Technical analysis is the study of past stock prices using stock charts. Stock traders study charts to help them predict the future of those prices.
So what components does this terminology entail?
Technical analysis entails methods used to analyse stock and make investments decisions that fall into two fundamental categories: Technical analysis and Fundamental analysis.
Technical analysis, as explained, takes a rather different approach as opposed to fundamental analysis.
It does not care about the value of a company.
On the other hand, fundamental analysis focuses on analyzing the characteristics of company in order to determine or estimate its value.
In short, technical stock analysts are interested in just the price movements in the stock market.
Our focus in this book is technical analysis and it’s therefore important to dig a little deeper it for a bigger picture.
In spite of the exotic and fancy tools it demands, technical analysis tends to focus more on the demand and supply ends of the stock market and an attempt to determine the trend or direction that the prices will take in the future.
Quite simply, technical analysts attempt to understand the emotions in the stock market by studying the market itself rather than the opponents.
Understanding the benefits and limitations of technical analysis helps identify a new set of skills and tools that will make you a more successful stock trader.
The Basic Assumptions
Technical analysis involves evaluating market securities on the basis of the statistics the stock market generates e.g. past prices and volume.
Note that technical analysts are not interested in measuring a stock’s intrinsic value, but instead use tools such as charts to determine the patterns that will influence future activity.
Just as there are several investment styles on the fundamental end, there are also several types of technical traders.
Some employ technical indicators, others technical indicators and oscillators.
However, most of them tend towards the combination of both.
In simple terms, technical analysts’ use of volume data and historical prices is what set them apart from their fundamental counterparts.
History Tends To Repeat Itself
One other very essential aspect of technical analysis is that history repeats itself, particularly in price movements.
This repetitive nature of price movements is usually attributed to market psychology: market players tend to offer a consistent reaction to similar stock market stimuli over time.
Technical analysis employees chart patterns to help understand trends ad analyse market movements.
Though most of these charts have been used time and again, they have stood the test of time to still be in use today and are among the best indicators of patterns and price movements that have a tendency to reoccur.
Price Moves in Trends
As far as technical analysis is concerned, price movements are believed to follow a trend which means that once a trend has been established, the future price movement of that stock is more likely to follow the same trend than to go against it.
Most technical trading techniques are based on this assumption.
The Market Discounts Everything
The major criticism of technical analysis is that it only focuses on the price movements, ignoring other important fundamental aspects of a company.
Despite this, technical analysis assumes that at any given point in time, a stock’s price indicates everything that has an impact on the business including the fundamental factors.
Technical stock analysts believe that technical analysis along with market psychology and economic factors; are all factored into stock which removes the need to consider these factors independently.
This leaves behind the analysis of price movements only, which in technical theory is a product of demand and supply for a particular stock in the market.
Technical Analysis can predict both short-term and long-term trends.
So, we see how understanding the benefits and limitations of technical analysis helps us identify a new set of trading skills that will make you a more successful stock trader.
We are well aware that all traders wish to make the most of their trading skills.
When one invests in a stock or a ‘tradable’ commodity, they are aware of the risks they might have to undertake.
Trading is thus, not just an investment of money but also an investment of precious time and mental wealth.
To make this an easy task, one must know the initial rules to be followed before beginning to indulge in e-trade.
Let’s take a quick look at five pointers which would help to understand the functionality of Technical Analysis in trading –
Technical Analysis is often graphically represented and it focuses on the movements of stock/trade instrument price.
Technical analysis is based on the following three assumptions – history tends to repeat itself, price of stocks always move in trends and that the market discounts everything.
Along with all this, one must remember that learning about the “Trends” forms the most important part of understanding Technical Analysis.
There are two types of ‘Trends’ you may have to deal with in stock trading – Uptrend and Downtrend.
Further more, these trends can be of three lengths – short term trend, long term trend and Intermediate trend.
It is very important to know the signs which would help one map the current market trend.
There are several indicators used by traders like the Average Directional Movement Index (ADX) line, which helps to determine whether the market is in a trending or a trading phase.
One must remember that major trend lines show the longer trend while minor trend lines show the shorter trend.
While reading a trade chart, if one notices that triangles on the chart are usually broken on the flat side, it is an indication that an ascending triangle is usually broken marking an upside breakout, while a descending one is usually broken to the downside.
In such cases, trade chartists must look for other hints to determine if a triangle signals accumulation or distribution.
While analyzing a trade graph, it is important to remember that the broader the market, the stronger it is.
A show of narrow breadth indicates limited participation and in such cases the chances of failure are above average.
Direction is a very important factor in technical analysis.
A long sideways concentration after an advance shows signs of future resistance.
In such cases, it would be advisable to expect resistance or a bearish reversal when prices go down and return to the previous level.
A long sideways concentration after a descent shows relative support in the future and in such cases it would be advisable to expect support or a bullish reversal as the prices go up and then return to this level.
At the same time, when a crowd of traders are proven right during a particular market trend, excessive sentiments towards one direction or another can delay a movement in price.
3. Volume and Gaps
Always look for a volume pitch that could signal the end of a long move.
An extended move could indicate a volume surge which would end in a fizzle while an extended descent could indicate a volume surge creating a selling pitch.
It is important to remember that during an advance in stock movement, begin or add to long positions after a one day decline, more so when the decline is on lower volume.
During a decline, begin or add to shorter positions after a one-day advance, more so if the bounce is on lower volume.
Understanding functions of gaps is very important.
Breakaway gaps could mark the beginning of a new trend and are illustrated by gaps that are not filled.
Continuation gaps could mark a continuation of the existing trend while exhaustion gaps mark a trend reversal and are illustrated through gaps that are filled.
Moving averages throw better light on buy and sell signals.
They tell you if the existing trend is still viable and they help in confirming trend changes.
Nonetheless, moving averages do not help in forecasting approaching trend changes.
It is widely accepted that a combined chart of two moving averages is the most accurate method to find trading signals.
With the help of Elliot’s Theory in Technical Analysis, you can map the speed of a particular direction.
Elliot’s Theory is nominally based on the mathematical expression of Fibonacci Ratio.
The Elliott Wave Principle is based on the concept that in the stock market the movement of the prices is not a result media speculation but is related to the psyche of the market participants or traders.
The theory states that the unfolding of market prices in specific patterns or “waves” as traders call it today.
These are price patterns which can help a trade analyst dealing with Elliott Waves to understand whether the prices are likely to go up or down.
With the understanding of where the prices might move through the Elliott Wave cycle, traders have a unique tool at their disposal to find a low risk and high yielding entry and exit point for their trading.
While dealing with the Elliot Wave Theory in technical analysis, always remember that only in case of a positive market does a chart show 5 waves up and 3 waves down but it is highly possible that in case of a declining market, the chart might show 5 waves down and 3 waves up.
Technical analysis has become very popular in the recent years.
However, it continues to throw people off due to lack of a proper understanding of how it works.
Still, it’s important to understand that technical analysis and fundamental analysis are not mutually exclusive strategies. In fact, these two stock trading strategies are quite complementary.
Also, do not expect a single stock trading strategy to outperform in all market conditions.
And yes, technical analysis is the only way you’ll limit your risks when the floor fall out of the stock market.