If you are interested in trading using technical analysis having a basket of tools is the cornerstone of any successful trading strategy. The problem is knowing which tools and techniques to use. The markets are so complex and the variables so many that traders biggest battle is focusing on what matters. To be successful at anything in life requires laser focus. If we can master a handful of things, it’s possible to be successful at whatever one chooses. Trading is no different. In this post I’ll outline the 5 best technical analysis tools which I use and focus 100% of my efforts on to master.
5 best technical analysis tools
In this post I will discuss the 5 best technical analysis tools. These simple tools that I use in my own trading to develop my trading ‘edge’. These technical analysis tools when mastered help to produce high probability trading setups.
Support & Resistance
Support and Resistance levels are the bread and butter of technical trading. Most likely you have already heard about or know of support and resistance. Finding support and resistance levels is a fundamental skill all traders should aspire to master.
What are Support and Resistance?
Support and resistance levels are horizontal levels of price indecision with the expectation that price will reverse. These levels are also often referred to as supply and demand zones. Demand zones or ‘Support’ levels are price levels where the market is seen to be of good value and buyers step in. Supply zones or ‘Resistance’ levels are price levels where the market is seen to be over supplied and sellers step in to take control of price.
At these levels there is typically a flood of buy and sell orders. One side exhausts their order pressure and the other side takes control.
For example, if price is trading up to a known level that level will act as resistance. As price approaches this level prices are expected to reverse and trade down. If price is trading down to a price level that level will act as support and prices are expected to reverse and trade up.
How are Support and Resistance zones created?
The exact reason for the predictive power of support and resistance zones is not universally agreed upon. There are many suggested reasons. The most commonly discussed are clustered order flow and self-fulfilling prophecies.
A support zone represents a high concentration of demand and a resistance zone a high concentration of supply. Traders compound the effects of market supply and demand forces by identifying and trading around these levels.
For example traders holding long positions into an area of identified ‘supply’ or resistance exit their positions by placing a sell order. At the same time other market participants recognizing the area of resistance look to enter the market short. The net effect is downward pressure on price and the market trades lower.
As price begins to trade lower. More long positions begin to cover and shorts add to their favorable positions drivings prices even lower.
The opposite applies to ‘support’ or demand zones.
‘Old support level becomes new resistance and old resistance becomes new support’
If a support or resistance level is broken, their roles reverse. Old support level becomes new resistance and old resistance becomes new support. This is often referred to as flipping. The reason for this role reversal can be attributed to simple psychology. People are reluctant to take a loss. Whilst some traders deal with this emotion by cutting losses early. Others hold there open position until price comes back to the original entry price. Here the trader is able to break even and exits the position creating an amount of supply where there was once demand or demand where there was once supply.
The benefits of identifying support and resistance
- Allows traders to define a trading direction with a higher probability for success.
- Allows traders to enter at the start of any move, increasing the risk reward ratio of a single trade.
How to find support and resistance levels
There is to much detail to cover this topic comprehensively here. I will look to cover this in more detail in later posts. The following is a number of ways commonly used to identify support and resistance zones:
- Visual assessment – This is the simplest method to identify areas of support and resistance. This method looks at the maxima and minima of recent price levels. Support is identified as a series of previous lows and resistance a series of previous highs.
- Simple Price rules – The most common being the 50% rule, which states, price will reverse after retracing 50% of a major move.
- Round numbers – Simple psychology – Traders tend to think in important round numbers. These numbers tend to act as support and resistance levels.
- Times and sales – Real time market order flow. Size and order type can be tracked and support and resistance areas can be identified by order clustering in the time and sales data.
- Volume profiling – Volume clusters at support and resistance areas. Volume profiling indicators plot volumes at different price levels.
Moving averages are a powerful tool for any trading technician. Moving averages smooth out price trends so that price extremes are reduced to a minimum.
Moving averages, like trend lines are considered dynamic levels of support and resistance. They are dynamic because their values are always changing. The principles of support and resistance described above apply the same.
Moving Averages can also be used to identify trend direction.
Types of Moving Averages
There are 3 main types of moving averages:
- Simple Moving Average (MA)
- Weighted Moving Average (WMA)
- Exponential Moving Average (EMA)
Each moving average has a specific calculation method and each are more or less sensitive to long and short term price fluctuations.
Simple Moving Average (MA)
The simple moving average is constructed by summing the total set of data values and dividing by the number of data points. The number of data points is referred to as the period. For example the 50 MA, refers to the previous 50 data points.
When referring to the the Simple Moving Average (MA) of a price chart. The data points are taken as the ‘close’ price for a single price bar. The moving average is therefore the sum of these price bar ‘closes’ across the specified period divided by that period. This value is plotted as single value on the Simple Moving Average line. Consecutive MA points are calculated moving the period window forward one data point and calculating the next MA value. As new price bars are created new MA values are calculated from the new period window.
