Technical analysis: Finding trade opportunities using technical indicators

Technical analysis involves examining the stock market charts of a specific financial asset to determine optimal buying and selling points.

Unlike fundamental analysis, which looks into the financial and business fundamentals of a company, technical analysis solely focuses on the historical trends in prices and trading volumes.

Technical analysts use mathematical formulas and probabilistic models to identify trading signals—market conditions that statistically suggest favorable opportunities to buy or sell the financial product in question.

Of course, even math-averse people can use technical analysis to trade. Most trading platforms and charting tools offer technical indicators that do the work for you so you can spot your own buy and sell signals without doing the complicated math. 

Understanding technical analysis

Technical analysis is based on the assumption that historical stock prices and trading volumes can help predict future market trends.

Supporters of technical analysis argue that it enhances the accuracy of predicting when a trend will start or finish and aids in pinpointing key price levels.

Whether used alone or alongside other analytical methods, technical analysis can support various trading strategies. These range from very short-term approaches like scalping to longer-term active strategies such as position trading.

Technical analysis utilizes technical indicators, which are mathematical formulas displayed visually on charts.

Top trading platforms offer several hundred technical indicators. As a result, many technical analysts choose to specialize in a select few, creating a personalized toolkit.

The limits of technical analysis

Technical analysis contradicts the Market Efficiency Hypothesis formulated by Eugène Fama in 1970, which states that the price of a financial product represents all available information (including that contained in the stock market history).

In other words, price evolution follows a random path, and examining the past to try to predict the future would be useless (except to get a partial idea of the field of possibilities).

For critics of technical analysis, survivor bias explains the apparent effectiveness of certain technical indicators. 

Even within the technical analysis community, some resist the notion of predicting the future. Instead, they advocate using technical analysis as a tool to objectively describe market conditions.

With the rise of automated trading, technical indicators have become increasingly valuable for defining the conditions under which an algorithm will open or close a position.

For example, forecasting the purchase of a stock when volatility has fallen leaves room for many interpretations (what is “low volatility”?). On the other hand, scheduling the purchase of a stock when its standard deviation is below 1 already offers a more precise signal.

Overview of Technical Indicators

A technical indicator serves as a tool for technical analysts by providing buy and sell signals.

It consists of a mathematical formula, which can vary in complexity. The outcome of this formula is visually displayed either directly on the price chart (known as on-price indicators) or adjacent to it (referred to as off-price indicators).

Each indicator operates over a specific period of time, designated in units of time (n).

For instance, setting a technical indicator to 12 means it will calculate its value based on the last 12 units of time shown on the chart. So, on a chart with a “1-hour” time unit, the indicator would analyze data from the previous 12 hours.

For each time unit, 5 pieces of information can be used to calculate the indicator value:  

This chart features the DAX 40 index as displayed on the ProRealTime Web platform, enhanced with a simple 20-period moving average represented by a blue dotted line. This price indicator computes the average based on the last 20 time units. On this specific chart, which uses “1-day” time units, each point of the moving average corresponds to the average of the last 20 stock market sessions.

Choosing the formula, period, and time unit for a technical indicator can create countless combinations on a chart.

Nevertheless, here are the most commonly used technical indicators:

• RSI (Relative Strength Index)
• MACD (Moving Average Convergence Divergence)
• Stochastic
• Bollinger Bands
• Ichimoku Cloud

Some technical indicators, called oscillators, range between two fixed values, such as 0 and 100. Others are open-ended, stretching from negative infinity to positive infinity.

This chart features the CAC 40 futures on the ProRealTime Web platform. It showcases two distinct indicators: the RSI indicator, displayed in blue and bounded between 0 and 100, and the unbounded MACD indicator, positioned just below the RSI.

Trend indicators offer insights into the direction of market trends. Meanwhile, other indicators provide details about the strength of current movements or key price levels to monitor.

Additionally, while some technical indicators are applied to a single stock market chart, more complex ones integrate multiple charts. These may use different time units for the same asset or compare different assets for a comprehensive analysis.

An Overview of Chart Patterns in Technical Analysis

Chart pattern analysis, a subset of technical analysis, involves identifying recurring geometric patterns on market charts.

At the heart of chart pattern analysis are two key concepts: support and resistance.

• Support is a price level that may stop a downward trend and lead to a price rebound. 
• Conversely, resistance is a price level that could halt an upward trend and result in a price decline. While these price levels can be fixed over time (horizontal lines), they can also be dynamic (diagonal lines).

This ProRealTime Web chart of the Dow Jones index features several key elements. The red horizontal line, positioned at the last significant high, represents resistance that may prevent price increases. The green horizontal line, placed at the last significant low, indicates support that could stop price declines. The blue diagonal line, which previously acted as resistance blocking price increases on three separate occasions, is now likely to serve as support.

While several methods exist for drawing support and resistance, the most common approach involves drawing support lines through the last significant low points and resistance lines through the last significant high points.

Technical analysis can detect the formation of specific patterns that are characteristic of the well-known chart patterns based on identified support and resistance..

This ProRealTime Web chart of Microsoft shares displays a chart pattern known as a “triple top,” highlighted in black. This pattern shows that the price failed to break through the horizontal resistance line, marked in red, three times. When prices broke below the horizontal support line, shown in green, a theoretical target was established at the level of the pattern’s starting point, indicated by the blue dotted line. This target was achieved a few days later.

In addition to chart patterns, technical analysts may also employ other drawing tools, such as Fibonacci retracements, Andrews’ Pitchfork, or the Gann Fan.

This ProRealTime Web chart of the NASDAQ Composite index shows an initial bullish impulse. After this surge, prices retreated to test the 61.80% Fibonacci retracement level before resuming their upward movement.

