Technical analysis is a surefire way to analyse potential investments to decide if or when to buy or sell. The premise is that supply and demand impact a security’s price and that changes help in predict future movement.
In other words, technical analysis employs the study of past price movements in an attempt to decide future price movements of a specific security or a securities group.
A basic understanding of the underlying principles and tools used when conducting the technical analysis can really facilitate your investment research.
What is the basis of technical analysis? Or What are the basics of Technical Analysis? Or What are the types of analysis in trading?
The birth of technical analysis is credited to Charles Dow, instrumental co-founder of the Wall Street Journal, and the Dow Jones Industrial Average.
Rather than analysing a company’s dynamics – balance sheet or corporate structure – technical analysis employs price and volume data to try to forecast future security prices.
Technical analysts say that price is a reference merely to the degree to which a single security share costs. On the other hand, volume is the number of security shares that are traded in a given time frame.
Diverse price chart types are used in technical analysis to study price and volume. From there, technical indicators are extracted, suggesting stock movement patterns and signals if to buy or sell.
How technical analysis works?
There are three main technical analysis principles:
- Market action accounts for everything;
- Prices move in trends;
- History repeats itself.
Market action accounts for everything
Technical analysts believe that the first technical analysis tenet is the elementary belief that the efficient markets hypothesis is correct. The implication is that all available information about a stock’s value is shown in a stock’s price.
New information impacting a stock’s value becomes available, it is swiftly and completely absorbed by the market, reflected in its price.
Prices move in trends
The second elementary tenet finds its basis in the belief that prices will continue moving in the same direction until a technical analysis indicator advises reversal.
There are diverse technical indicators. The particular one chosen is the individual investor’s choice.
The premise here is to identify and follow the trend till it shows reversal signs. For instance, if a price has been on the ascent when a given technical indicator says there will be a plunge, an investor may well opt to sell said security.
History repeats itself
The final principle of technical analysis is that stock price movement historical patterns generally repeat themselves. There is a pronounced dependence on market trading psychology to make sense of price chart patterns.
Market psychology is the collective investor sentiment. It is believed that that’s what propels security prices up or forces them down.
Technical analysis methods or What are the methods of technical analysis?
Technical analysis is concerned with studying past market activity to identify a security technical trend. PrimeFin customer support staff will gladly guide you to the correct use of Technical analysis methods.
Or traders can take help of technical analysts to make correct decisions and have proper utilisation of the technique.
There are diverse technical analysis indicator types. Chartists or technicians,technical analysts, will use more than one indicator to arrive at an investment decision.
Following are instances of technical analysis indicators:
- Bollinger Bands
Bollinger Band makes a relative study of the current moving average security price with the same average’s standard deviation. The current moving average is the average at the time of comparison.
Standard deviation judges the degree to which a value fluctuates around its average. These are merely bands plotted above and below the moving/rolling average. Therefore, these are based on standard deviation.
SMA or simple moving average denotes the average price over a particular period, used to decide a trend’s direction.
Generally, the bands would be set at two standard deviations above and below the 20 days rolling average.
When a technical analyst sees the bands tighten, trend formation is the implication. In case the trend is positive, investors would buy said security to follow the trend up.in the event of the distance separating the bands widening, the trend may be nearing its end.
This determines for the investor that he ought to sell. The trend’s strength is expected to be very strong in case the moving average goes outside one of the bands.
- Average volume
The average volume is merely a SMA of the number of shares exchanged for the given time period in the financial markets. So, for instance, you may reckon the average daily volume over the foregone 60 days.
A trend is stronger when the recent volume is greater than the average volume.
For instance, in case the price has been ascending, and recent volume is well above the average volume, that implies a strong trend. An investor may opt to buy/increase holdings.
In case the recent volume is below the average moving volume, the trend is seen as weaker.
Moving average convergence/divergence – MACD – compares the 26-period exponential moving average price with the 12-period EMA of the same price.
Exponential Moving Average -EMA – is just like a simple moving average, save for the fact that EMA places a greater accent on current data.
You can arrive at your approximate MACD line by subtracting the 26-period EMA from the 12-period EMA, plotting the resultant value.
However, for the MACD to be used, you have to compare it to a signal line, which is the 9 period EMA of the MACD line.
In case the MACD Line moves above the signal line, a bullish trend is indicated. An investor, therefore, would be tempted to buy the security. Conversely, the MACD line plunging below the signal line points to a negative trend, and the investor might well sell.
How many patterns are there in technical analysis? Or technical analysis chart patterns Or What are charting techniques in technical analysis? Or What are the different types of charts used in technical analysis?
Technical indicators are inescapable. To the question, if you must learn technical analysis, we have to answer – ‘Absolutely.’
