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Day Trading Strategies
Edited By
Dan Buckley
Updated
Sep 13, 2024
Technical analysis involves studying past market data to predict future price movements. This approach is a key method within security analysis, alongside fundamental analysis.
In this tutorial, we look at how beginners can use technical analysis in day trading.
Quick Introduction
- Technical analysis is an approach to finding trading opportunities by assessing price patterns on charts.
- Traders believe studying historical market activity and price fluctuations can help identify future trends.
- It can be applied to a range of strategies strategies and markets including day trading forex, crypto, oil and other commodities.
- Technical analysis is suitable for all experience levels from beginners to professionals.
Best Brokers for Technical Trading
For traders that want to start using technical analysis we recommend one of these brokers with great technical trading features:
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HEADWAY
For advanced charting features, which make technical analysis easier to apply, we recommend the trading platform TradingView or broker eToro.
Technical Analysis Explained
Technical analysis encompasses various charts, indicators, and tools that help investors identify future trading opportunities by analyzing historical market behavior and price movements.
In contrast, fundamental analysis can be applied at both the microeconomic and macroeconomic levels. On the micro level, it involves examining factors such as revenues, costs, earnings, assets and liabilities, capital structure, and “soft” elements like management quality and competitive positioning.
Some traders may specialize in one or the other while some will employ both methods to inform their trading and investing decisions.
Most large banks and brokerages today have dedicated teams specializing in both fundamental and technical analysis. Generally, the more high-quality information a trader uses to improve the chances of making accurate predictions, the better their trading outcomes are likely to be.
Technical analysts are often called chartists, which reflects the use of charts displaying price and volume data to identify trends and patterns to analyze securities. Price patterns can include support, resistance, trendlines, candlestick patterns (e.g. head and shoulders, reversals), moving averages, and technical indicators.
Assumptions in Technical Analysis
While some traders and investors use both fundamental and technical analysis, most tend to fall into one camp or another or at least rely on one far more heavily when making trading decisions.
Technical analysts rely on the methodology due to two main beliefs:
- Price history tends to be cyclical and
- Prices, volume, and volatility tend to run in distinct trends
Let’s take a look at both…
Market Cyclicality
Human nature tends to be cyclical i.e market history has a tendency to repeat itself. The sequence of events may not repeat itself perfectly, but the patterns are generally similar. These can take the form of long-term or short-term price behavior.
In the long-term, business cycles are inherently prone to repeating themselves, as driven by credit booms where debt rises unsustainably above income for a period and eventually results in financial pain when not enough cash is available to service these debts. This tends to result in slow progressive gains in stocks and other “risk-on” trades (e.g., carry trading) during an expansion and a sharp fall upon a recession.
Technicians believe that market participants are inclined to repeat the behavior of the past due to collective, patterned nature. If behavior is indeed repeatable, this implies that it can be recognized by looking at past price and volume data and used to predict future price patterns. Essentially if traders can locate opportunities where behavior is likely to be repeated, they can identify trades where the risk/reward runs in their favor.
Thus, there is the inbuilt assumption in technical analysis that a market’s price discounts all information influencing a particular market. While fundamental events impact financial markets, such as news and economic data, if this information is reflected in asset prices upon release, technical analysis will instead focus on identifying price trends and the extent to which market participants value certain information.
For example, if US CPI inflation data come in a tenth of a percentage higher than what was being priced into the market before the news release, we can back out how sensitive the market is to that information by watching how asset prices react immediately following.
If US stock futures move down X%, the US dollar index increases Y%, and the 10-year US Treasury yield increase Z%, we can get a feel for how such economic inputs impact certain markets. Knowing these sensitivities can be valuable for stress testing purposes as a form of risk management. For example, if inflation were to unexpectedly move up by 1%, we can use data points regarding surprise inflation readings to determine how the portfolio might be affected.
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HEADWAY
Price, Volume, and Volatility Run in Distinct Trends
Another assumption behind technical analysis (and all securities analysis more broadly) is that price does not move according to a “random walk”, or according to no discernible or logical pattern. Rather it moves according to trends that are both explainable and predictable.
For example, if we look at a chart of the EUR/USD from mid-2013 to mid-2017, we can see how technical analysis played a role by looking at support and resistance within the context of the trend. After the euro began depreciating against the US dollar due to a divergence in monetary policy in mid-2014, technical analysts might have taken short trades on a pullback to resistance levels within the context of the downtrend (marked with arrows in the image below).
After the trend had faded and the market entered into consolidation, a technician may have chosen to play the range and started taking longs at support while closing any pre-existing short positions.
Characteristics
Originally, technical analysis was largely a matter of “reading the tape” or interpreting the successive flow and magnitude of price and volume data through a stock ticker. As computers became more widespread in the 1970s, data was compiled into chart form and became a technician’s standard point of reference.
Recognition of chart patterns and bar (or later candlestick) analysis were the most common forms of analysis, followed by regression analysis, moving averages, and price correlations. Today, the range of technical indicators is greater. Anyone with coding knowledge relevant to the software program can transform price or volume data into a particular indicator of interest.
Though technical analysis alone cannot wholly or accurately predict the future, it is useful to identify trends, behavioral proclivities, and potential mismatches in supply and demand to spot where trading opportunities could arise.
Analytical Approaches
There are several ways to approach technical analysis. The simplest method is through a basic candlestick price chart, which shows price history and the buying and selling dynamics within a specified period.
Other investors employ a price chart along with technical indicators or use specialized forms of technical analysis, such as Elliott wave theory or harmonics, to generate trade ideas. Some use parts of several different methods. At the same time, traders must resist the idea of “information overload” or cluttering charts with so many indicators and lines that it begins to adversely impact one’s ability to read the chart.
Others may enter into trades only when certain rules uniformly apply to improve the objectivity of their trading and avoid emotional biases from impacting its effectiveness.
Types of Charts
Candlestick
Candlestick charts are the most common form of charting in today’s software. Green (or sometimes white) is generally used to depict bullish candles, where the current price is higher than the opening price. Red (or sometimes black) is common for bearish candles, where the current price is below the opening price.
It essentially shows the distance between opening and closing prices (the body of the candle) and the total daily range (from top of the wick to bottom of the wick).
Open-High Low-Close
A candlestick chart is similar to an open-high low-close chart, also known as a bar chart. But instead the difference between the open and close price are represented by horizontal tick marks. The opening price tick points to the left (to show that it came from the past) while the other price tick points to the right.
Candlestick charts are particularly popular with beginner traders starting out with technical analysis.
Line
A line chart connects data points using a line, usually from the closing price of each time period.
Area
An area chart is essentially the same as a line chart, with the area under it shaded. This is done to visualize the price movement relative to a line chart.
Heiken-Ashi
Heiken-Ashi charts use candlesticks as the plotting medium, but take a different mathematical formulation of price. Instead of the standard procedure of candles translated from basic open-high low-close criteria, prices are smoothed to better indicate trending price action according to this formula:
- Open = (Open of previous bar + Close of previous bar) / 2
- Close = (Open + High + Low + Close) / 4
- High = Highest of High, Open, or Close
- Low = Lowest of Low, Open, or Close
Trading charts can analyse a range of time periods depending on objectives, from 1 minute to 1 hour or even 8 hour charts. The 8 hour time frame is particularly popular amongst forex traders.