Technical Analysis Methods

Technical analysis is a process used to quantify the price action on the chart of a security and identify trading and investing opportunities based on the patterns created by buyers and sellers. Technical analysts believe past and present trading activity in price changes can be used to create an edge for what will happen next based on what is happening now. Technical analysts try to establish a higher probability of one thing happening over another or to create a good risk/reward ratio through trade entry and management as it plays out.

Markets alternate between range expansion and range contraction.

All charts go through cycles of volatility and tight trading ranges. Understanding the current phase is crucial for trade management and position sizing. Downtrends tend to be more volatile than uptrends.

Trend continuation is a higher probability than a reversal.

A chart moving primarily in one direction will tend to continue in that path of least resistance until the trend is permanently broken. It’s better for profitability to trade in the direction of the current trend on a chart.

Buy the breakout in ranges.

Buy the dip in uptrends.

Sell the rallies in downtrends.

Sell short the breakdowns in downtrends.

Trends end in one of three ways: blow off tops, capitulation bottoms, or bending.

Uptrends can end on a huge expansion on volume and price action followed by a big reversal in direction. Long upper wicks on candles and black candle reversals are usually the two biggest signals.

Downtrends can end on huge drops in price that extend far from short-term moving averages that are followed by big candle reversals with long lower wicks.

Uptrends can form curved upper patterns that look like an upside down cup to put in a top.

Downtrends can form curved lower patterns that look like a cup to put in a bottom.

Momentum precedes price.

Strong directional price action generally continues to move in the direction of the strength. Gaps usually continue in the direction of the gap in price. Big candles are usually followed by more candles with the same directional bias.

There are two major schools of thought within technical analysis: predictive technical analysis and reactive technical analysis.

Predictive technical analysis is practiced when traders project what will happen next in price movement based on a current chart pattern. They look for the clues of volume, trendlines, and the levels of support and resistance to project the probabilities of the future price movement. It’s an attempt to predict the future price action based on the past price pattern.

Reactive technical analysis is practiced when trader’s entries and exits are based on current price signals that backtest as profitable by creating good risk/reward ratios. Their quantified price signals tell them when to get in for a good probability of success and where to get out with a small loss or to lock in a profit. Reactive traders rely on trade management as the price action plays out to minimize losses and maximize gains for profitability. They rely on quantified systems to make money in the markets, not knowing the future.

The best use of both types of technical analysis is to create good risk/reward ratios on entry. You know where you will be getting out if the trade doesn’t work out and the potential magnitude of the win if you are right. This is the true value of technical analysis.