How technical analysis shapes trading strategies

Basic Understanding of Price Behavior

Technical analysis is an analytical framework that uses historical price data and trading volumes to identify future market movements. This method differs from fundamental analysis in that it ignores the company's financial health and instead focuses solely on price history and charts.

A central axiom within this form of analysis is that all available market information is already embedded in the price. Therefore, traders can make predictions about upcoming price movements by studying trend patterns and volume flows.

The Market Mechanics Behind the Analysis

Price development fundamentally reflects the forces between buyers and sellers. These opposing forces are generated by traders' and investors' emotional reactions – primarily fear and greed. When liquidity is high and the volume significant, the possibility of price manipulation is minimized, making technical analysis more reliable.

During periods of low volume or extreme market disruptions, this method is less effective. External shocks and unexpected events can generate false price behavior that contradicts the patterns.

Historical Development of the Analysis Method

Although early variants of this technology appeared in 17th century Amsterdam and 18th century Japan, the modern form was primarily developed from Charles Dow's theoretical work. As a financial journalist and founder of the Wall Street Journal, Dow observed that both individual securities and entire markets tend to move in segmentable trends.

Dow's contributions led to the development of what later became known as Dow theory. This theory stimulated further research and refinement of analytical tools. From the early period when chart analysts worked with manual calculations and hand-drawn charts, the advancement of technology has enabled modern traders to apply these principles much more effectively.

Most Important Indicator Systems

Traders use various measurement systems to read price movements and locate trading opportunities:

Relative Strength Meter (RSI)

This is an oscillator that measures the rate of change in price movements on a scale from 0 to 100. Traditionally, values above 70 are interpreted as overbought conditions (potential sell signal), while values below 30 indicate oversold situations (potential buy signal).

Moving Averages (MA)

Two variants are often used:

The simple moving average (SMA) calculates the average price over a defined period and smooths out short-term price fluctuations. The exponential moving average (EMA) weighs the most recent prices more heavily, making it more sensitive to new market information.

These indicators help traders determine the direction of trends and identify potential support and resistance levels. A proven strategy involves observing when short-term moving averages cross long-term moving averages – this can signal buying or selling opportunities.

MACD system ( Moving Average Convergence Divergence )

This trend-following indicator reveals the relationship between two exponential moving averages. It consists of the MACD line, the signal line, and a histogram. These components can be used to detect potential buy or sell points based on line crossings.

Volatility Bands (Bollinger Bands)

This indicator features two lateral bands that surround a midline based on a moving average. The bands act as gauges for market volatility and help identify overbought or oversold conditions.

The Practical Application of Trading Signals

Indicators are often converted into concrete signals for entry and exit points:

Overbought/oversold detection: Measurement instruments such as RSI can indicate when a security is overbought (sell signal) or oversold (buy signal).

Moving Average Crossovers: A bullish signal occurs when a short-term moving average crosses upward through a long-term moving average (called a golden cross). A bearish signal occurs at the opposite movement (death cross).

MACD Crossings: When the MACD line crosses above the signal line, this can indicate a bullish trend; a downward crossing may suggest a bearish trend reversal.

Important limitations and pitfalls

Trading signals from this analytical method are far from infallible. On the contrary, the indicator systems often produce significant amounts of noise and false signals, especially at short-term trading horizons. To minimize losses, it is important to combine the indicator with other analyses and implement robust risk control strategies.

Critics point to several weaknesses:

Self-fulfilling prophecy: Many assert that this analysis works primarily because a large number of traders use identical indicators, which creates predictable outcomes.

Interpretation variability: Different traders can draw completely opposite conclusions from the same chart and patterns, reflecting the subjectivity of the method.

Performance degradation during market anomalies: This analysis method becomes less effective during periods of extreme price fluctuations or when unforeseen external factors shake the markets.

Despite this criticism, proponents of the method argue that each chart analyst develops their own particular style when it comes to interpreting charts and combining indicators. This would theoretically make it practically impossible for many traders to use exactly the same strategy.

Technical analysis compared to valuation analysis

While technical analysis focuses on historical price movements, valuation analysis examines an asset's intrinsic value by studying financial statements, macroeconomic data, and other qualitative factors.

Technical focus: Best suited for traders with a short-term time horizon and helps to pinpoint optimal entry and exit points for positions.

Valuation focus: Better suited for long-term investors who assess an asset's overall health and growth potential.

Many experienced investors prefer to combine both methods to create more robust and well-informed trading decisions.

Concluding Perspective

Regardless of the long-standing debates about the relative value of the methods, many market participants use a hybrid of both approaches. While valuation analysis typically guides long-term portfolio constructions, technical analysis can provide valuable insights into short-term market dynamics – insights that are useful for all types of traders and investors. A balanced growth by leveraging the strengths of both forms of analysis often represents the most sustainable path to consistent success.

This article is presented for educational purposes only. The content is provided “as is” and for general information. It does not constitute financial, legal, or professional advice of any kind. Investments in digital assets carry significant risks. The value of your investment may decrease, and you may lose all invested capital. You are fully responsible for your investment decisions. Before making major financial decisions, it is recommended that you consult independent professional advice.