There are three rules that form the foundations of technical analysis. Firstly, the market discounts everything. Secondly, prices move in trends. And lastly, history repeats itself. Learn more about technical analysis with this brief introduction.
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Broadly speaking, there are two approaches that traders use to access the market in order to determine whether a market will go up or down. These are known as fundamental analysis and technical analysis. The approach is similar to the one you take when you’re buying a car. You can analyse its price, or you can decide to take a look under the hood.
While fundamental analysis focuses on the economic information of a company, commodity or currency, technical analysis focuses on the chart to predict potential future price movements.
Technical analysis is one of the most popular methods used today by traders to help identify trading opportunities. There are three principles of technical analysis:
The Market Discounts Everything
Technical analysis only considers price movement, ignoring the fundamental factors, since all these factors affecting the market price are assumed to be contained within these movements. Therefore, all that needs to be examined is the price itself.
Of course an unexpected event - such as a natural disaster or geopolitical tensions - may affect a certain market, but a technical analyst is not interested in the reason. A technical analyst focuses on the chart itself and the shapes, patterns and formations occurring on the chart.
Prices Move in Trends
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is considered more likely to be in the same direction as the trend than against it. Most technical trading strategies are based on this concept.
History Repeats Itself
The cornerstone of technical analysis is the belief that history tends to repeat itself. For example, if the EURUSD rose ahead of the FED’s meetings, a trader would buy the pair ahead of the next decision on interest rates in the United States.
As such, technical analysts utilise historic price data to help them forecast where prices are likely to head to next. This is where support and resistance levels come in.
Charts tend to form shapes that have occurred historically and the analysis of past patterns helps technical analysts to predict potential future market movements. This principle focuses on the technical analyst’s belief that trading is highly connected to probability.
The analysis of historical shapes gives the analyst advantage before opening a trade. These shapes are known as price patterns.
Forecasting the Future
Technical analysis is the practice of forecasting potential future price movements based on the examination of past price movements. Technical analysts believe that if the DAX was on the rise recently, it may gain further in the future because it is in an upward trend.
There are many different techniques for identifying trends, but much like weather forecasting, the results of technical analysis do not cover all possible eventualities. Instead, technical analysis can help investors anticipate what is likely to happen with prices over time.
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