Technical analysis is a trading technique used to evaluate price movements and trends. By looking at price charts and technical indicators, a trader can determine the direction or trend of
Technical analysis does not involve any fundamental analysis, such as evaluating a company’s balance sheet. Instead, a technical analyst will focus on patterns, price movement, volume
The use of technical analysis is applicable in all realms of trading. It is useful in equities, commodities, cryptocurrency, forex, futures and more.
Key Concepts of Technical Analysis
- Analyzing the past to predict the future is a major principle of technical analysis. A technical analyst believes history is likely to repeat itself and that price movements are cyclical. While past performance is not a guarantee of future results, there are common patterns that do repeat themselves.
- Another major principle of technical analysis is that market prices reflect all available information. If the market is efficient, then performing fundamental analysis is unnecessary because everything is already factored in.
- A technical analyst does not believe prices are random. They believe all prices follow a trend. Trends can be either short-, medium- or long-term. The key concept of technical analysis is identifying the trend to predict future price movements.
Technical Analysis Basics
Technical analysis does not involve fundamentals or focus on a stock’s intrinsic value. The main focuses are trends, price action, volume, chart patterns, momentum and more. So how are these used to analyze a stock or security?
Identifying trends is a very important part of predicting a security’s forthcoming performance. Examining long-, medium- and short-term trends help a trader forecast if a stock price is likely to go up or down.
Past price movements and patterns can signal how the stock is likely to perform in the future. If a trader can identify the trend, they’re more likely to make profitable trades.
The trend represents the overall direction of a stock or security.
There are three main trends, uptrends, downtrends and sideways trends.
- Uptrends have higher highs and higher lows.
- Downtrends have lower highs and lower lows.
- Sideways trends move horizontally and are usually a sign of consolidation.
The short-term trend can be in a downtrend while the long-term trend can be in an uptrend. Daytraders and scalpers will use very short term trends, while swing traders are likely to use medium or long-term trends.
The current and past price of a security is what makes technical analysis possible. The price is logged in charts that track the stock’s historical performance. Before computers, traders would draw the charts by hand.
The price of a stock by itself can tell a trader a lot about market sentiment and demand. The price rises when there are more buyers and falls when there are more sellers.
A chart illustrates the past performance, thus making the direction more clear. Price charts allow traders to identify trends, patterns, and volume.
Analyzing trading volume is a major factor in technical analysis. Volume is the number of shares or contracts that are trading. Volume can be analyzed at different time periods however, the daily volume is most common.
Traders use volume to find out how much strength is behind a price movement. In a downtrend, the volume is high during down moves and low during up moves. The opposite is true for an uptrend.
Volume can also help confirm a chart pattern. If a stock breaks out over a major trend line on low volume, it’s most likely a false breakout. Traders use high volume to confirm trend changes or significant movements.
Chart patterns are one of the main ways to perform technical analysis of a stock or security. As past prices are put into charts, traders can start to identify patterns.
Ten of the most common chart patterns include
- Head and Shoulders
- Inverse Head and Shoulders
- Double Top or Double Bottom
- Triple Top or Triple Bottom
- Ascending Triangle
- Descending Triangle
- Bullish or Bearish Symmetric Triangle
- Cup and Handle
- Falling or Rising Wedge
Charts are used to draw and identify trend lines and areas of support and resistance. The visual representation that a chart provides allows a trader to see how stocks react to market news and fundamental changes.
There are several different types of charts used for technical analysis. The 3 most commonly used types are the candlestick chart, bar chart
Many traders prefer to use the candlestick chart because of its ability to account for multiple time frames into single price bars.
Relative Strength Index (RSI)
The relative strength index is a momentum indicator that measures the significance of recent price changes to determine overbought or oversold conditions. It tracks the number of price increases or decreases over a period of time. The most common timeframe is the 14-day period.
The RSI will assign a stock a value between 0 and 100. A value of 30 or below is considered oversold and a value of 70 or higher is considered overbought.
Moving averages help simplify the movements in the stock price. They focus on a stock or security’s average price movements and not the daily changes.
The two types of moving averages are “simple moving averages” (SMA) and “exponential moving averages” (EMA).
A simple moving average takes the total amount of all closing prices for a specific time period and divides them by the number of days. For example, to find out a 20-day SMA you add up a
EMAs use a much more complicated formula that places more weight on recent prices.
Support and Resistance
Technical analysts examine a security’s support and resistance levels to help determine if it’s in a bullish or bearish path. Typically the previous lows are seen as support while the previous highs are levels of resistance.
The support level is the price that has enough demand to prevent it from falling lower. The resistance level is where there isn’t enough demand to drive the price higher and sellers step in to take profits.
If the price of a stock breaks above a resistance line, that is a bullish signal, and the price is likely to continue higher. Conversely, if the price of a stock breaks below a support level, it is a bearish signal, and the price is likely to drop further.
After a stock has fallen past a line of support, the previous support line becomes a resistance. If the stock has broken past a resistance level, then the previous resistance turns into support.
Stock prices often bounce between support and resistance lines. Knowing the areas of support and resistance are crucial to identify trends and possible reversals.
Other Indicators and Oscillators
Indicators use price statistics to calculate chart patterns and trends. They’re created to determine buy or sell signals to help traders enter or exit a trade. Using technical indicators allow traders to confirm price movements and develop a profitable trading strategy.
Some indicators are referred to as “oscillators.” Oscillators are tools like RSI that allow traders to analyze momentum and oversold/overbought conditions.
Other popular indicators used in technical analysis include:
- Moving average Convergence Divergence (MACD)
- Bollinger Bands
- Ichimoku Cloud
- Stochastic (similar to RSI)
- Money Flow
- Fibonacci Retracements
Basic Trading Strategies
Technical analysis is used to create many basic and advanced trading strategies. A few basic strategies include trading with the trend and finding trend changes like a bottom reversal or breakdown.
Trading with the Trend
One of the most popular forms of technical trading is trend trading. Trend trading allows investors to make profits as a security follows its overall trend.
The first step is to identify the stocks current trend. Drawing a trend line and using indicators like SMAs and support and resistance lines are a simple approach. If the stock is in an uptrend, buy it when it pulls back and
In a downtrend, the trading method is reversed.
Technical analysis can be used to determine a bottom in
This technique is riskier than trend trading as false bottoms are common. Some stocks turn into falling knives and trying to catch them will result in large losses.
On the flip side, a trader that is capable of identifying a bottom will be handsomely rewarded.
Using technical analysis to find short entries is very common. There are patterns like the head and shoulders or double top that indicate a security is topping out.
Identifying or calling a top is just as risky as trying to call a bottom. Use a stop loss and only enter the trade if there is enough evidence or confirmation the security is reversing.
How to Perform Technical Analysis
Start by picking a stock or security, and pull up its chart. For charting, I recommend using TradingView (affiliate link).
Once you’ve selected
Watch the price movements of the stock to confirm if is following the trend line you came up with. Try adding some moving averages to help identify its overall long and short term trend.
If the trend begins to change make sure to check the volume to confirm the strength behind the movement. Get familiar with the available charting tools and keep it simple at first. Like anything else in life, you’ll get better and better the more you practice.