What is technical analysis and how does it work?

A technical analysis is a meticulous approach used by investors and traders to predict future price movements of assets such as stocks, currencies, commodities, and even cryptocurrencies.

Unlike fundamental analysis, which focuses on the underlying economic factors of a company or economy, technical analysis completely ignores these aspects, focusing solely on historical price behavior and trading volume.

The basic premise is that all the information needed to predict future movements is already reflected in price and volume, making these variables the main sources of data for decision-making.

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How does technical analysis work?

The operation of technical analysis involves the use of graphs and indicators that, over time, have proven to be effective in identifying recurring patterns in the market.

Charts are the visual tools where price and volume are plotted over time, and technical indicators, such as moving averages, the Relative Strength Index (RSI), and the MACD (Moving Average Convergence Divergence), are mathematical formulas applied to this data to highlight trends and potential reversal points.

The underlying logic is that markets follow cycles and that by recognizing these cycles, investors can position themselves advantageously.

This approach is widely accepted and used around the world, especially by traders operating in the short and medium term.

An example of this is recent research from the CFA Institute, which revealed that 80% of professional traders use some form of technical analysis in their investment strategies.

Indeed, this data highlights the continued relevance of this methodology in the contemporary financial environment.

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How did technical analysis come about?

Many people don't know, but this analysis has deep historical roots, dating back to the 17th century, when rice traders in Japan used candlestick charts to predict price movements.

However, the modern technical analysis, as we know it today, began to take shape in the late 19th century with Charles Dow.

Dow, co-founder of The Wall Street Journal, developed the Dow Theory, which is widely considered the basis of modern technical analysis.

Dow Theory postulates that the market reflects all available information, and that prices move in trends that can be identified and analyzed.

He also noted that these trends tend to repeat themselves over time, and that investors could benefit from identifying and following these trends.

His theory was later expanded upon by other analysts, leading to the development of a variety of tools and techniques that continue to be used today.

A modern example of the application of technical analysis can be seen in the growing popularity of day trading and swing trading, where traders seek to capitalize on small price movements in the market.

These practices are almost exclusively based on technical analysis techniques, and their effectiveness is directly related to the trader's ability to correctly interpret chart signals and patterns.

What is the main objective of this strategy?

The main objective of technical analysis is to accurately predict future price movements.

In this way, it allows investors to identify buying and selling opportunities that offer significant profit potential.

This strategy is particularly effective for those trading on short to medium-term horizons, where market volatility can be leveraged for quick gains.

Contrary to fundamental analysis, which aims to identify the intrinsic value of an asset for long-term investments, technical analysis is predominantly used to identify optimal entry and exit points based on price and volume patterns.

This allows traders to position themselves strategically in both bull and bear markets to maximize their returns.

Furthermore, this analysis is a crucial tool for risk management.

Since, by using technical indicators and graphic patterns, investors can determine the best points to set stop-loss orders, limiting their losses in case of adverse market movements.

As John Murphy, one of the most renowned technical analysts, stated:

"Chart study is an art form, a combination of science and art, that requires an understanding not only of the numbers, but also of the human behavior and emotions that drive the market."

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What is the difference between technical analysis and fundamental analysis?

The distinction between technical analysis and fundamental analysis is one of the most important aspects for investors seeking to understand the different approaches to market analysis.

While technical analysis focuses on price patterns and trading volume, fundamental analysis focuses on underlying economic factors such as earnings, revenue, debt, and others. financial indicators that determine the intrinsic value of an asset.

Fundamental analysis is ideal for investors looking to build a long-term portfolio based on assets that offer real value, regardless of daily price fluctuations.

On the other hand, the technical analysis is best suited for traders looking to take advantage of market volatility to make quick profits.

This approach allows traders to trade based on current data rather than long-term predictions, making it a powerful tool for short-term trade management.

How to do a technical analysis?

To perform a technical analysis effective, it is necessary to master a series of skills and tools that allow you to correctly interpret market signals.

Choosing the Analysis Tool

The first step is to choose the right analysis tool. There are several platforms on the market, such as TradingView and MetaTrader, that offer a wide range of features, from advanced charting to custom indicators.

Choosing the right tool is crucial to the success of your analysis, as it must offer the features that meet your specific needs.

Selection of Indicators

After choosing the tool, the next step is to select the technical indicators. These indicators are essential for analyzing trends and identifying possible reversal points in the market.

Moving averages, for example, help smooth out price fluctuations, revealing the general direction of the market.

The RSI is used to measure the strength of a price movement, helping to identify whether an asset is overbought or oversold.

Chart Analysis

Graphical analysis is the heart of technical analysis. By looking at charts, you can identify patterns such as "head and shoulders", "triangles" and "flags", which historically indicate potential changes in price trend.

These patterns are visualizations of market behaviors, reflecting the psychology of investors and their reactions to price movements.

Decision Making

Finally, based on the analysis of the charts and indicators, it is time to make informed decisions. Defining entry and exit points is essential to maximize profits and minimize losses.

Additionally, it is important to set stop-loss and take-profit orders, which help protect your capital in case of unexpected market movements.

Final considerations on technical analysis

A technical analysis It is an indispensable tool for any trader who wants to operate based on concrete data and avoid relying exclusively on intuition or subjective analysis.

However, it is important to remember that, like any investment strategy, technical analysis is not infallible.

It should be used in conjunction with other forms of analysis and always with a clear understanding of the risks involved.

The financial market is dynamic and constantly evolving, which means investors must continue to educate themselves and adapt their strategies as market conditions change.

By doing this, the technical analysis can become a fundamental part of your investment arsenal, allowing you to make more informed and potentially more profitable decisions.