Technical analysis takes into assumption that the price of a security reflects the information that is available publicly. It concentrates on the statistics of the market and the price movements. Technical analysis aims to get a clear understanding of the “market sentiment” regarding the happening pricing trends. At the end, technical analysis leads to the supply and demand analysis to see direction of the current pricing trend and its ultimate goal.
Technical analysis acts as a tool to evaluate securities by analyzing market statistically, like for example price and volume. Technical analysis takes the help of charts and statistical tools for the identification of various patterns to create the basis for investment decisions.
Technical analysis come in different forms, some use patterns of charts, some technologically enhanced “indicators and oscillators” and many use techniques in a combined form. The wise use of “historical price” and “volume data” by the technical analysts is what makes them really distinguishing. Stock’s valuation is what concerns technical analysts the most. Trading data of the past and the information that the data would provide regarding the pricing trends in the near future are the main matters of concern for the technical analysts.
The three assumptions upon which technical analysis is based include: Discount is provided to almost everything by the market, movement of price in the form of trends, the fact that repeating itself is the nature of history. It is believed by the technical analysts that everything has got it priced into the stock starting right from the fundamentals of the company to the big factors of the market and right to the entire scenario of the market. Technical analysts have the belief that the trends which the price follows is normally short, medium and long and that the stock price normally follows the trend in the past and instead of undergoing sudden changes. Market psychology is the one to which the repeating nature of movements of price is attributed to and it is quite predictable depending upon human emotions like fear or excitement. Chart patterns are used for the analysis of such emotions followed by the market movement and understand from it the patterns of trend. Technical analysis could be applied over any kind of securities and not just stocks like currencies, commodities, futures and others.
Trend, it is the most important term when it comes to technical analysis. Trend, it really means the path or direction which is being followed by any security and also the market. It is not always an easy task to track trends because price is one thing which never follows a concrete straight way. Technical analysis is all about this, that is to say covering the highs and the lows that make up the total space under consideration or rather the trend. Uptrend is made up of the “higher highs” and “the higher lows”. Downtrend is made up of “lower highs” and “lower lows”.
The three different types of trends as per direction are the uptrend, the downtrend and the sideways or the horizontal trend. Technically, horizontal trend is one where no particular or proper trend is found in any of the directions.
As per length, trend is classified into short-term, intermediate-term or long- term trends . Long-term trend is one which is more than a year long. The duration of intermediate-trend is around one-three months. The duration of short-term trend is less than even one month. Often trends occur in embedded form, that is, long-term could consist of intermediate-term trend which in turn could consist of short-term trends. Different combinations would be like a long-term uptrend could have many short- and intermediate-term downtrends all the way.
Analysis of a trend needs the proper sketching of the chart which would help to correctly understand the direction which the trend follows. Daily and weekly charts are the most suited for long-term trends. Minutely sketched charts which are done on an hourly basis are best suited for short-term trends. Long-term trend weighs heavy than short-term trends because four-year trend would be more important than a one- or two-month trend.
A trendline is a technique which is related to charts and in this a line is introduced to the chart which helps in the representation of the trend in a market or stock. Introducing such a line is like connecting the “higher lows” (for an uptrend) or the “lower highs” (for a downtrend) for the purpose of showing the direction of the path which the trend follows. Such lines are meant to avoid the noise and give a clear picture as to where the price is moving. They also help to figure out the “areas of support and resistance”. Support levels are those wherein the price “rebounds higher multiple times”. Resistance levels are those wherein the price “rebounds lower multiple times”. The number of rebounds occurring in the trendline determines how strong a trendline is.
Two trendlines acting as strong areas of support and resistance having price within them make up a channel. A “series of highs” make up the upper trendline whereas a “series of lows” make up the lower trendline. Sloping of a channel could be upward, downward or sideways but direction doesn’t influence the interpretation in any way. Expecting the price to trade between the support and resistance trendlies and wait till it breaks out beyond either of the two levels is what the motive of the traders is and in such a case traders do expect a steep move towards the direction of the breakout. Together with the displaying of trend, channels also help in the display of crucial areas of support and resistance concerning the stock price. Trend is a very crucial concept and it asks the trader to “trade with it” and not against it.
Support and resistance plays a very important role in the field of technical analysis. The proverb “battle lines” defines the point where the maximum trading occurs and it is nothing but the support and resistance level. Support level is that where it is considered that the demand is more so that it prevents the price from reducing down whereas resistance is that where it is considered that the selling is quite powerful so it helps to prevent prices from increasing further.
Support and resistance are crucial levels wherein the traders have willingness to “trade the stock”. With the breaking of trendlines, new levels of support and resistance gets established, and entire market psychology gets shifted.