There is no investment research without technical analysis. And so, every trader worth his salt has his own set of favourite technical indicators. Indicators thus become a standard part of traders’ strategy.
The truth is that there are a good number of indicators present in the financial markets. These may be used in any manner, and the combinations and usages differ as there’s a diversity of trader types. No two traders are the same.
So, naturally, their trading strategies and choice of indicators has to be individualistic, too.
We will like at the most essential technical analysis tools/indicators:
- Moving averages
The Moving Average identifies the direction of an ongoing price trend, sans the interference of shorter-term price spikes.
The MA indicator brings together a financial instrument’s price points over a particular time frame, dividing it by the number of data points to give a single trend line.
The data used is contingent upon the MA’s length. For instance, a 200-day MA needs data worth 200 days. The indicator enables you to study support and resistance levels and see preceding price action.
The implication is that you may also predict possible future patterns.
Forex oscillators point out the moment when the market reaches a limit. Then, an opposite current trend correction becomes the most likely result. When a price appreciates too high, it is deemed overbought.
The implication is that the price will stay stable or slip down slightly. When a negative correction takes place, new traders enter the market, leading to price appreciation.
Conversely, an oversold market leads to the reaction of the other direction or a positive correction. Generally, it is best to buy oversold and sell overbought forex pairs.
Oscillators also predict a breaking point in the price movement. Graph-wise, the lines would apparently be moving in the same direction as the price. However, as the lines begin to move apart, the trend will be deemed to be losing momentum.
Stochastic oscillators point out zones of overbought and oversold conditions. However, the stochastics also indicate potential price reversals. There are many variants of stochastics. The slow stochastic is the most widely used.
A stochastic oscillator compares a particular asset closing price to a range of its prices over time on the price charts. The indicator, therefore, signifies momentum and trend strength.
It uses a scale of 0 to 100. A reading below 20 stands on the price charts is for an oversold market. A reading over 80 stands for an overbought market.
- Fibonacci retracement lines
Fibonacci retracement lines are horizontal, indicating potential support and resistance levels where price could possibly reverse direction.
You have to buy on a retracement at a Fibonacci support level when there’s an uptrend. Conversely, you have to sell on a retracement at a Fibonacci resistance level when the market is trending down.
- Relative strength index
RSI mostly shows momentum, market conditions, and warning signals for unusual price movements. The indicator is expressed between 0 and 100 and helps in financial analysis. Level 70 signifies ‘overbought.’
Conversely, an asset close to 30 is frequently deemed oversold.
- Bollinger bands
A Bollinger band offers a range within which an asset price generally trades. The band’s width increases/decreases to reflect recent volatility. The narrower the bands, the lower the instrument’s volatility.
It shows when an asset is trading outside of its usual levels. These are generally used as a method of predicting long-term price movements.
What are the most profitable chart patterns? Or How is a technical analysis used?
Per Thomas Bulkowski, is the most profitable chart pattern, in all likelihood, are bullish flags that are high and tight that breakout to the upside and head and shoulders top chart pattern with breakouts to the downside.
Bulkowski based his choices on backtesting of chart pattern price action.
High and tight bull flag chart:
The high and tight bull flag is a variant of the standard bull flag that needs a much stronger trend and tighter price base for the flag. It is a continuation pattern of the preceding uptrend before the flag.
Price ought to appreciate by at least 90% or double in the 2 months or less prior to price range formation. A consolidation price range pattern forms following the significant uptrend. The price range may look like a flag.
Volume ought to diminish as the flagging price range forms. The preceding price uptrend prior to price consolidation is what the ‘pole’ stands for. The ‘flag’ is a rectangular descending price range following the uptrend to new higher price stops.
The flag has mainly lower highs and lower lows. The flag patterns’ end’s signal and the start of a new potential uptrend is when the descending upper trend line is broken with a move upwards in price.
The pattern is deemed an uptrend consolidation. Validation takes place when the price closes above the highest price pattern, which is nearly always the flag’s peak.
Flag breakout with higher than normal volume amplifies the chance of uptrend continuation.
A stop-loss may be set at the lower trend line in the flog post entry. Naturally, this pattern cannot guarantee results each and every time. When it does, however, it does set up a momentous win.
The complex head and shoulders chart pattern is the other arguably most profitable chart pattern. However, a discussion of the said pattern is outside the scope of the present article.
There are lots of ways to conduct technical analysis and a wide selection of indicators and overlays to add to your chart. You have to be curious about things when you are analysing a chart.
Not only that, it is only commonsensical that the questions will be answered with the aid of a large range of technical indicators. PrimeFin has the best guidance in this regard. Check our PrimeFin Review.