What is technical analysis?
Technical Analysis is the study of price movement and volume change to analyse the trend in a chart. In brief, a technical analyst follows the historical pattern and proven indicators to forecast the price movement.
Besides, a thorough knowledge of chart types, historical pattern and proven indicators is mandatory to take a position in the stock market.
Thus, our main area of focus is:
Charts and its types
Chart plays an important role to analyse the trends, predict the movement of price and change in volume but the selection of the right chart is very important to get the desired results.
Therefore, we cover the common type of charts and their importance:-
- Line Chart
- Open-High-Low-Close (OHLC) Chart
- Candlestick chart
1. Line Chart
It is the most basic and simple chart to study a trend in a simpler form. In Line chart, the trend is finally formed by connecting the dots which represents a closing price of a stock in a defined time period.
An illustrative image shows the line chart which particularly represents the time period in X-axis and closing price of a stock in Y-Axis
2. Open-High-Low-Close Chart (OHLC)
Although, line charts form simple trends but cannot predict the exact sentiments of the market. It is generally due to the absence of other important information such as high, low and open price.
Thus, an OHLC chart provides more useful information to predict the market. Moreover, these charts also show the increase or decrease in momentum to give a fair idea about the volatility of the market.
OHLC charts consist of one vertical line and two horizontal lines to the left and right of the vertical line.
In the above image, the bottom point shows the low, while the top point shows the high price. Similarly, the left line shows the open price and the right line shows the close price.
3. Candlestick CHART
To begin with the history of Candlestick charts, it was developed by a Japanese rice trader Munehisa Homa in the 18th century with a purpose to study the price movement of rice trades.
Later, it becomes popular in the world due to its graphical representation of price movements in a given period of time.
Although, the candlestick display the stock’s high, low, open and close price like OHLC chart but its graphical representation is the main advantage over an OHLC chart
The charts can give all the important data required by a trader but if interpreted in the wrong manner can result in big damage.
Above all, the chart supports the trader to see either the quick trend or to predict the in-depth nature of the market.
Patterns for technical analysis
The patterns play an important role to anticipate the future direction of price because they are the predefined plotted data that repeats over a period of time with the same characteristics.
The price pattern mainly consists of two types:-
1. Continuation price pattern
2. Reversal Price Pattern
1. Continuation price pattern
It consists of a trend which continues to move in the trending direction with small intervals. A common type of continuation price patterns are:-
- Cup with Handles
For instance. the image shown below represents the cup with handle pattern which continue to move in the trending direction with the small downside and pause.
2. REVERSAL PRICE PATTERN
It consists of a trend which reverses from its prevailing direction. A common type of reversal price patterns are:-
For instance. the image shown below represents the head and shoulder pattern which reverse the uptrend direction into a downside.
Indicators for technical analysis
The indicators forecast the market direction especially on the basis of historical price data.
The major type of indicators that most of the traders use are:-
- Moving Average
- Support and Resistance level
- Trading Volume
The moving average has shown over a chart by means of a line. Consequently, a line forms by taking the closing price average of a defined period of time.
The most common type of moving average is:-
- 20-day moving average – It is the line formed by average the closing price of 20 days.
- 50-day moving average – It is the line formed by average the closing price of 50 days.
- 200-day moving average -It is the line formed by average the closing price of 200 days.
Support and Resistance level
A stock price tends to oscillate within a specific zone for a definite interval of time. This zone consists together with top and bottom levels. These levels are:-
- Resistance Level – It is the top level of a zone above which the price fails to move and bounce back
- Support Level – It is the bottom level of a zone below which the price stops to fall and bounce back.
Trading volume is an important parameter to view the overall activity of a market with respect to time.
It can either be high trading volume or low trading volume
- High Trading Volume – In high trading volume, the participation of retail investors are high. Thereby, it is easy to judge the market sentiments when the trading volume is high.
- Low Trading Volume – In low trading volume, the participation of a small group of investors is high. As a result, it is difficult to judge market sentiments when the trading volume is low.
But, the trading volume itself cannot figure out anything. Therefore, Put to call ratio is used to test the market sentiments.
If the ratio of Put to call is high, the investors are more pessimistic and try to take the market at the top whereas if the ratio of Put to call is low, the investors are more optimistic and try to take the market at the bottom.
Which is the best a technical analysis or Fundamental analysis?
A frequently asked question from the beginner is which type of analysis (a fundamental or technical) is best for returns.
In my opinion, both are a complement to each other. Technical analysis can predict the entry and exit time whereas fundamental analysis checks the financial health of a company.
But, to become an expert in fundamental analysis, it is better to ask the three questions to yourself:-
- Are you a man with patience?
- Can you follow the buy and forget principle?
- Can you invest hours, weeks to analyse the economic situation, industry performance and annual report of a company?
If the answer of the above questions is “Yes” then follow value investing else learn technical analysis.
- Technical analysis is the study of price movement and volume change
- The most common chart types are Line Chart, High-Low-Close and candlestick chart
- Proven historical patterns are the best tools to predict the behaviour of the crowd.
- Indicators support a trader to take his/her position
- Fundamental and Technical analysis both complement each other.