Technical analysis is the most popular and powerful method of stock market predictions among traders.
It is a disciplined process of analyzing the actual state of the price of a financial instrument or security and enables you to estimate the future price using historical price movements.
But due to lack of knowledge of technical analysis, we do not even know how much loss we make in the stock market! By the time we know it is late.
Therefore, before we start investing in the stock market, we should have at least an understanding of fundamental analysis and technical analysis. Let us know in detail about technical analysis today.
Here, we should be clear that financial instruments or securities can be any type of stocks, derivatives (futures and options of stocks or indices), currencies, commodities, etc., where we can use technical analysis.
Does Technical Analysis Really Work?
Sure! Technical analysis actually works. But in a disciplined manner.
Although a large group of investors understand that technical analysis is more important and useful for traders (day trader, swing trader or positional trader) only. (Actually positional traders are short term investors). This is also true.
But this does not mean that it is less important for investors. I think whether you are an investor or a trader, it is equally important in both cases.
Technical analysis acts as the backbone of fundamental analysis. So if you invest in a stock after both fundamental analysis and then technical analysis, your investment and stock trading will be protected at double level.
Suppose you fundamentally complete research on stocks and find the appropriate stock for investment. There comes a time when you want to invest.
But at what price should you buy that stock?, this is an important question in front of you. Because the market price is not always relevant to the fundamental factors of the stock.
It is also often said that after fundamental analysis, invest for a longer period. But till when? It is a technical analysis that gives you entry and exit prices on your investment. In further discussion you will be more clear whether this analysis works or not.
Technical Analysis Basics
The concept of technical analysis has not developed in a day. It has taken a long time to develop. The Dow theory is behind the origins of the modern form of technical analysis.
As you have seen in fundamental analysis, the major source of analyzing stocks is the financial statements of a company’s annual report. The annual report gives you all the necessary information like balance sheet, profit and loss statement, fundamental ratio to carry out quantitative analysis.
Similarly, the main sources for technical analysis of stocks are technical charts.
Technical Analysis Charts
Image source: Investing.com
During your academic classes you have learned to make a chart between two different parameters on the X and Y axis. The only difference is in the technical chart that the Y-axis lies to the right hand side on the plane surface. Here, a chart is plotted between the security price on the Y-axis and the fixed time period on the X-axis.
But you don’t have to draw it yourself for this analysis. There are many free and paid softwares and websites. TradingView, investing.com, TD Ameritrade or Google Finance, etc. are the best chart sites for technical analysis. Which draw these charts even during live market hours.
Apart from this, technical charts are also available on your broker company website where your demat and trading account is open.
Technical Chart Divisions
There is no clear cut category of technical analysis like fundamental analysis.
These are technical chart divisions that describe the essential elements present on a technical chart at a time when you want to look, learn and analyze professionally.
For learning purposes, I would like to advise you that while reading this post you should have a website or software related to the chart, as it will give you a better understanding level.
These technical chart divisions are as follows –
1. Price and Volume
Price And Volume are the prime focus for the formation of a chart. It is called as technical chart since you can conclude so many things from it technically.
There is a popular saying in the stock market – ‘Bhava Bhagwan Chhe’. This means that ‘Price is God’. Meaning all kinds of value and information are included in the price of the stock. It describes itself the true position of a stock whether share price is overvalued or undervalued.
Volume is one another main source to analyze technically a stock. It is defined as the number of shares traded in a given period of time. It shows the strength or weakness of a trend of the price-movement.
Volume is plotted traditionally in the form of vertical histogram. Its height or thickness represents high or low volume.
The color of a bar of volume histogram is green if price closes above opening price for a particular time period. And if the price closes below opening price the color is red.
Nowadays volume profile is going to most convenient and popular to analyze easily the support and resistance plotting volumes in the form of horizontal histogram.
For beginners, the chart seems a little bit difficult. But as you start to see the chart many times attentively you become able to understand it easily.
2. Time-Frame of Charts
There are different charts available for different time frame. You can choose the time frame according to your need of analysis. For intraday trading you can select 5-minutes or 15-minutes chart. Whereas for short term investing you should select day chart where everyday closing prices of script are shown.