Changes in trend using the Simple Moving Averages are identified by prices crossing above or below the MA. The crossover of Tandem MA’s of different periods on the same chart can also be used identify trend changes.
Weighted Moving Average (WMA)
The main issue with the use of the Simple Moving Average (MA) is the responsiveness of the signal. Since equal weighting is given to every data point in the period window, the MA delays the signal of most recent price movements. To overcome this the Weighted Moving Average (WMA) is designed to weight data in favour of the most recent price values.
The WMA is calculated by applying a weighted factor to each data point. For example the first data point is multiplied by 1, the next my 2, the 3rd by 3 and so on… Whilst in the Simple Moving Average (MA) the sum of the data points are divided by the number of data points. In the Weighted Moving Average (WMA) the sum of the weighted data points in divided by the sum of the weights.
The WMA is more responsive to changes in trend. A signal of a trend reversal is given my a change in direction of the WMA.
Exponential Moving Average (EMA)
Exponential Moving Averages (EMA) are a type of Weighted Moving Average. The EMA was adopted as a shortcut to the time consuming process of calculating a WMA.
The EMA is determined by first calculating the SMA for the required period. This value represents the first EMA value. Subsequent EMA values are calculated by subtracting the Previous EMA value from the current price data point. This difference is then multiplied by an ‘exponent’ value. This value is then added to the previous EMA to give the new EMA value.
The ‘exponent’ value is calculated by dividing 2 by the period +1.
Trend changes using the EMA are indicated by crossovers the same as SMA’s.
Simple Moving Averages Vs. Weighted Moving Averages and Exponential Moving Averages
The decision to use an SMA over a WMA or EMA with depend on your trading strategy. The Simple Moving Average represents a truer average value of prices over the time period and is more commonly used. It therefore may act better for identifying areas of support and resistance. On the other hand Weighted Moving Averages and Exponential Moving Averages have less lag and better for identifying trend changes.
It is also worth noting that some MA periods work better on one instruments over another. It is therefore a good idea to investigate the right MA for the instrument being traded.
Trend Lines & Channels
Trend lines and by derivation Channels are 2 of the simplest and most effective charting tools. They form the basis for the construction of most charting patterns and are fundamental building blocks for price pattern recognition.
Trend lines trace a line between a series lower highs in a descending market or higher lows in an ascending market. A series of lower highs is referred to as a downtrend and a series higher lows is referred to as an uptrend. Trend lines are a simple graphical representation of the underlying trend in the market.
Channels are formed by transposing a line parallel to the trend line and finding a series of peaks in an uptrend and troughs in a down trend forming a channel.
Trend lines and Channels act as powerful dynamic support and resistance levels. Trend lines and Channels can be constructed horizontally. This is known as a price range and represent a price consolidation.
Breaks of trend lines and channels are also great tools for identifying changes in markets trends and providing reversal signals.
How to Draw trend Lines
Being able to correctly identify and draw trend lines is a skill every trader should master. The principle is simple but so often trend lines are drawn incorrectly essentially making them useless or worse a hindrance. To read how to draw trend lines and trend channels correctly see my post – How to draw trend channels correctly. In it I describe in detail how to draw trend lines and trend channels. It is an important skill to master and will greatly improve your trading.
Tick or Volume Charts
Whilst time based candle stick charts graphically represent the price movement over a specific period of time. i.e 5 min, 1 hr, 1 Day. Tick charts graphically represent the price movement over a number of trades (not contracts traded) i.e 500 ticks, 2000 ticks.
Tick and volume charts provide greater insight into actual trading activity. They are particularly good in time of low and high volatility. Ticks and volume charts compress low volatility price movements into less bars and provide greater resolution price action in high volatility when price is moving quickly.
The speed a which candles are printed provides excellent insights into the trading activity and trader enthusiasm over a period of time.
For technical traders volume is a genuine parameter variation to pure price. Almost all indicators and technical tools rely on or are derivatives of price. Therefore volume provides an independent parameter for interpreting market psychology.
Volume measures the enthusiasm of buyers and sellers at any moment in time. It therefore provides insights to whether a price move is genuine or is likely to fail. It also provides confirmation of areas of supply and demand.
There are several tools available to assist traders to interpret volume signals. Having at least one volume tool in your trading strategy is a good idea. Below is a list of my favorite volume tools.
- Volume histogram – The volume histogram can be used to supplement a tick chart or with time based candlestick charts. Divergence signals between price movements and volume histogram trends signal reversals. Volume spikes also confirm breakout price signals.
- Time and Sales – The time and sales or ‘Tape’ gives real insight into trading volume at any point in time. It lists the price a trade was executed, the time, the number of contracts and whether the order was executed of the bid or the ask. The Tape is most important for validating breakouts and identifying critical areas of supply and demand.