Technical analysis differs from fundamental analysis in that it does not seek to identify the appropriate price for a currency or security based on economic indicators or other news events. Instead, technical analysts track historical prices and volumes in an attempt to identify trends. Technical analysts use charts and graphs to quantify historical performance to identify repeating patterns as a means to signal buy and sell opportunities – for this reason, technical analysts are sometimes referred to as chartists. The field of technical analysis is based on three important assumptions:
Technical analysts do not consider factors such as interest rates and other fundamental indicators when evaluating a security. They believe that any impact that economic conditions could have on a currency will automatically be factored into the price of the security through the natural actions of buyers and sellers within the market.
Technical analysts believe that prices move in trends and price movements generally follow established patterns. Some commentators attribute this partly to the phenomenon known as market psychology (or more euphemistically as herd mentality) which is based on the widely-held belief that participants in the markets – who for the most part have the same goals and objectives – react in a similar fashion when faced with similar situations.
In some instances, this may even be an unconscious aversion to breaking a certain price barrier such as the case in September of 2007 when the Canadian dollar reached parity with the U.S. dollar or when oil finally broke the $100 a barrel mark. Both events eclipsed long-standing price barriers and oil in particular saw the price see-saw back and forth several times before finally breaking through the $100 plateau in January of 2008.
As noted, technical analysts look for trends as a way to predict future prices and this is the strategy most commonly-used by technical analysts. Essentially, there are three self-explanatory trends:
Chartists believe that future price movement is tied closely to the current trend and while trend reversals are inevitable, often times there is sufficient historical data available to identify potential reversal points that mark the end of a trend.