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One of the things you’ll do a lot as a trader or investor is to study price charts of the instruments that interest you. And if you’re new to this and often wonder what the purpose of studying price charts is, you should know that it is an element of what is called technical analysis. But what is technical analysis? How does it work? This post answers these and many other questions you may have.
Defining What is Technical Analysis
Technical analysis refers to the study of past trading activity and price movements. The technique focuses on analyzing trading patterns and price charts, then uses the insights to predict where the price of a currency pair, stock, or other financial instrument is likely to move next. Simply put, technical analysis is like studying the “footprints” that buyers and sellers leave on a price chart. You use the knowledge to guess where the price might go next.
Two things immediately jump out of this definition. First, technical analysis is only concerned with the price history of a financial instrument and how much was bought or sold. Second, those using this technique don’t worry about why the price moved. No. All they want to know is the repeating trends and patterns in the charts.
The basic idea that is the foundation of technical analysis is that prices move in patterns and that they follow trendlines. Why does this happen? Traders (who are mostly humans) often react the same way in similar situations. So, someone using this technique hopes to spot the right time to buy or sell an instrument.
How Technical Analysis Works
This approach is “technical” because it focuses on the measurable techniques of market action (trading volume, trends, and chart patterns). And you can see this in how it works. So, how does it work?
Technical analysis happens in five major stages. Let’s walk through each one using an example.
Suppose you’re a foreign exchange (forex) trader; that is to say, you buy and sell currency pairs, such as the EUR/USD.
Stage 1: Collecting market data
The data for the EUR/USD pair would include:
- Price history: How the market has bought and sold the pair over time.
- Timeframe: Say you look at the daily chart. If you’re using a candlestick chart, each candle would represent one day.
Volume or liquidity: The forex market doesn’t have centralized volume like equities, but trading platforms (or brokers) show tick volume (which is just how active the market is).
Source: Sigmanomics.com
Stage 2. Plot and study charts
Here, you plot the chart (typically a candlestick chart) for the currency pair. Suppose you pulled up the last six months of EUR/USD daily prices. Plotting the data on a candlestick chart creates patterns.
Let’s say, for purposes of this discussion, that your chart shows the EUR/USD bouncing between two levels. It touches but doesn’t cross the 1.07000 level, and when it rises, it doesn’t cross the 1.1000 level. Traders call the lower price level support, and the upper level resistance.
Suppose that, after carefully studying the chart, you notice that the 50-day moving average (MA) indicates the pair’s price is slightly trending upwards. You also see that the pair is testing the resistance level for the third time.
Source: Sigmanomics.com
Stage 3. Identify signals
This is where you start looking for clues. First, there is a trend clue; recall the 50-day MA trending upwards? Traders read this as bullish, which is another way of saying that the pair’s price action is trending upwards.
Second, suppose you use a Relative Strength Index (RSI) indicator and you see that it has moved from 40 to 60. This is a momentum clue and is a sign that buyers are gaining strength. In technical terms, we say the market is trending towards the “Overbought” zone.
Third, you see that the price chart has a series of higher lows. This is a pattern clue. The signal here is that the market is building pressure towards a breakout. A breakout happens when the price ‘breaks’ above the resistance level.
Lastly, you see that two candles are forming a familiar pattern just below the 1.1000 level. There is a small red candle followed by a towering green candle that completely covers (or engulfs) the red one. This is a candlestick clue and traders call the pattern formed a bullish engulfing candle.
Stage 5: Review results
Let’s say the trade plays out:
- The pair breaks above 1.1000 and rallies to 1.1100 in three days.
- Your trade hits the take-profit target (+100 pips).
As part of reviewing the results, you enter the following information in your trading journal:
- Setup: Breakout resistance at 1.1000.
- Signals: Rising MA, RSI momentum, bullish engulfing candle.
- Outcome: Target hit, reward double the risk (+2R)
- Lesson: Breakout setups with multiple confirmations work well.
If the trade had failed, the review would focus on whether signals were weaker than thought or if stop placement was too tight.
Tools and Techniques of Technical Analysis
A lot comes out in the illustration above, but two elements stand out. They are the tools (indicators) and techniques (chart patterns) that facilitate technical analysis. Without them, you wouldn’t know what signals (if any) to read from the price movements.
- Chart patterns: As price climbs and falls in daily trading, the path it tracks across the chart forms distinctive patterns. Traders study these shapes in a bid to anticipate how price action will behave in the future. Great examples that we saw are support, resistance, and the bullish engulfing candle.
- Indicators: These are tools that use mathematical calculations (applied to price or volume data) to identify trends or signals. The illustration above used two to identify signals: the 50-day moving average and the RSI.
Why Does Technical Analysis Work (When It Works)?
Technical analysis has been around for ages because it works. In fact, analysis shows that candlestick charts (and early forms of technical patterns) were in use during the 18th century. But the main reason traders keep coming back is because markets are shaped by human psychology. And human behavior often follows patterns.
Two key ideas help to explain why this technique works. First, the self-fulfilling prophecy. Many traders around the world watch the same price charts. If many of them see EUR/USD approaching resistance at 1.1000, they expect selling pressure there, so they place sell orders around that level. As a result, the price really does stall at 1.1000, not because the number itself is magical, but because enough people believed it was important. Technical signals often “work” because so many participants act on them at the same time.
Second, there is the idea of market memory. Markets “remember” where significant price action happened before. If a stock falls hard from $60, traders remember that level as a painful one and may sell again when the price returns to it. Likewise, if a currency pair bounced from 1.0700 multiple times, traders remember it as strong support and are more willing to buy at that level again. These memories create recurring price patterns.
Beyond psychology, technical analysis stands on three guiding principles (we’ve done a deeper dive into these principles in a previous article, so please check it out here):
- The market discounts everything: That is, all available information is already reflected in the price.
- Prices move in trends: Once started, trends often persist longer than expected.
- History repeats itself: Patterns form because human reactions to fear and greed don’t change.
Taken together, these factors explain why technical analysis often provides useful clues. It doesn’t always predict the future, but when crowd psychology aligns with these principles, it can give traders and investors an edge.
