Financial Literacy

Technical Analysis Beginner’s Guide to Trading

Technical analysis can help you improve your investment returns. On top of that, some of these techniques can help with limiting losses. Whether you’re a short-term trader or a long-term investor, this discipline is good to know.

To start, let’s look at a clear explanation of technical analysis. Then to get a better understanding of it, we’ll dig into how it’s evolved over time. And last but not least, you’ll find a list of more resources.

writing down technical analysis techniques in a book

What Is Technical Analysis?

Technical analysis uses patterns and charts to determine when to buy and sell assets. This works by looking at past trends and predicting how prices will move going forward.

There are many repeatable patterns in finance and throughout the world. In nature, we see both high and low tides. And in the stock market, we see expansions and contractions. Comparing these two doesn’t necessarily lead to better trading decisions. But there are many overlapping patterns that traders have found to be useful.

For example, here’s the Fibonacci sequence…

0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

Do you see a pattern in the numbers above?

Spoiler Alert: Add up the two previous numbers.

You can find this pattern in shells, beehives, trees and storms. It’s everywhere, and some traders use it in technical analysis. One ratio derived from the Fibonacci sequence is the golden ratio. It gives percentages that traders use to find support and resistance levels. Traders use these levels to help determine when to buy and sell assets.

For one more unique example, traders value option contracts based on a modified thermodynamics equation. This heat equation underpins the entire derivates market, which is many trillions of dollars.

Overall, there are many repeatable patterns in both nature and financial markets, although picking any old technical analysis technique might not work. That’s why it’s important to look at how technical analysis has evolved over time…

Technical Analysis History and Why It Matters

One of the earliest forms of technical analysis is Dow Theory. It came from Charles Dow in the late 1800s. One key takeaway is that market trends have three big phases. And applying this framework to stock market moves can lead to better entry and exit prices.

Since Dow Theory, technical analysis has come a long way…

With the rise in technology, we have access to more market data. This data has given us a better look at past market trends. Plus, it’s enabled traders to use technical analysis techniques to find shorter-term trends.

Technical analysis is commonplace with swing traders and day traders. Many brokerages and trading platforms have built-in pattern techniques in their charts. Here’s a list of some common technical analysis charting…

  • Trading Volume Changes (Liquidity)
  • Relative Strength (RSI)
  • Moving Average Convergence Divergence (MACD)
  • Average Directional Index (ADX).

There are thousands of technical analysis strategies. And as more traders use and adjust their processes, some techniques can lose their luster. For example, even if a specific use case of MACD works for a few months, it’s not guaranteed to keep working.

This is why it’s important to keep testing and improving your technical analysis. As more traders come online, it’s vital to stay one step ahead of them. Too often people forget that there’s someone on the other side of every trade.

Limit Trading Losses

Many technical analysis traders start their journey with dollar signs in their eyes. Experienced traders know managing risk is just as important… if not more important. And technical analysis can be a great tool for limiting losses.

One useful trading technique is stop losses. Traders can set a dollar amount or percentage they’d like to sell their position at. For example, if you buy a stock for $100 and set a 25% stop loss, you’ll sell if it drops down to or below $75.

To set more effective stop losses, traders will look at a stock’s past pricing volatility. They also factor in their holding period and position size. With these simple – yet valuable – factors, traders can limit downside risk.

Overall, technical analysis can be a great discipline for managing both risk and reward. And technology has helped level the playing field. Anyone can start using technical analysis to improve their trading process.

To receive more technical analysis tips and tricks, sign up for the free Trade of the Day e-letter. It’s packed with useful insight from trading experts. You might also be interested in trying out this Investment Calculator. You can use it to help you see how your portfolio can grow.

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