they trade trends depends on investment philosophy and personal preference, but most strategies can be described as either ‘mean reversion’ or ‘trend following’. Mean reversion trading is sometimes called contrarian trading or trading against the market, but in reality rather than trading against strong trends mean reversion traders look for weakening or over-extended price movements. A classic indicator for identifying a weakening trend is the RSI, which highlights overbought and oversold conditions that may reverse.

By contrast, trend following traders look to join trends while they still have momentum, and ride part of the way up before exiting. Useful indicators here are continuation chart patterns or MACD. In both cases, technical traders use support and resistance lines to guide stop loss and take profit levels, placing their profit level a little below where they expect the next move to take them.

 

Summary

Technical analysis is a big topic, and it isn’t possible to cover everything in one article. Part of becoming a successful CFD trader is discovering how to use technical indicators and charting analysis to make informed trading decisions, and to do so you need to steadily read more about the topic, combining what you learn in the abstract with practical experience in a live or demo account.

FAQs

Which is better, technical or fundamental analysis?

There is no ‘better’ kind of analysis, the two different methods are just preferred by different traders. Because most CFD traders use short-term strategies such as swing trading, technical analysis is often more useful as minor price fluctuations on short timescales may not be linked to broader economic events. So, for CFD day traders, technical analysis often has the edge, but it is still important to understand the fundamental factors driving prices, so you can identify which trends are more likely to persist.

Where can I learn candlestick patterns?

As well as through the learning section of the ADSS website, you can learn about candlestick patterns through multiple sources including online tutorials, books on technical analysis, and our detailed articles on the topic. Try and strike a balance between knowing as many candlestick patterns as possible and being able to trade well using just a few of them.

What are moving averages?

Moving averages are trendlines used in technical analysis that smooth out price data over a specified period, helping to identify trends by reducing noise and highlighting the direction of price movement. The crossover of long- and short-term moving averages can be used as a trading signal.


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