The Basics of Technical Analysis

The Basics of Technical Analysis. A few weeks ago, the global stocks market started to fall. Some indices, such as the S&P and Hong Kong’s Hang Seng dropped so much that they entered a correction zone. To many investors and market watchers, this was a surprise to them.

However, to traders who believe in technical analysis, this situation was not a surprise. It was an expected thing. As I had written before the drop, the S&P was trading in an increasingly overbought position as shown below.

In the financial markets, assets move for several reasons which are categorized into technical and fundamental reasons. In the fundamental aspect, assets because of the economic and intrinsic issues. For example, an economic reason for the rise in a currency is the improving employment numbers. For stocks, fundamental reasons could include the quarterly and annual financial results.

On the other hand, technical reasons are those associated with the chart patterns. Every day, traders take time to analyze chart patterns and then decide on when to enter and exit. In the example above, while the fundamentals for US stocks were strong, the technical chart pattern showed a different picture.

There are hundreds of technical indicators today. To be excellent at doing this type of analysis, there are a few things you need to do.

First, select a few indicators and study them. A common mistake I often notice is when traders want to be excellent at all indicators. This is wrong because, using multiple indicators will only present you with confusing details.

For years, I have specialized on a few indicators that have been really good and if you are a new trader, I recommend them. First, there is the Fibonacci Retracement indicator. When plotted well, the Fibonacci Retracement indicator will give you an indication of where the asset is likely to move to. It will not help you predict whether the chart will go up or down, but it will give you a guidance of where to look at.

For example, in the chart below, you can easily predict where the asset will find support and resistance.

The second indicator I regularly use is the Relative Strength Index. This is the one I used to predict the coming correction in the S&P 500. The RSI is an oscillator indicator which can tell you when an asset is overbought and oversold. In this, it is always risky to buy assets that are in the overbought zone and short those in the oversold zone. To make a better decision on this, you can combine this with other oscillators like Stochastics and the Relative Vigor Index.

The third best indicator I recommend is the Moving Average. There are several types of this but, the underlying principle is the same. Moving Averages give you the average pricing of the asset within a certain period. One way to use moving averages is to combine two MAs where one has a shorter timeframe than the other. In most cases, when the longer-term MA crosses the shorter term one in the outside, this is an indication that the asset could move higher. A good example of this is shown below.

Finally, the Elliot Wave is an important method to predict the future movements of financial assets. The idea behind Elliot Wave is that assets tend to move in patterns. These patterns could either be impulse or corrective. After ending an impulse or bullish wave, assets tends to go through a 3-step corrective wave.

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