For long-term investment you should also go for weekly and monthly charts.
Selection of time frame is totally arbitrary and it depends on your chart practices. Selection of wrong time frame can mislead your decision of buying or selling and you may have loss. So practice of technical analysis using multiple time-frame is advised.
3. Type of Technical Charts
Charts are of many types. Each type has its own merits.
i. OHLC Based Charts
Candlestick chart and Bar chart are the example of OHLC chart having four important price information.
O stands for opening price, H for highest price, L for lowest price and C for closing price.
Color Code
It is conventional to show candlesticks or bars in two different colors. Generally these are in combination of colored red and green or black and white, etc. In a bar chart, the color is decided on the basis of previous close. If current’s close is higher than previous close – the color is green and if current’s close is lower than previous close – the color is red.
And if current’s close is equal to previous close – the color is same as previous bar.
But in candlestick charts, the color is decided within same candle. If the closing value is greater than the opening value – the candlestick mid-section is hollow or shaded green and if the opening is greater than the closing value – the candlestick mid-section is filled with red or shaded red.
Candlestick Chart
It is the most popular interpretation among other charts. This chart was first used in Japan to analyze rice prices in 17th century.
Bar Chart
This is the second most popular chart. On a bar chart, each bar represents price performance for a specific period. These periods may be as long as a month or as short as one minute.
ii. Closing Price Based Charts
These charts don’t contain all price information. These are based on closing price information only but are more useful in trend deciding.
Line Chart
As the name suggested, line chart is obtained by joining closing price only. Besides trend deciding it is also useful to get support and resistance levels.
Area Chart
It is traditional chart made up under closing price. I get it least useful for trading.
iii. Special Type of Chart
There are some special types of charts Heikin-Ashi, Kagi, Renko and Point and Figure etc., but I would suggest to learn more about Heikin Ashi only in the beginning.
Heikin Ashi Chart
Heikin-Ashi, also sometimes spelled Heiken-Ashi, means “average bar” in Japanese. The Heikin-Ashi technique can be used in conjunction with candlestick charts when trading securities to spot market trends and predict future prices. It’s useful for making candlestick charts more readable and trends easier to analyze. For example, traders can use Heikin-Ashi charts to know when to stay in trades while a trend persists but get out when the trend pauses or reverses.
Source: Investopedia (see section trading/heikin ashi better candlestick for detail)
4. Indicators for Technical Analysis
Indicators are great value tools that give investors and traders a third eye to predict the next price movements.
There are two types of indicators according to their nature.
- Leading Indicators– These indicators are able to tell the next move in advance. For example Bollinger Band, Momentum are leading Indicators.
Lagging Indicators- The lagging indicators are formed only after the event. But they are useful for clarifying and confirming a pattern that is happening over time. Moving averages (EMA or SMA) are lagging indicators.
Please read the 6 best technical indicators for day-trading and swing trading to change your trading style effectively and dramatically. There are several effective indicators like ADX, Bollinger Bands, Ichimoku Cloud, MACD, RSI, SuperTrend, Stochastic, VWAP, etc. about which we will write and learn separately.
5. Technical Analysis of Stock Trends
Another but popular saying in the stock market is the trend is your friend. This means that if you are able to follow the trend, it will not only give you a good return on your investment, but will also reduce the risk involved.
Actually, stock prices move in three ways.
- UP Trend– when the security price movement is in an upward direction.
- Down Trend– when the security price movement is in a downward direction.
- Consolidation-It is a stock price situation when the price keeps moving within a particular range.
You only have to find their direction as stocks trend. This gives a basis for your stock trading, also known as Trend Trading.
6. Patterns and Trading Signals
The patterns obtained in candlesticks chart formation or bar chart formation are of spectacular importance. The pattern arises due to repeated behavior of investors and traders during stock trading.
Some important things that should be in your mind while studying the pattern. The pattern should be easily recognizable. Volume must be confirmed. Take position only when the trading signal is generated.