Pivot points and their variations are used to outline trading sessions with a central point, known as the pivot point, and several support and resistance levels.

This ProRealTime Web chart of the CAC 40 index shows prices repeatedly testing the pivot point (highlighted in black). After these tests, prices decline to test the second support level (in green) before moving back up towards the pivot point again.

Overview of Price Charts

Similar to simple technical indicators, the price chart types chosen to depict stock price trends also provide their own trading signals.

While the default price chart type is often the line chart, there are numerous alternatives available for displaying price history on your trading screen.

Popular price charts include:

• Line Chart
• Bar Chart
• Japanese Candlesticks
• Heikin Ashi
• Point and Figure Charts

The most advanced price charts can provide technical analysts with unique trading signals.

This approach, known as Price Action, is a minimalist method of technical analysis that relies solely on observing price trends without using technical indicators.

To customize your price chart, you can adjust several settings such as the time unit, the number of units displayed, or the scale.

The time unit (TU) refers to the duration that each unit represents on the chart. For instance: 2 minutes, 15 minutes, 1 day, 1 week…

The number of units indicates how many of these time units are visible in the chart window. For example, a chart with a “1-day” time unit displaying 50 units would show the prices from the last 50 trading sessions.

Additionally, you can manipulate the chart’s scale to highlight specific information more effectively.

The vertical axis, or ordinate scale, which represents price levels, is typically linear—meaning the distance from 1 to 2 is the same as from 2 to 3, or from 100 to 101. 

However, using a logarithmic scale can prevent the chart from appearing too compressed and allow price movements to be compared in percentage terms rather than absolute values.

This ProRealTime Web chart of Nvidia shares uses a linear scale. The recent price variations make the fluctuations from the early years difficult to read. On this scale, a $1 increase in 2024 appears the same size as a $1 increase in 2013.

The horizontal axis, which generally represents time, can be modified to no longer depend on the passage of time, but on the number of transactions, by using a “tick” scale.

In this context, one tick represents one market transaction. The more active the market, the higher the number of ticks per minute, and vice versa.

Instead of using a time unit (like “2 minutes”), a technical analyst might opt for a number of ticks (such as “20 ticks”).

This change means that rather than the chart advancing at a constant rate, with a new time unit appearing every two minutes, the chart’s progression will vary based on the level of market activity. The more active the market, the faster the chart advances, while in quieter conditions, the chart’s progression slows down.

Volume Analysis

Trading volumes and open interest in the asset under analysis are critical components that enhance technical analysis by assessing the strength of the trading signals identified.

Higher trading volumes typically indicate stronger, more reliable trading signals. Conversely, lower volumes suggest a higher likelihood of false signals.

Volumes are essential for refining the analytical framework and ensuring the consistency of an analysis. If volumes increase as prices approach support and resistance levels, the accuracy of these identified key levels is confirmed.

However, if the market breaches these crucial levels without any corresponding change in volumes, it may indicate that the technical analyst has overlooked some important factors.

Technical analysts also closely monitor the presence of price gaps. These sudden price shifts, especially when accompanied by significant trading volumes, can provide a wealth of information.

How do you learn technical analysis?

Technical analysis is a field all its own. To start learning technical analysis, the best strategy is to learn from some of the most influential experts in the industry. Here are several key texts recommended for both beginners and seasoned traders:

• “Technical Analysis of the Financial Markets” by John J. Murphy — This book is considered a fundamental resource for understanding all aspects of technical analysis.
• “Trading for a Living” by Alexander Elder — This work covers not only technical analysis but also the psychological challenges of trading.
• “Japanese Candlestick Charting Techniques” by Steve Nison — Introduces the Western world to the Japanese style of charting, providing essential techniques.
• “Bollinger on Bollinger Bands” by John Bollinger — Offers insights from the creator of Bollinger Bands, one of the most popular technical indicators.
• “Encyclopedia of Chart Patterns” by Thomas Bulkowski — This is an excellent resource for learning about and understanding chart patterns with statistical performance evaluations.
  

To complement your reading, many of these texts offer practical exercises:

• “Study Guide to Technical Analysis of the Financial Markets” by John J. Murphy
• “Study Guide for Trading for a Living” by Alexander Elder

Practice plays a crucial role in technical analysis as it trains the eye to detect trading signals as early as possible. Beyond workbooks, practicing in real-world conditions on a trading simulator is also valuable.

However, caution is necessary to avoid overemphasis. There’s a saying that to a man with a hammer, everything looks like a nail. The goal isn’t to identify trading signals at all costs.

Some novice analysts may tend to see buy and sell signals everywhere and might exaggerate their chart markings just to make their signals appear more convincing. Be wary of falling into this trap.

Conversely, it’s also important not to be overly meticulous or strict in your interpretations. Technical analysis is not a course in geometry but rather an attempt to decipher the underlying dynamics of the market based on a set of indicators.

Chartered Market Technician (CMT)

Founded in 1967, the CMT Association awards Chartered Market Technician® (CMT) certification based on an examination, the CMT Exam. 

This certification goes beyond just understanding technical indicators to study the price formation system through the interaction of supply and demand, as well as related fields such as behavioral finance and quantitative analysis.

Sayings of the Technical Analyst

While each technical analyst typically takes the time to develop their own trading plan, some consensus views have become part of popular wisdom in the form of stock market proverbs.

Conclusion

Technical analysis is a crucial trading tool for some, yet considered mere gibberish by others, sparking lively debates within the financial community.

One thing is certain: before using technical analysis to invest in the markets, it’s important to thoroughly test your trading strategies through backtesting and to practice risk-free with paper trading.

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