Technical Analysis is the forecasting of future financial price movements based on an evaluation of past price movements. Like climate forecasting, technical analysis can’t tell you the future, but it helps anticipating and preparing for market moves.
Because binary options are short term trades in their nature, and technical analysis is the preferred method of reading the market for short term trading, it is important for every binary trader to know how to use technical analysis correctly.
Technical analysis can be used on any type of asset – currencies, indices, commodities, futures or stocks where the forces of supply and demand influence the price. You can analyze any timeframe, from intraday (1-minute, 5- minutes, etc), to daily, weekly or monthly.
The Basis of Technical Analysis
At the turn of the century, the Dow theory was the foundations for what became modern technical analysis. These are the three pillars of the Dow theory:
1. Price discounts everything
2. Price movements are not completely random
3. “What” is more important than “Why”
Principle #1 - Price discounts everything
Technical analysts believe that all information is fully reflected by the current market price. Because of this, the market price reflects the fair value of the asset. After all, the market price reflects the sum knowledge of all members, including traders, investors, portfolio managers, market strategist, technical analysts, fundamental analysts and many others.
There’s no point in arguing with so many smart participants – we accept that they have evaluated the market price, and use this information to form our view on what should happen next.
Principle #2 - Price movements are not completely random
Most technical analysts agree that prices move in trends – they trend up or down. However, the market is not trending all the time, and there are periods of random movement in between trends. If prices were always moving in random, it would be impossible to make money using technical analysis, but we do know that people are making money consistently using technical analysis.
A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends.
The chart below shows an example of trends in the USD/CAD currency pair. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
Principle #3 - “What” is more important than “Why”
Technical analysts are only concerned with two things:
What is the current market price?
What is the history of the price movement?
By focusing on price and only price, technical analysis is a direct and straightforward approach. Fundamental analysts are concerned with why the price has reached its current level. For technical analysts, the why portion of the equation is too broad. How can you know everything about all financial markets? And what guarantess you that even if you knew everything, your analysis would be correct? Especially given how complex financial markets are.
That’s why technical analysts believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers in the market than sellers – more demand than supply. After all, the value of an asset represents what someone is willing to pay for that asset. There’s no need to know why.