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Beginners guide to technical analysis
What is technical analysis?
What is technical analysis?
Technical Analysis is the forecasting of future price movements based on past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.
Key Assumptions of Technical Analysis
Technical analysis is applicable to securities where the price is only influenced by the forces of supply and demand. Technical analysis does not work well when other forces can influence the price of the security. In order to be successful, technical analysis makes three key assumptions about the securities that are being analyzed:
No Artificial Price Changes
No Extreme News
The Basis of Technical Analysis
Price Discounts Everything
Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. For example, the trend is up as long as price remains above its upward sloping trend line or a certain moving average. Similarly, the trend is up as long as higher troughs form on each pullback and higher highs form on each advance.
Support: Areas of congestion and previous lows below the current price mark the support levels. A break below support would be considered bearish and detrimental to the overall trend.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish and positive for the overall trend.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks, it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or underperforming (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Strength of the current trend.
Maturity or stage of the current trend.
Reward to risk ratio of a new position.
Potential entry levels for a new long position.
Types of charts
Types of charts
Line charts: A line chart is the figure that, perhaps, automatically comes to mind when you think of a chart. The line chart has the stock price or trading volume information on the vertical or y-axis and the corresponding time period on the horizontal or x-axis). Trading volumes refer to the number of stocks of a company that were bought and sold in the market on a particular day. The closing stock price is commonly used for the construction of a line chart.
Once the two axes have been labelled, preparation of a line chart is a two-step process. In the first step, you take a particular date and plot the closing stock price as on that date on the graph. For this, you’ll put a dot on the chart in such a way that it is above the concerned date and alongside the corresponding stock price.
Let’s suppose that the closing stock price on December 31, 2014 was Rs 120. For plotting it, you’ll put a dot in such a way that it is simultaneously above the marking for that date on the x-axis, and alongside the mark that says Rs 120 on the y-axis. You will do this for all dates. In the second step, you will connect all the dots plotted with a line. That’s it! You have your line chart.
Bar charts: A bar chart is similar to a line chart. However, it is much more informative. Instead of a dot, each marking on a bar chart is in the shape of a vertical line with two horizontal lines protruding out of it, on either side. The top end of each vertical line signifies the highest price the stock traded at during a day while the bottom point signifies the lowest price at which it traded at during a day. The horizontal line to the left signifies the price at which the stock opened the trading day. The one on the right signifies the price at which it closed the trading day. As such, each mark on a bar chart tells you four things. An illustration of the marks used on a bar chart is given below:
A bar chart is more advantageous than a line chart because in addition to prices, it also reflects price volatility. Charts that show what kind of trading happened that day are called Intraday charts. The longer a line is, the higher is the difference between opening and closing prices. This means higher volatility. You should be interested in knowing about volatility because high volatility means high risk. After all, how comfortable would you be about investing in a stock whose price changes frequently and sharply?
Candlestick charts: Candlestick charts give the same information as bar charts. They only offer it in a better way. Like a bar chart is made up of different vertical lines, a candlestick chart is made up of rectangular blocks with lines coming out of it on both sides. The line at the upper end signifies the day’s highest trading price. The line at the lower end signifies the day’s lowest trading price. The day’s trading can be shown in Intraday charts. As for the block itself (called the body), the upper and the lower ends signify the day’s opening and closing price. The one that is higher of the two, is at the top, while the other one is at the bottom of the body.
What makes candlestick charts an improvement over bar charts is that they give information about volatility throughout the period under consideration. Bar charts only display volatility that occurs within each trading day. Candles on a candlestick chart are of two shades-light and dark. On days when the opening price was greater than the closing price, they are of a lighter shade (normally white). On days when the closing price was higher than the opening price, they are of a darker shade (normally black).A single day’s trading is represented by Intraday charts. Higher the variation in colour, more volatile was the price during the period. The appearance of candles on a candlestick chart is as follows:
Point and figure charts: A point and figure chart bears no resemblance with the other three kinds of charts discussed above. It was used extensively before the introduction of computers to stock analysis. These days, however, it is used by a very limited number of people. This is chiefly because it is complex to understand and provides limited information. A point and figure chart essentially displays the volatility in a stock’s price over a chosen period of time. On the vertical axis, it displays the number of times stock prices rose or fell to a particular extent. On the horizontal axis, it marks time intervals. Markings on the chart are exclusively in the form of X’s and O’s. X’s represent the number of times the stock rose by the specified limit, while O’s represent the number of times it fell by it. The specified amount used is called box size. It is directly related to the difference between markings on the y-axis.View Articles