Is technical analysis good for day trading?

As traders begin to dig deeper into theory and strategy, they may begin to wonder about how the type of market analysis conducted ties in with the trading strategy. Does every trading strategy benefit from both fundamental e ainda análise técnica? Is all market analysis applicable to every trading strategy?

Possibly the easiest connection to make is between News Trading and Fundamental analysis. Fundamental analysis involves examining the economic health of a company or country to uncover the stock or currency’s intrinsic value. Since news trading involves trading around the times when these economic indicators are announced, it is clear to see how this type of analysis and strategy go hand in hand. But what about the rest?

An interesting strategy to consider is that of day trading and whether it is compatible with technical analysis.

What is technical analysis?

Technical analysis forecasts price movements in mercados financeiros by studying historical price charts and market data. It rests on the assumption that past market patterns can help predict future price trends. This differs from fundamental analysis in that it does not look to ask why a market might move.

O que é o day trading?

Day trading is a type of speculation where traders buy and sell financial instruments within the same trading day, ensuring all positions are closed before the market closes. This strategy helps avoid the risks associated with price gaps between one day’s close and the next day’s open. Day traders differ from long-term investors who follow buy-and-hold or value investing strategies. Day trading often requires rapid execution, particularly in strategies like scalping, which may require direct-access trading software for quick transactions.

How day traders apply technical analysis

Given the short-term nature of day trading, it might be intuitive to realise that it is impractical if not impossible to apply the principles of fundamental analysis in real time. By the time all the fundamental variables are identified and assessed, the day may be over. Not to mention that, on an average day, not a lot changes fundamentally – supply and demand still affect the markets at every moment – but the market drivers are the traders, not the companies or governments. Therefore, the retrospective nature of technical analysis is better suited to this style of trading.

Day traders can apply technical analysis in any combination of two ways.

Análise de gráficos

Charting Analysis involves observing the price movement on a chart and using visual tools and cues to act. The three common charts observed are bar charts, candle charts and line charts. Some of the tools include:

Candlestick Formations

Candlesticks depict the opening and closing prices of any given timeframe as well as the highs and lows. Traders notice certain candlesticks with distinct features recurring and these have been studied and categorised since they often predict the direction of the incoming market movement – a reversal or a continuation

Support and Resistance

A concept in technical analysis is that the price at which a security will stop, and reverse is predictable. The support is the price level at which the asset’s value will unlikely move below whilst the resistance is the level at which it will unlikely move above. By buying and selling close to these “borders” traders can maximise their potential margin of success.

Trendlines, Ascending and Descending Channels

Trend lines are used to identify potential entry and exit points in trades. They are created by drawing a diagonal line that connects two or more market highs or lows, representing the boundaries of price movement. The trend can be downward, upward, or sideways.

A similar principle applies where the lines connecting the highs and lows are parallel and upward-sloping, or parallel and downward-sloping. These define ascending and descending ‘channels’ respectively.

Head and Shoulders

Another visual cue in technical analysis is the ‘Head and Shoulders’. This is a reversal pattern that consists of a left shoulder, head, right shoulder, and neckline. It forms as prices rise with high volume, then dips before rising again to a higher peak (the head). It then dips and rises once more to form the right shoulder.

The neckline, drawn at the troughs between the shoulders, acts as a support level. When the price breaks below the neckline, the pattern is complete, signalling a potential sell position. Essentially, the price reaches three highs, with the second being the highest, before entering a downtrend.

Indicadores Técnicos

A technical indicator is a mathematical tool based on historical data, used by traders and investors to forecast future price movements and inform trading decisions. It applies a formula to generate data points from past prices and volume.

There are many technical indicators used in day trading many of which can be used in combination with each other. Technical indicators are particularly useful in determining trends, but experienced traders will know they should be used to complement charting and fundamental analysis and not vice versa.

In day trading, when there are visually observable signs in the price action of an asset, no indicator should be used to overrule these findings. Many intermediate traders first exploring technical indicators go through an inevitable learning curve, initially believing them to be a ‘cheat code’, only to eventually find out they are not the gospel of trading.

It’s easy to believe that applying the same concoction of indicators to any given chart will work and when it doesn’t, all it takes is a tweaking of the formula before repeating the same process.

However, there is no special recipe – each asset must be evaluated and respected based on reality. Technical analysis examines the past to predict the future, which is useful but always limited by the fact that information is inherently lagging.

Nevertheless, indicators have a big part to play in day trading and the indicators listed below invariably crop up in the arsenal of many day traders:

Médias em movimento

The moving average is a widely used technical indicator that helps identify the beginning or end of a trend. It is calculated by selecting a specific number of time periods and averaging the closing prices for each. As the average changes with each new period, the term “moving” average is appropriate. Examples include the SMA (Simple Moving Average), EMA (Exponential Moving Average), and LWMA (Linearly Weighted Moving Average).

Osciladores

Another family of technical indicators is oscillators. They are momentum indicators, meaning they measure how fast prices fluctuate.  An asset rallying means there is an increase in buyers willing to pay higher prices. Conversely, during a decline, sellers aim to sell to buyers willing to pay lower prices.

However, amidst this buying or selling pressure, a point comes when the asset is “overbought,” signalling a potential pullback, or “oversold,” suggesting a bounce. Determining these conditions is the purpose of Oscillators.

Like Moving Averages, they are constructed using an asset’s price history over a certain period. There are three well-known oscillators, often used in conjunction with each other as well as other technical indicators and charting analyses; they are the Stochastic Oscillator, RSI (Relative Strength Index) and MACD (Moving Average Convergence/Divergence).

Summary

Technical analysis is not just good for day trading but rather essential. It allows traders to gather precise information rapidly, which is conducive to the short-term nature of their operation. However, care should be taken to use a comprehensive and multi-disciplinary approach, using both chart patterns and indicator signals to form trading decisions.

Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.