Technical analysis consists primarily of a variety of technical studies, each of which can be interpreted to generate buy and sell decisions or to predict market direction.
Support and Resistance Levels
One use of technical analysis, apart from technical studies, is in deriving “support” and “resistance” levels. The concept here is that the market will tend to trade above its support levels and trade below its resistance levels. If a support or resistance level is broken, the market is then expected to follow through in that direction. These levels are determined by analyzing the chart and assessing where the market has encountered unbroken support or resistance in the past.
Popular Technical Analysis Tools
- Moving Averages (MA): Indicators used to smooth price fluctuations and identify trends. The most basic type of moving average, the simple moving average, is the average of the past x bars ending with the current bar;
- Moving Average Convergence Divergence (MACD): Indicator that utilizes moving averages to identify possible trends and an oscillator to determine when a trend is overbought or oversold;
- Bollinger Bands: Bands that are placed x moving average standard deviations above and below a simple MA line;
- Fibonacci Retracement Levels: Indicator used to identify potential levels of support and resistance;
- Directional Movement Index (DMI): A positive line (+DI) measuring buying and a negative line (-DI) measuring selling pressure;
- Relative Strength Index (RSI): Momentum oscillator that is plotted on a vertical scale from 0 to 100;
- Stochastics: Momentum oscillator that measure momentum by comparing the recent close to the absolute price range (high of the range minus the low of the range) over a period of x bars;
- Trendlines: Straight line on a chart that connects consecutive tops or consecutive bottoms of prices and is utilized to identify levels of support and resistance;
Fundamental analysis is the evaluation of non-visual information to evaluate trading activity and make trading decisions. Whereas technical analysts utilize charts and mathematical indicators to quantify price activity, fundamental analysts utilize market news and market forecasts to qualify price activity.
There are numerous market events that move financial markets every week. Some affect every market instrument while others affect specific instruments. If the outcome of a market event has been fully discounted by the market, traders will not notice any discernible impact on their charts. If the outcome of a market event has not been fully discounted by the market, the result is either price appreciation or price depreciation and traders will see this activity on their charts.
Every week, there are fundamentally-important market events that are scheduled in every country at specific times. Similarly, there are fundamentally-important market events that may not be scheduled for specific times. Some countries (Germany, for instance) often do not schedule market events for specific times. The outcome of market events is sometimes leaked in advance in certain countries (Germany, for instance) for different reasons.
Controlling risk is one of the most important ingredients of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he or she is willing to lose on each trade before cutting losses, and how much he or she is willing to lose in trading account before ceasing trading and re-evaluating.
Risk will essentially be controlled in two ways: by exiting losing trades before losses exceed your pre-determined maximum tolerance (or “cutting losses”), and by limiting the “leverage” or position size you trade for a given account size.
Too often, the beginning trader will be overly concerned about incurring losing trades. Trader therefore lets losses mount, with the “hope” that the market will turn around and the loss will turn into a gain.
Almost all successful trading strategies include a disciplined procedure for cutting losses. When a trader is down on a position, many emotions often come into play, making it difficult to cut losses at the right level. The best practice is to decide where losses will be cut before a trade is even initiated. This will assure the trader of the maximum amount he or she can expect to lose on the trade.
The other key element of risk control is overall account risk. In other words, a trader should know before start of trading endeavor how much of trading account he or she is willing to lose before ceasing trading and re-evaluating strategy. If you open an account with $2,000, are you willing to lose all $2,000? $1,000? As with risk control on individual trades, the most important discipline is to decide on a level and stick with it. Further information on the mechanics of limiting risk can be found in trading literature.
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