You can further classify the generated patterns and trading signals as short-term patterns and long-term patterns.
Ascending Continuation Triangle, Cup with Handle, Reverse Head and Shoulders, etc. are some examples of bullish patterns. Whereas Double Top, Head and Shoulder, Rounded Top, etc. are examples of bearish patterns.
7. Support and Resistance
It is amazing to know that there is a memory in the market that causes support and resistance levels. When the price receives a bounce on the support, the prevailing trend continues and thus the results rally. For resistance, it is the opposite.
There are some principles of drawing horizontal or trend lines to find support and resistance levels.
Remember, if a trend reversal occurs then the previous support acts as resistance and the previous resistance acts as support.
As both names mean, the value is used for reference. After going up continuously, the share price reverses and goes down. There may be a fixed value at which it takes support and then turns back. This price is known as the support level at which buyers are expected to enter the market to take control from sellers.
Similarly, the price has a resistance level when coming on a downtrend. Sellers are expected to enter the market in sufficient numbers to take control from buyers.
8. Price & Trend Reversal
Trend reversal is the process of breaking the prevailing trend. There are several single patterns and indicators that indicate the possibility of trend reversal. But sometimes it can be confusing or less reliable. Here, you must first decide the strength of the signal.
Hook reversal, key reversal, island reversal, morning star, evening star, doji star, inverted hammer, etc. are the trend reversal structures.
9. Gap Theory
During chart analysis you may sometimes notice that there is a gap (unfilled space or interval) between two consecutive bars or candlesticks. These gaps are of many types like breakaways gaps, continuation gaps, etc. You can get to know it better with the help of Gap Theory.
10. Fibonacci Retracement
You can google or visit Best Strategy for Intraday Trading to know more about Fibonacci Series and Golden Ratios. Both are magnificent and surprising. Which give rise to the Fibonacci Retracement concept that actually occurs in the market.
Stock price moves are not always in one direction. After a strong upside or downside movement, prices tend to go against the trend. These are not random movements. These are the levels known as the Fibonacci retracements, as far as the share price repeats its way.
Master Stock Calculator is an excellent example of both mathematical calculations.
Books for Technical Analysis
There are many books available on technical analysis but these are some of the best one for not only novice but also for a exhaustive knowledge of the subject. Getting started in technical analysis by Jack Schwager and How to make money in stocks by William O’Neil are two my most favorite. You should read this if wanna a successful trader. You can also implement some of Strategies explained in the book even for your profitable investments.
There are many books available on technical analysis, but these are best not only for novices, but also for those who want complete knowledge of the subject. Two of my favorite books are Getting Started in Technical Analysis by Jack Schwager and How to Make Money in Stocks by William O’Neill. If you want to become a successful trader then you should read this. You can also apply some of the strategies mentioned in the book to your profitable investments.
How to Learn Technical Analysis
My favorite and even free technical chart app or website is investingdotcom.
This is for example. You can go to any trading system as you wish. When you open the chart you have the option to select the stock or index name in which you want to perform technical analysis. The default chart will now appear on the computer or mobile screen.
Here, you first select a chart type such as Candlestick, Bar or Heikin Ashi from the list at the top of the chart. Now you can observe the pattern by selecting different time ranges.
Use a single and then a combination of different indicators. Observe the pattern of a candlestick or bar, a group of candlesticks. Imagine their behavior.
Back Testing
History repeats itself. And the repeated behavior of the crowd and the psychology of fear and greed between investors and traders form the basis of patterns and technical analysis. Even a novice retail investor or trader can learn it very easily.
Back testing is the most obvious tool, through which you can practice by looking at the maximum number of stock charts and conclude the actual position of the stock.
My Words
It was not possible to describe in-depth technical analysis in a single post. I would like to write more deeply in the next various posts.
Like other stock predictions methods, technical analysis is also not a perfect method. Despite this gives you a vision to see in the future of stocks. Don’t be in a hurry. Try to visualize and analyze more and more charts everyday using different charts, different indicators and with different timeframes. One day you will not need to seek advice from anyone. You will be a technical analyst yourself.
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