Their psychological importance makes round numbers important support and resistance levels. 10, 20, 35, 50, 100 and 1000 represent turning points important because traders keep a lookout for those numbers to make buy and sell decisions.
Buyers often make a purchase once the price shows a sign of moving toward a “major round number” and this makes it quite difficult for shares to move down below that level whereas sellers start selling off stock when a round number peak is approached and it makes it more difficult to go aside the upper level. This is what makes them important as well as psychological points of support and resistance, and here “this” refers to increased buying and selling pressures.
When a trendline is broken, it doesn’t stop in being important areas of support or resistance instead it faces only a reversal of its role. The trendline represents a support level moving ahead when there is a price breakout from a trendline. The only issue that concerns is that there should be a true reversal and not a fake breakdown or breakout and it really means that important price spikes and volume accompanies.
Support and resistance are important parts in matters of trend analysis as it plays a very crucial part in helping to make critical trading decisions and understand the point of reversal of a trade. Not always does a break hint reversal.
Volume refers to the number of shares or contracts that are involved in trade given a period of time which is normally a day. Volume is important because it helps in the confirmation of trends and patterns of charts. Whether a stock is gaining momentum or losing it is determined by the trends in the volume with time.
“Head and shoulders”,” triangles”, “flags” and other patterns are the chart patterns which render volume not so valuable during their confirmation.
Volume precedes price and analysts keep a lookout over volume to understand when reversals might occur.
Given a series of prices over a period of time, charts would bring about simple graphical representations of those prices.
Time scale, price scale and price point are the different proportions that are used while creating a chart.
The ranges of dates that are provided at the end of the chart represent the time scale and the variation could be from “seconds to decades”. Intraday, daily, weekly, monthly, quarterly and yearly frequently used time scales. Day traders use short “timeframe” charts for seeking more details but this has more “noise” and trends are hard to identify. Exclusively used are intraday charts that help in plotting movements of price during the course of single day and seconds or minutes show minute details.
Daily charts have the price points denoting one single day. Points in line charts denote closing price of the day. Points in a candlestick chart denote “open, high, low and close for the day”. The one that occurs on the right side and showing the price ranges of the stock is nothing but the price scale. Linear or arithmetic and logarithmic are the two types of price scales.
Line charts, Bar charts, Candlestick charts, and Point and Figure charts are the different charts that are important for technical analysis.
Reversals and continuations are the two different types of chart patterns. Chart patterns help to identify the trading signals by looking at the entire picture. The chart pattern that tells about the possible reversal of trend on completion is the Head and Shoulders. Upward trend pauses and continues once the pattern gets confirmed is what a Cup and Handle pattern is. Double Tops and Buttons are another kind of pattern. Under Triangles pattern, symmetrical, ascending and descending triangles are different patterns. Flags & Pennants, Wedges, Gaps , Triple Tops & Bottoms and Rounding Bottom are other types of pattern.
Chart patterns are not always a feasible solution. Moving averages come into play to sort the problems and identify trends.
Simple Moving Averages (SMA), Exponential Moving Averages (EMA), and Linear Weighted Moving Averages are the different types of moving averages.
Moving averages can be used in different ways like Price cross over and MA crossover.
Indicators denote a statistical-based approach for technical analysis.
Leading indicators and Lagging indicators are the two types of indicators. Trying to predict the future by preceding movements of price is the task of leading indicators. Used as confirmation tool lagging indicators follow movements of price. They prove to be very useful during the trending periods.
Based on their built-up indicators are further categorized into oscillator and non-bounded.
Crossovers or divergence help indicators generate buy and sell signals.
Accumulation/Distribution Line is a volume indicator that helps in the measurement of money flow in a security.
A trend indicator that helps in the measurement of the strength of the current is the average directional indicator (ADX).
Trending of a security, whether higher or lower, as well as the magnitude of that trend is measured by the Aroon indicator.
The Aroon oscillator works upon the Aroon indicator. They help to provide useful information regarding trends.
The Moving Average Convergence/Divergence (MACD) is very useful and very powerful technical analysis indicator. It helps to signal the current direction of momentum instead of price by comparing short-term and long-term momentum.
Used for the identification overbought and oversold conditions with respect to a security having a range between 0 (oversold) and 100 (overbought), relative strength index (RSI) is another momentum indicator.
A simple volume-based indicator used for the understanding of changes in volume over a given period of time is the On-Balance Volume (OBV) indicator.
During upswings prices should be moving towards the highs trading range and the reverse during downswings–this is the basis upon which works the momentum indicator, the stochastic oscillator.
The ultimate aim of technical analysis thus, is to penetrate into the market sentiment and understand the direction of the price.