In this article, we will delve in detail into the details of Technical Analysis, and see how a newcomer in the markets can obtain mastery over it . Following are a few pointers which you must know about Technical Analysis –
- Technical analysis is a method of forecasting the direction of prices through the study of past market data, primarily price and volume.
- Technical analysis only deals with the secondary market.
- This type of analysis works extremely well for short term trading (intraday or swing trading). It works on the assumption that price patterns in the market tend to repeat themselves because market participants behave in the same way in a similar situation.
- The main purpose of Technical analysis is to answer the question of “WHEN TO BUY?”
Three basic principles/assumption of technical analysis
- History tends to repeat itself – Market participants react to price actions in a similar manner every time prices move in certain directions.
- Stock prices move in trends – Stock prices move in uptrend, downtrend, or horizontal (sideways) trend.
- Market discounts everything – All known and unknown information is reflected in the stock market through price movements.
Learning Technical Analysis
Technical Analysis consists of various types of charts viz Candlestick, bar charts, Line graphs, point & figure charts, Heiken-Ashi chart, etc. Amongst these charts, the most commonly used is the candlestick chart as it helps in identifying various candlestick patterns, which are used to generate trade signals.
Let us now dive deep into learning technical analysis –
Types of charts
- Charts form the most important part of technical analysis and there are various types of charts available, which helps in improving the analysis.
- Candlestick, bar charts, line charts, Heiken-Ashi chart, point & figure charts, etc. are some of the charts available to market participants. They can select the charts as per their convenience, whichever would help them form their strategy.
- Candlestick is one of the most popular chart types among technical analysts because it not only captures the OHLC (Open-High-Low-Close) but also helps in identifying candlestick patterns, which helps in taking trades accurately.
Understanding the trend
- The first important point to understand while applying technical analysis is to identify the trend of the stock/security.
- We know that prices move in a trend. We need to first identify if the prices are moving upwards (shows uptrend) or downwards (shows downtrend).
- Understanding a trend is important because sometimes indicators give conflicting signals and hence a clear trend aids us in avoiding the trade with such divergent signals.
Support and Resistance lines
- Support lines refer to that level where prices often hit but fail to break below due to strong demand. At this level, buyers are likely to buy and sellers unlikely to sell. Support lines can temporarily change the short-term trend, which provides an opportunity for trade.
- The resistance line refers to that level beyond which the price of the stock is unlikely to increase. Here, the supply is likely to be heavier than demand, which forces the prices lower and results in traders taking short positions, while buyers wait for breakout (prices moving beyond the resistance line) to take a buy position.
- The more time particular support or resistance is tested (touched and bounced off); the more significance is placed on that level.
- A move beyond the resistance or below the support emerges as a breakout, typically providing a good trading opportunity.
- Channels are two parallel lines consisting of series of highs which acts as channel resistance and a series of lows, which acts as channel supports.
- These trendlines are considered strong resistance and supports, and prices move within the channel. It aids in anticipating the direction of the prices, which could support in taking trades wisely.
- A channel can be upward, downward, or horizontal. It plays an important role in intraday or swing trades. Besides, it helps in envisioning the directional movement of the stock over the long-term as well.
- There can be a minor violation of the channel as prices sometimes break it but re-enter the channel. It is known as “throw-over”
Like mentioned earlier, Candlestick charts are one of the most preferred chart types among analysts. Apart from displaying the trend, it also shows various candlestick patterns, which is considered effective while trading, and these patterns complement the analysis.
Some of the most effective candlestick patterns are as follows:
Engulfing patterns: Engulfing patterns are candlestick patterns consisting of two consecutive candles. The second candle engulfs (surrounds) the first candle. There are two types of engulfing patterns viz, Bullish Engulfing and Bearish Engulfing. Bullish Engulfing forms at the bottom of the downtrend and Bearish Engulfing forms at the top of the uptrend.
DOJI candle: DOJI candles are neutral candles that show indecisiveness in the market but gain significance if appeared after an Engulfing pattern. A spinning top is another pattern, which indicates indecisiveness in the market.
Morning star: A morning star pattern is a bullish candlestick pattern. It indicates a downtrend reversal and is formed with three consecutive candles.
Evening star: An evening star pattern is a bearish candlestick pattern. It indicates an uptrend reversal and is identified by three consecutive candlesticks.
Use Indicators for analysis
- Indicators are tools that indicate a change in trends, it aids in making buying or selling decisions by predicting future price movements.
- It is calculated mathematically based on the price or volume of the stock/security.
- There are two types of indicators namely leading and lagging indicators. A leading indicator gives an advance indication of a change in trend whereas a lagging indicator follows the trend rather than predicting a reversal or trend change. A majority of leading indicators are called oscillators as they oscillate within a bounded region.
Examples of Leading Indicators: RSI (Relative Strength Index), Stochastic Oscillator, Williams’ % R, etc.
Examples of Lagging Indicators: Moving Averages, MACD (Moving Average Convergence Divergence), Bollinger bands, etc.
- There is another category of indicator, which is an amalgamation of leading and lagging named Momentum indicator. Momentum is the rate at which price changes. These indicators determine the movement of price over time and the strength of these movements irrespective of the direction of the prices. Example: RSI, MACD, etc.
- Indicators are extremely helpful as that supplement the analysis and provide the right entry point for taking trades.
You can consider the above-given points as a basic guide to begin technical analysis. The above points are written in a step-wise format and hence can be considered in the same manner for anyone who wishes to analyse any stock/security.
- To learn Fibonacci retracement we first need to know what Fibonacci series is. Fibonacci series is a series of numbers whose value is the sum of its previous two numbers. (E.g. 0,1,1,2,3,5,8,13,21,….infinity)
- Any number divided by its previous number always gives a number close to 1.618, which is also known as “Golden ratio or phi” E.g. 21/13= 1.615, 34/21=1.619.
- A golden ratio is a universal number as it is found in nearly everything in our surroundings. E.g. Human face, flowers, vegetables. To learn about it in-depth, you can read about it on the internet.
- Fibonacci retracements consist of Fibonacci numbers that assist in determining the levels where prices could pause at the time of retracements or could extend when in a Bull Run.
- Retracements are movements that go against the trends, say a stock is in a bull run but the upward move pauses and a minor down move is witnessed, that is known as retracement.
- Retracement provides an opportunity for market participants to re-enter the stock just in case the trader missed the first leg of the rally.
- How to apply retracement – To apply retracement select a bottom and top of the same leg of the rally and then apply the retracement to the up move. The retracement tool consists of 23.6%, 38.2%, 50%, 61.8%, and 100%, all these numbers are Fibonacci numbers derived by dividing the Fibonacci series numbers in a certain manner. (see image)
- The retracement helps in identifying the price levels from where prices can certainly bounce back and can be used to identify entry points to buy or sell a security.
The above image shows that prices bounced off several times after hitting 61.8% of the retracement level.
This is a rough framework of what technical analysis comprises of. Technical analysis is an ocean if one really wishes to learn. There are various other aspects like Elliot Wave Theory, Gann Theory, Option Chain Analysis that help us to make better decisions about how to take an accurate trade.
How to learn technical analysis in detail?
These aspects require in depth explanations and hands on training as they are complex to understand, especially for beginners. These concepts are covered in our Stock Market course along with detailed study of above mentioned techniques on live market charts which will give you hands on training and confidence to take actual trades in live market.