The Basics of Technical Analysis That You Need to Know

Technical analysis is the study of human psychology, which is represented in the form of price action. The study of historical price movements relay the fear and greed associated with financial markets as markets tend to move in the direction which generates the most significant emotions. The study of technical analysis ranges from specific trigger areas that form support and resistance levels, to statistical studies that express momentum as well as the perceived fair value of a financial security. This visual representation of price action and current psychology of price action may give an investor a picture of potential future market movements. In this article we will discuss the human emotion attached to specific price action and how that reflects supply and demand for an asset.

Historical movements in the market represent how people felt at a time about a security as all the current available information is reflected in the price of an asset. As new information becomes available people change their view which is immediately reflected in the price of a security or asset. While the short term movements in price can represent noise, the distribution of price eventually leads it to an equilibrium level.

There are many tools that have been developed that may help an investor measure past price action and predict future price action based on a pattern that has recently occurred. Although past performance does not guarantee future returns, the memory of where prices moved becomes a guide to traders on which direction prices may eventually flow.

As prices congregate at specific levels, they entice both supply and demand, where traders are buying and selling. If buying increases relative to selling at a specific price, it is generally forced higher. As selling increases relative to buying at a specific level, the price is forced lower. One of the best ways to begin to follow prices is to define for yourself areas of supply and demand which are referred to as support and resistance.

Support and Resistance

Support is a level that designates demand where buyers are increasing relative to sellers, pushing the price higher. Resistance is the opposite of support in that it designates an area of market price action in where prices have a difficult time moving higher. The supply for a financial instrument is strong at resistance levels, and sellers are willing to either short or sell long positions (profit taking) at resistance levels.

When you follow prices you attempt to find levels where prices congregate. Many traders use the high of a day or the low of a day, to define short term support or resistance. You may also use weekly, or monthly highs and lows as well as intra-day highs and lows to define both support and resistance. Another way to define support and resistance is by using trend lines.

Trend Lines

A trend line connects two or more points in an effort to create a subjective area which can act as either support or resistance. Many strict technicians believe three points are required to form a trend line. Trend lines are generally downward sloping when forming resistance levels and upward sloping when forming support levels. Another generality of trend lines is the more points on the line; the more robust the line is considered, especially when it is breached.

Trend lines that form resistance are usually downward sloping, although horizontal trend lines can also form resistance. The slope of the trend line points to price levels that can be used to subjectively generate a resistance level.

A trend line can also be drawn by finding highs and lows and extending a horizontal line to find new support and resistance levels. You can also draw a channel that shows a trading range that is extended in the direction of the trend.

When a trend line is broken, there is a change in market psychology. Prior to a break of support or resistance, investors can become complacent with consolidating market price action. The breakout or breakdown, changes market sentiment, and generates a quick reaction based on the fear of a change in the market dynamic. This change in market sentiment is usually accompanied by increasing market volume. Another method of finding support and resistance is by using averages.

Moving Averages

Moving averages are also used as areas that designate support and resistance. Moving averages will quickly switch as pivot points representing support and then resistance. A moving average is often used as the fair value of a security’s price. Moving averages designate the current trend of a market, but are considered a lagging indicator. A moving average is calculated by taking the average of a specific time frame, and when you add the next day the earliest date is dropped. For example, if you are calculating a 50-day moving average, you would determine the average of 50-days, on day 51, you would drop day one from the calculation. If you want to further define the distribution of prices you may use a Bollinger band.

Bollinger Bands

When prices reach the upper Bollinger band they are considered relatively high and when prices reach the lower Bollinger band are considered relatively low. A Bollinger band, which was created by John Bollinger, calculates a moving average, and then projects 2-standard deviations above and below that moving average. Those point incorporate approximately 95% of the distribution of prices during that period which is defined by the moving average.

For example, if you used a 20-day moving average, you would have areas that defined 2-standard deviations above and below the 20-day moving average. When prices are over-extended, they generally snap back in the short-term. A measure of over-extension is the Bollinger band high and Bollinger band low. Bollinger bands incorporate 95% of all price action which means there is 5% which is unaccounted for by the study. To avoid selling when the market is continuing to move higher or buying when the market is continuing to move lower, a trader should seek confirmation from other technical tools to find a prudent entry point.

Defining support and resistance is one of the best ways you can start to learn about market changes and how to use technical analysis to evaluate future price movements.

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