Creating a strategy for technical analysis means basing decisions about when to invest around a fixed set of rules. Read on for some sound guidelines.
Technical analysis is an evaluation technique used by traders to predict price movements in the financial markets. Unlike fundamental analysis, which focuses on underlying fundamentals such as revenue growth and industry trends, technical analysis relies purely on statistical analysis and chart reading.
Technical analysis tries to predict the future price of an underlying asset by using past prices as well as trading volumes. The evaluation practice in itself can involve analysing charts in a bid to determine price patterns that may indicate future price movements.
Technical analysis can also be quantitative, involving the use of indicators to predict future prices using past price and volume data; there are different forms of technical analysis that you can use to squeeze a profit while trading in capital markets.
While long-term investors tend to lean heavily on fundamental analysis, traders with shorter-term goals rely on chart patterns and technical indicators. Likewise, there are automated algorithms that open and close positions, depending on price movements and technical indicators.
I. Basics of technical analysis strategy
A technical analysis strategy comprises of a set of rules that define when a trader should take action, be it to enter or exit a position, depending on price patterns in the market. Most technical analysis strategies consist of trade filters and triggers that are based on various technical analysis indicators.
A trade filter identifies setup conditions, while trade triggers identify a particular time when an action is executed. A trade filter may involve paying attention to whenever a price moves above a given moving average, while a trade trigger might be whenever a stock’s price is about to breach the moving average.
The indicators that you use to develop a trading strategy will depend on which strategy you choose. For traders looking for long-term moves with large profits, a trend-following strategy using moving averages will make sense. A trader looking for smaller moves with frequent gains would focus on volatility indicators.
While developing a technical analysis strategy, it is important to consider a number of different points. Those include:
- The type of moving average being used
- How far above or below the moving average a price should move to enter or exit a position
- What type of order to place whenever market conditions are met
- How many contracts or shares to trade
- What are the exit rules
II. Moving Average Crossovers
Crossover is a popular technical analysis strategy where technical analysts track how two moving averages react to price movements. For instance, one can use both the 50-day, which acts as the fast-moving average, with the 200-day acting as the slower moving average.
The crossover strategy will come into play whenever the 50-day moving average crosses the 200-day moving average from below. The crossover indicates an upward price trend, signalling that it’s time to look for buy opportunities. The widening of the gap between the 50-day and 200-day moving average after the crossover, affirms the strength of the emerging uptrend.
Conversely, the 50-day moving average crossing the 200-day moving average from above signals the development of a downtrend. Widening of the gap between the two moving averages in that direction affirms the strength of the emerging downtrend, meaning you should look to sell.
The crossover strategy is ideal with highly volatile and liquid securities, given the increased frequency with which the moving averages may cross each other, giving rise to buy and sell opportunities.
Sources & references
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