In this article, we will explain to you what technical analysis is and how technical analysis can help you in finding a great stock to make a profit.
We have different groups of professionals in the stock market.
One group of professionals makes investment decisions by analysing fundamental information such as the company’s financial statements, economics, politics, industry, and demographics. Based on these fundamental details these professionals forecast the future earning potential of a company and industry as a whole. After a thorough analysis, they choose fundamentally strong stocks to invest their money for a long term to get good returns.
On the other side, we have technical analysis which is the opposite of fundamental analysis. Now let us know what technical analysis is and why it’s so important.
What is technical analysis
Technical analysis is the study of a security’s past and present price chart in order to determine the likely future direction based on the psychology of buyers and sellers. By using technical analysis, traders identify trading opportunities in the market.
Over time, behaviour of these market participants can be analysed based on the pattern formed. Each pattern conveys a certain message, it’s up to the traders to decode the pattern.
Traders relying purely on technical analysis don’t care about what the company does, what is its debt to equity structure, how the company makes money, what will be its growth in sales and earnings, or the competency of the management.
The only thing that matters to technical analysts is the stock’s past trading data and the information this data can provide about the future movement in the security.
Therefore, technical analysis is the study of the collective psychology of the market. Its used to anticipate the probability of future price movements.
Axioms of Technical Analysis
Market price discount all known information efficiently, but not perfectly. Market price is used as a leading indicator as its a reliable measure of collective human psychology.
Price move with the trend. In uptrend, probability for prices to move up is higher. In downtrend, probability for prices to move down is higher.
Market is not completely random. By studying chart patterns and price movement, we can anticipate the probability of future price movements.
Why to use technical analysis
Technical analysts believe that based on the psychology of crowds, market participants react similarly to major news.The market is always right. Market participants have reference points when they buy or sell stocks. Therefore stocks tend to find support and resistance at certain points.
Technical analysis is a popular technique used by market participants to get answer to following questions;
- Price at which one should buy and sell stocks
- Expected reward
- Is the stock trending or in a trading range?
- Who is in control of the market – buyers or sellers?
- In which direction the market can move?
- When to enter and exit the market?
- Risk involved
- What will be the trend of the stock in the short and long term?
Technical analysis is best used to identify short term trades.
Long term investment opportunities are best identified by using fundamental analysis. In addition to fundamental analysis, you can take help of technical analysis to calibrate the entry and exit points.
One of the most important benefits of technical analysis is that you can apply technical analysis on any asset class. This means the concept of technical analysis will remain the same irrespective of the asset you are studying. For example, technical indicators such as Moving Average convergence divergence (MACD) or Stochastic or Relative Strength Index (RSI) is used exactly the same way on equity, commodity or currency, futures and options market.
Use of OHLC in Technical analysis
In India, the stock market opens from 9:15 AM to 3:30 PM IST. During this 6 hours and 15 minutes time period, there are millions of trades that take place. Every tick in the stock market indicates trade taking place in the market.
The question is as a technical analyst how to analyse the market behaviour. It’s difficult to track all these different price points. Therefore chartists for better technical analysis across the world use the opening, high, low and closing price of stocks or securities to analyse market behaviour.
Opening price is the first price at which a trade is executed in the market. High is the highest price market participants agreed to trade during the trading session.
Low is the lowest price at which the market participants agree to trade for the trading session. Closing price is the final trading price at which market is closed for the day or trading session.
If the closing price is higher than the opening price, it’s said to be bullish or it is considered as a positive closing. Or else, if the closing price is lower than the opening price, it’s said to be bearish or considered as a negative closing.
Therefore the open, high, low and close are the most important data for a chartist to analyse the market. Each of these data are plotted in the chart for technical analysis.
Open, High, Low and Close prices are usually abbreviated as OHLC.
To analyse these prices at one place you need a charting technique.
Behaviour of the market participants can be visualised by using the above four prices in a Bar or Candlestick chart. Bar chart shows the open and close prices by a left tick and right tick respectively, however in a candlestick the open and close prices are displayed by a rectangular colored body. We have selected these two charts because its so popular that many well known traders across the world use it for short term trade.
If you are new to technical analysis, then we recommend candlestick charts due to its various advantages in comparison to bar and other forms of charting technique.
Candlesticks are very easy to interpret and help you to quickly visualise who is in control of the market.
How different time frames can help you in technical analysis
As a technical analyst, you need a time duration during which you want to study a particular chart by analysing Open, High, Low and Close (OHLC) data. The time duration chosen by you is known as time frame.
Here are few popular time frames used by traders;
- Monthly charts
- Weekly charts
- Daily charts
- Intraday charts – 1 Hour, 30 Minutes, 15 Minutes and 5 Minutes
Time frame selection is purely based on the type of trader you are.
For instance high frequency traders use a 1 minute chart as opposed to any other time frame. Swing Traders might use Weekly, daily and hourly time frame for a trade.
Within the time frame you choose, candlesticks form different patterns based on how buyers and sellers trade. These patterns are helpful to understand in which direction the market will most probably move.
Here are the most important candlestick patterns to understand market behaviour;
- Hammer
- Shooting Star
- Inverted Hammer
- Hanging Man
- Bearish and bullish engulfing Candlestick Pattern
- Three inside up/down Candlestick Pattern
- Three outside up/down candlestick pattern
- Morning Star
- Evening Star
- Meeting Line
- Piercing Line
- Inside Bar
- Dark Cloud Cover
In addition to these candlestick patterns we have price action patterns that can help you analyse the psychology of buyers and sellers.
Technical Vs Fundamental Analysis
As discussed earlier technical analysis is used by traders for short term trade. How about fundamental analysis? When is it used? Many beginners have confusion about the use of fundamental and technical analysis.
Fundamental analysis is concerned to know the underlying reason for market movement, which consists of financial information and news that is directly associated with security and market.
On the flip side, technical analysis focuses on the price movement and human behaviour by assuming that all fundamental information and economic factors that can impact the price movement are already reflected in price action. Therefore, technical analysts avoid financial information and economic impact on a stock.
Many experts use both technical analysis and fundamental analysis. They use fundamental analysis to select fundamentally healthy stocks and then use technical analysis to pick it at the right price at the right time.
Often amature traders get into the argument contending fundamental analysis is better than technical or vice versa and within technical analysis they fight for the best indicator to take a trade. However, in reality there is no such thing as the best research approach or indicator. Each method and indicator has its own merits and demerits. It’s up to the trader how they interpret the market by using these methods. You need to put in the required effort to learn the technique to becode the market behaviour.
