Technical Analysis – How To Analyse Financial Markets

Technical analysis is the best way of predicting short-term price movements. For binary options traders, the use of technical analysis is without alternative. To help you create your own successful technical analysis strategy, this article will explain the basics of technical analysis and its use in binary options trading.

In this article, you will learn:

  • What Is Technical Analysis?
  • Why Do Traders Use Technical Analysis?
  • Should Binary Options Traders Use Technical Analysis?
  • What Could A Technical Analysis Strategy Look Like?

With this information, you will be able to understand the logic behind technical analysis and use a technical analysis strategy to trade binary options.

What Is Technical Analysis?

Technical analysis is a way of understanding what has happened to the price of an asset and predicting what will happen to it next. The unique characteristic of technical analysis is that it focuses solely on price movements.

When they analyse a stock, for example, technical analysis ignore everything about the company behind the stock. They are not interested in its earnings, nor its economic future, nor the quality of its products. All they look at is what its stock price has done in the past and which implications this history allows for the future.

Technical analysis is based on a simple assumption: everything that you can know about a stock is already factored into its price. By looking at the price, you can learn everything about a stock, and you can learn a lot more than with any other form of analysis.

Predicting Financial Markets

For example, assume that you are supposed to predict how many people go into buildings every day. You know that thousands of people a day went into a building for a year. You also know that only two or three people a day went into the building next to it. This knowledge is all you need to predict that more people will go into the first building than into the second.

This process is exactly how technical analysis works. It focuses solely on the thing you are trying to predict and ignores the reason behind it.

In the building example, the first building might be a train station and the second one a small house. You could spend a lot of time gathering this type of knowledge, but what good would it do you? It would only tell you what you already know from looking at the numbers alone.

But if there are two small houses, what do you predict now? You would need to find out which house houses a family and which a single person, which of them has more friends, and so on – an endless task that would never get you all the information.

Alternatively, you could also analyse how many people went into each house in the past.

  • If the relationship is 10 to 2, you know what you have to predict. Likely, more people will go into the house with the 10-people average.
  • If the relationship is 5 to 4, you could think that this one is too risky to predict and analyse the next houses.

Technical analysis adapts this philosophy to financial investments.

  • If the price of an asset currently is rising, it is unimportant to understand why. The fact that it is rising tells you everything you need to know to make a good investment.
  • If the price of an asset currently is falling, it is unimportant to understand why. The fact that it is falling tells you everything you need to know to make a good investment.

Technical analysis follow this principle and also allows you to analyse many characteristics

Why Do Traders Use Technical Analysis?

When traders of all types analyse the market, they have two options. They can use:

  • Technical analysis, and
  • Fundamental analysis.

We have already explained what technical analysis is. Fundamental analysis is the prediction of price movements based on economic data, earnings, and other indicators of a stock’s, commodity’s, or currency’s future.

Fundamental analysis assumes that there is a direct connection between these values and the price of an asset. While the market often fails to reflect this connection right now, fundamental analysts assume that the price will eventually adjust to these factors.

There are several good reasons why traders choose technical analysis over fundamental analysis.

There Are Many Things That Are Impossible To Quantify

For example, the electric car company Tesla is valued at a much higher price than many other car makers in the world. This is despite the fact that Tesla has never turned a profit and only sells a fraction of the cars that other companies sell.

How do you justify this price based on technical analysis? Many people buy Tesla because they like Elon Musk, and because they think that electric cars are the future. But why do so many people put so much more trust in Elon Musk than in other managers? After all, they never heard of most of these other managers, so how can they mistrust them?

Trust is one of the many things that are impossible to quantify. If traders trust a CEO, does that mean Tesla should trade at £50, £500, or £1,000?

Fundamentals Do Not Show Whole Picture

There are many other things that are impossible to quantify. Coca-Cola seems to have an advantage over Pepsi but why? Google has an advantage over Yahoo, Mercedes-Benz over Renault, and so on. How do you quantify image and similar soft criteria?

With technical analysis, you can avoid such impossible decisions. When the stock of Coca-Cola is worth two times more than the stock of Pepsi, traders apparently quantify the value of the stock twice as high. If the gap is increasing, you know how to invest. There is no need to understand why.

With fundamental analysis, such simple investment decisions are impossible.

Which Market Influence Will Be Strongest?

Regardless of how much data a fundamental analyst gathers, they can never paint a complete picture of a stock’s worth. As we already pointed out, there are many factors that are impossible to quantify and therefore inaccessible to fundamental analysis.

