Forex Trading Library

What is the Purpose of Technical Analysis?

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Technical analysis employs statistical methods to evaluate financial instruments. Additionally, it identifies trading opportunities, based on historical data of price and volume.

This type of analysis is based on the assumption that the past momentum of prices serves as a valuable indicator of their future value. While fundamental analysis concentrates on the intrinsic value of a financial instrument, based on news reports and other external factors, technical analysis depends on several analytical tools, like charting tools, trend lines, and mathematical formulae, to get the right trading signals. The modern-age electronic trading software allows testing of investment strategies on historical data to evaluate their efficiencies, even before they are tried out in the live markets.

Technical analysis is a powerful tool at a trader’s disposal.

The Basic Assumptions of Technical Analysis

When Charles Dow introduced technical analysis in the late 1800s, it was based on two essential factors:

  1. The market price of any currency pair accurately reflects all available information and, represents the real value of the pair.
  2. Price movement is not random; it is based on identifiable trends and patterns that tend to get repeated in cycles.

These underlying assumptions provide advantages to traders who use analytical tools.

The Advantages of Technical Analysis

Traders use technical analysis for decision making. By using various indicators, patterns, and analytical objects, they can carefully assess the price direction of an asset, while also understanding how long the trend is likely to last. The forex markets are either trending or ranging. Through this, they can find potential trading opportunities.

Technical analysis also helps in confirming decisions. A trader has many sources of information that point towards a particular market sentiment. Through technical analysis tools, this information can be verified, in the form of potential trends that coincide with the fundamental analysis.

Hundreds of signals and patterns have been developed by researchers to help traders employ technical analysis in their trading. Some indicators identify crucial support and resistance areas, to indicate the ongoing market trend. Others, like moving averages and momentum indicators, tell the strength of the trend in any direction, and the likelihood of reversals.

Do you need more reasons?

Since all fundamental factors that affect the price of an asset show up in the charts, a trader can quickly find the value of an asset, without extensive research. Rapid price movements or trends occur as a result of the release of new fundamental data, which proves that the markets take human behavior into account too. One of the most important aspects of technical analysis is that it helps in risk management.

Traders can know how to cut short their losses, by exiting a trade at the right moment. Technical analysis helps short-term traders, who can resort to aggressive day trading or swing trading, by using mathematical algorithms.

However, it is essential to know that technical analysis tools or indicators are not perfect. They can generate false signals from time to time. But, with experience in using them, they can provide a means to achieve consistency in trading decisions. Combined with good fundamental analysis, technical analysis remains an essential part of every trader’s journey.

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