The stock market can be a challenging knot to untangle. Although fundamental analysis looks at the company’s fundamentals, there is a very attractive alternative to make better trading decisions, and that is technical analysis in stock market. This article serves to help you unravel the world of technical analysis. You will learn how to read charts, how to spot patterns, and make better trading decisions.
What is Technical Analysis in Stock Market?
Technical analysis is a trading discipline that uses market activity statistics, such as past price and volume, to analyse securities and identify trading opportunities. Technical analysis operates on 3 basic premises:
Market Action Discounts Everything: Everything that can affect a market price, whether it is a company's earnings or the news that comes from outside, is already factored into the market price.
Prices Move in Trends: Prices of stocks do not move randomly, as they move in trends that can be found and followed.
History Repeats Itself: Because traders and investors react to the same market conditions the same way, price patterns can be found on charts that can be repeated.
While fundamental analysis examines company value (intrinsic), technical analysis focuses solely on the price and volume information for a stock's historical performance and patterns. Fundamental and Technical analysis have several differences for numerous reasons.
Best Technical Indicators & Tools for Trading
The chart is at the core of stock technical analysis. As you look at a line chart, bar chart, or candlestick chart, you are looking at price moving through time. For a simple introduction to candlestick patterns, you can check out our other blogs.
Chart Patterns
Stock chart analysis is based on recognizing patterns that tend to repeat, giving us hints about future price direction. Patterns can be classified as reversal or continuation patterns.
Reversal Patterns
Indicates a shift in the current trend.
Head and Shoulders: This is a pattern with three peaks. The head, or middle peak, is the tallest. Indicates a reversal from an uptrend to a downtrend.
Double Top / Bottom: The letter "M" shape (double top), or "W" shape (double bottom). Indicates that prices have tried, and failed, to break a key level and is encouraging a reversal.
Continuation Patterns
Indicates that the current trend will likely continue after a brief pause.
Flags & Pennants: Small, compressed triangles or rectangles that form after a price move. Following these, it is common that the price will continue in the same price direction as the initial price crash / spike.
Triangles: Symmetrical, ascending, or descending triangles can signal consolidation, and then the price will break out in the previous trend. You can learn about one type of pattern that signals a reversal in our post about the Shooting Star Candlestick Pattern.
Support and Resistance
Support and resistance are considered essential concepts in share market chart analysis. A support level is considered a price floor where a trend down is likely to stop because of the high level of demand. A resistance level is a price ceiling where a trend up is likely to stop because of the high level of supply. Generally, our technical trader will look for support and resistance levels to suggest where their entry and/or exit points may be. When a price breaks through a support or resistance level, that support or resistance price level is reversed to become the new resistance or support level.
Technical Indicators
Technical indicators are calculations that are mathematical in nature, based on a security's price, volume, or open interest. They get plotted on a chart for various purposes, which a trader can use to establish trends and suggest predictions. Some of the best technical indicators for trading include:
Moving Averages (MA) - are used to smooth out price data in order to obtain direction in trends. For example, when an MA is moving up, it indicates an uptrend, whereas a MA that is moving down provides an indication of a downtrend.
Relative Strength Index (RSI) - A momentum oscillator that identifies the speed and change of price movements. It is measured from 0 to 100, and tells you if the stock is overbought (above 70) or oversold (below 30).
Moving Average Convergence Divergence (MACD) - A trend-following momentum indicator that reveals the relationship between two moving averages of a security's price. Read our blog to learn how to use the MACD in a successful manner.
If you're ready to master these tools, our Technical Analysis Course is an excellent next step.
Technical Analysis - Strategies and Applications
The real power of technical analysis is in its application. It does not simply identify patterns; it helps you create a strategy to trade on them.
Strategies for Different Types of Trading
Day Trading Technical Analysis: Day traders are more concerned with volatility and thus make decisions in seconds, minutes, or hours rather than days, weeks, or months. Day traders often use faster indicators such as the RSI and MACD. They also factor in the support and resistance levels for the day on a smaller time frame (5-minute chart, 15-minute chart, etc.). Daytraders are simply looking to capture small price movements throughout their trading day. For more information, read Successful intraday trading strategies for beginners.
Swing Trading: Swing traders hold positions for several days to several weeks and use technical analysis to recognize the trend and navigate profitable “swings” in price. More often than not, they will be looking at indicators on longer time frames (e.g., daily, weekly) to establish an entry or exit point. Our post on Swing Trading vs Day Trading would be a great reference as they compare.
Long-Term Investing: Long-term investors typically focus on fundamentally, but what may make them a savvy long-term investor is utilizing technical analysis to determine the best entry points for an asset. For example, a long-term investor may wait for a stock to reach a long-term support level before buying it, which can be beneficial in reducing their average cost.
Real-World Examples
Let’s go over a very simplified illustration on combining the above elements for equity technical analysis.
Let us presume you are evaluating a stock that is in an uptrend and notice a bullish engulfing pattern. The bullish engulfing pattern by itself is considered a strong bullish signal. Not only do you see this and note the price of the stock touching a nice, established support level, but the stock's RSI has just entered from an oversold territory. You are seeing three different signals altogether: an advantageous chart pattern, a key support level, and an RSI level providing a long trade setup of high conviction. Know the top 5 bullish candlestick patterns for better understanding.
The Importance of Risk Management
Regardless of how great your technical analysis is, it is only a portion of the entire trading picture. Risk management is crucial when trading and essential for long-term success. Unless you have very solid reasons not to, always use stop-loss orders to mitigate your potential losses on a trade. Never risk more capital on one trade than you are comfortable losing. The reason why consistent traders sustain their income, and losers lose money, is that disciplined trading stocks when trading is very different than losing money.
Conclusion
Technical analysis in stock market is a very powerful and useful skill that you could harness for your benefit in trading. With this skill, you can read charts, identify patterns, and use the best technical indicators when trading. Therefore, you will have a larger amount of confidence in your trading decision. You need to practice, and no one signal or pattern is going to define your success, but if you combine your technical knowledge with other strategies and negate risk management as stated, then you are in a good position to realise you are starting to become an expert in the art of trading. For continuing listeners who would like to have additional education about valuing companies, take a look at our post about Fundamental Analysis in Stock Market.
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