Technical analysis: what is it and what is it for?

Technical analysis helps you identify trends and make better investment decisions. Find out what it is and how to use it.

Technical analysis is one of the keys to making informed decisions and maximizing profits through its ability to identify trends and price patterns. Find out what it is, what the main indicators are, and how to use it.

Technical analysis is an approach used by traders and investors to make decisions about buying and selling financial assets. This analysis is mainly based on the study of historical price data and trading volumes of assets. The goal is to predict the likely direction in which a price will move in order to make an investment decision based on past performance.

This principle states that all factors that can affect the price of an asset are already reflected in its current value. In other words, it does not consider that an asset may be undervalued or overvalued relative to its intrinsic value. Instead, it interprets the current price as the true value of the asset. This approach is in contrast to that of some well-known investors, such as Warren Buffett, who defend the importance of the intrinsic value of an asset.

Technical analysis is based on the idea that the market tends to react similarly to past situations and stimuli. Traders use the study of past movements to try to predict future price movements. This ability to recognise historical patterns can help investors identify profitable trading opportunities.

In technical analysis, price trends show the general direction of the market over time. There are three main perspectives for analysing trends:

• Long-term market moves.

• Medium-term market moves, usually calculated on a monthly or weekly basis.

• Fluctuations that occur within the same day of trading.

Technical analysis uses different types of charts to illustrate price movements and identify patterns. These are the most important ones.

Bar charts

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In this type of chart, each bar represents a specific time period and shows four prices: opening, closing, high, and low. It provides a comprehensive view of price movements within each period and helps to identify price entry and exit points.

Line charts

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Line charts are one of the cornerstones of technical analysis. They are formed by a continuous line connecting a series of data points, usually the closing prices of a financial asset over a period of time.

Candlestick charts

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Candlestick charts are the most common as their configuration makes it easy to visualise trends. Each candlestick represents a period of time and shows the opening, closing, high and low prices. These candlesticks are colour-coded (usually green for bullish and red for bearish) to help identify patterns.

These are the main indicators used in technical analysis.

1. Médias Móveis (Moving Averages)

An average of the price of an asset over a period of time, used to smooth out fluctuations and identify trends. When a short-term moving average crosses above or below a long-term moving average, it can signal an entry or exit point.

2. MACD (Moving Average Convergence Divergence)

A momentum indicator that shows the relationship between two moving averages of an asset. Positive values indicate bullish momentum, while negative values indicate bearish momentum.

3. RSI (Relative Strength Index)

A variable that measures the speed and change of price movements. The RSI ranges from 0 to 100 and is used to identify buy (RSI above 70) and sell (RSI below 30) conditions. Extreme values can indicate impending price reversals.

4. Bollinger Bands

This volatility indicator is made up of an average band with two outer bands representing the standard deviations of prices. The bands expand and contract with market volatility. Prices tend to stay within the bands and when prices reach one of the bands they can indicate buying or selling conditions.

5. ADX (Average Directional Index)

The ADX measures the strength of a trend, whether it is up or down. It ranges from 0 to 100, with values above 25 indicating a strong trend and values below 20 indicating a weak or non-existent trend.

6. Stochastic

A variable that compares the closing price of an asset with its price range over a period of time. It ranges from 0 to 100 and indicates buying conditions when it is above 80 and selling conditions when it is below 20. When the lines cross, it can be a sign of a change in trend.

7. Fibonacci Retracement

This indicator is based on the Fibonacci sequence and is used to identify and predict where price reversals or advances may occur.

8. Volume

Although not a traditional technical indicator, trading volume is often used to confirm price movements and identify the strength of a trend. For example, an increase in volume combined with a rise in price can signal a sustained movement.

Technical analysis and fundamental analysis are two different approaches used by investors and traders to evaluate and make decisions in the financial markets.

• • Technical analysis focuses on the study of past and current movements in asset prices and assumes that all factors affecting the value of an asset are already reflected in its price.

• • Fundamental analysis is based on an assessment of the underlying economic and financial fundamentals of an asset or company, such as revenues, earnings, profit margins, balance sheet, management, etc. In other words, the main objective of fundamental analysis is to determine the intrinsic value of an asset and whether it is undervalued or overvalued in relation to its current market price.

For this reason, technical analysis is more likely to be used by traders looking for short-term opportunities based on market fluctuations, while fundamental analysis is more likely to be used by investors looking for long-term investments based on a company’s growth potential and fundamentals.

Technical analysis can be used in various financial markets and instruments. The most common are:

1. Stocks

Technical analysis is widely used in the stock market to help identify price patterns and trends that may indicate entry or exit points for individual stocks or market indices.

2. Forex

Forex traders often use technical analysis to make decisions about buying and selling currency pairs, identifying trends and reversal points as it is a very liquid and volatile market.

3. Commodities

Commodities such as gold, oil and metals are also traded on the basis of technical analysis. Traders look for patterns in the prices of these assets to predict future movements and make trading decisions.

4. Derivatives

Technical analysis is also used in derivatives to analyse the behaviour of underlying prices. This analysis is particularly used in instruments such as CFDs, which tend to be short-term investment solutions.

What to look out for when using technical analysis

When using technical analysis, it’s important to take certain precautions in order to make informed trading decisions and reduce risk.

1. Learning curve

Technical analysis takes time. Don’t expect to master all the indicators and price patterns quickly. Patience and practice are essential to developing solid skills.

2. Choosing indicators

Not all technical indicators are equally reliable. Some may work better in certain markets or under certain conditions. It’s important to test and understand which indicators work best for your trading style.

3. Market context

Technical analysis needs to be complemented by an understanding of the broader market context. Fundamental factors such as economic news and geopolitical developments can have a significant impact on price movements.

4. Confirming signals

Don’t make decisions based on one indicator or pattern. To validate your decisions, look for confirmation using multiple technical indicators or other forms of analysis, such as fundamental analysis.

5. Managing emotions

Avoid making decisions on the spur of the moment based on emotions such as fear or ambition. Be disciplined and stick to your negotiation plan.

6. Continuing education

Stay abreast of new trends and developments in technical analysis. Continuing education can improve your skills and help you adapt your strategies to market changes.

Banco Carregosa’s team of experts is committed to helping you achieve your financial goals and understand analytical strategies such as technical analysis. With our extensive experience and in-depth knowledge of the market, we can help you get the most out of these and other investment analysis methods. Contact us today and find out how you can maximise the potential of your investments.