Additionally, even the quantifiable factors are too numerous to consider them all, and it is impossible to predict which factor will influence the price the strongest.

For example, assume these scenarios:

  • You are looking at the stock of a company whose profit has increased, but its sales have decreased. Which factor will be more important to traders?
  • You are looking at the stock index of a country who has had an increase in open jobs and an increase in unemployment. Which factor will be more important to traders?
  • You are looking at the stock of a company that has cut 1,000 jobs. The savings could make the company more profitable, but it could also be a sign that the company is in trouble. Which factor will be more important to traders?

In hindsight, these questions are easy to answer. There are often cases in which so-called experts on news networks predict that if the central bank decreases the base rate by 0.5 percent, stocks will rise. But when the central bank does exactly that, stocks fall. In the evening, the same analysts will say that traders apparently expected even more – which is easy to say in hindsight, but impossible to predict.

Hindsight Fallacy

Traders have to make a prediction in advance, which is why they have to avoid letting the perfect vision of hindsight analysis trick them into assuming the same clarity for the future. The future is a much more unpredictable place, and it is impossible to predict which fundamental factors will dominate the price of an asset.

Technical analysts never ask why something happens. Therefore, they can avoid having to predict how the market will react to specific influence and which of these influences will dominate. They can sit back, wait for the market to show its hand, and then go with what they know instead of relying on their best guess.

Only Technical Analysis Can Make Short-Term Predictions

Maybe the biggest problem of fundamental analysis is that it is incapable of making short-term predictions.

Even if you knew everything about an asset, if you knew what will affect the asset and how it will affect it, you would only be able to predict how this asset will do over the next year or longer. You would be unable to use this knowledge to create short-term predictions, for example whether the price will fall over the next hour or the next day.

Very often, there are no fundamental influences on an asset. Quarterly reports are only released all three months, and in between, there can be weeks of quiet. Despite this lack of fundamental influences, almost all new stocks create a new price every second or even more often.

Fundamental analysis is incapable of explaining how these small movements come about and predicting how they will develop.

What Moves Asset Prices?

The truth is that most market movements are the result of random events.

  • When a large index fund decides to replace one stock with another, it has to sell off the first stock and buy the second one. Since selling such large positions all at once would lead to an immense sudden price rise or fall, funds sell and other large institutional investors buy and sell stocks in many small packages. These phases can take weeks or months, during which the investor constantly pushes the price in the same direction. Only technical analysis can recognize the consequences of these events and recommend the right investment decisions.
  • When a single person decides to buy or sell an asset, they rarely wait for the fundamental data to change. When they get a birthday present, an inheritance, or a raise, they buy. When they need money to repair the car, they sell. Fundamental analysis is incapable of predicting these movements that influence shorter time frames. Technical analysis can understand their effects and predict what they mean for the future.

All other market movements result from similar random influences. Only technical analysis can help you understand how these movements will play out.

Should Binary Options Traders Use Technical Analysis?

For binary options traders, the use of a strategy based on technical analysis is almost without alternative. Let’s analyse the reasons for this statement first and then take a look at the only exception.

  1. Binary options are short-term investments, and only technical analysis can create valid short-term predictions.
  2. Binary options require you to make many trades. Because binary options use short expiries of a few minutes to a few hours, you can easily make ten or more trades a day. Only technical analysis allows you to make this many trades. Fundamental analysis would require you to find out everything about a company, country, or commodity before you invest – which is simply impossible to do ten times a day.
  3. Binary options require you to be quick. On the short time scales of binary options, opportunities come and go within minutes. If you tried to perform fundamental analysis in this time, the opportunity would be long gone before you are done. Technical analysis enables you to take the time in advance and define a strategy that allows you to make a decision within seconds.

The only exception to these points is a single fundamental strategy that can work with binary options: trading the news. When important news is scheduled to hit the market, you know that they will result in a short, strong movement. Binary options are the ideal tool to trade these movements.

Even in this case, however, technical analysis can be helpful to predict how far the resulting movement can move and when it will end.

Summary On Technical Analysis

Technical analysis is the best and only way of predicting short-term market movements. For binary options traders, using a strategy based on technical analysis is almost without alternative – the only exception would be a news trading strategy.

Technical analysis focuses solely on price movements. This is the only way to understand how other traders feel about an asset because the infinite amount of influences is impossible to categorize and interpret by fundamental analysis.
If you are a binary options trader, use technical analysis. If you still lack the right broker to execute this strategy, take a look at our broker top list.

Further Reading On Technical Analysis