Technical Analysis
Master the art of reading charts and predicting market movements
Start LearningIntroduction to Technical Analysis
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume.
Technical analysts believe that the historical performance of stocks and markets are indications of future performance. In this comprehensive guide, we’ll explore the key concepts, tools, and strategies used in technical analysis.
Key Points of Technical Analysis
- Technical analysis is based on the belief that market prices reflect all available information
- Prices move in trends
- History tends to repeat itself in terms of price movements
- It can be applied to stocks, indices, commodities, futures or any tradable instrument
- It is used to forecast the direction of prices through the study of past market data, primarily price and volume
Chart Patterns
Chart patterns are distinctive formations on a stock chart that create a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals.
Head and Shoulders Pattern
The Head and Shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. It’s a bearish reversal pattern that signals a trend change from bullish to bearish. The pattern consists of three peaks, with the middle peak (head) being the highest and the two surrounding peaks (shoulders) being lower and roughly equal in height.
Double Top Pattern
The Double Top is another bearish reversal pattern that occurs after an uptrend. It’s characterized by two consecutive peaks at approximately the same price level. The pattern is confirmed when the price falls below the support level (also known as the neckline) that’s formed by the two peaks.
Technical Indicators
Technical indicators are mathematical calculations based on a security’s price, volume, or open interest. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation.
Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. The result of that calculation is the MACD line. A nine-day EMA of the MACD called the “signal line,” is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers.
Candlestick Patterns
Candlestick patterns are a form of technical analysis and charting used in trading. They visually represent the size of price moves with different colors. Traders use the candlesticks to make trading decisions based on regularly occurring patterns that help forecast the short-term direction of the price.
Doji Candlestick
A Doji candlestick forms when a security’s open and close are virtually equal. The length of the upper and lower shadows can vary, and the resulting candlestick looks like a cross, inverted cross, or plus sign. Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level.
Hammer and Hanging Man
The Hammer and Hanging Man are similar in that they have the same candlestick shape, but form under different circumstances. The Hammer forms after a price decline and signals a potential bullish reversal, while the Hanging Man forms after a price advance and signals a potential bearish reversal. Both are characterized by a small real body (the difference between open and close) and a long lower shadow.
Volume Analysis
Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume.
Volume Confirms Trend
When analyzing volume, there are several guidelines we can use:
- A rising market should see rising volume
- A falling market should see rising volume
- In an uptrend, volume should be higher on up days
- In a downtrend, volume should be higher on down days
- A breakout should be accompanied by a significant increase in volume
Trend Analysis
One of the most important concepts in technical analysis is the trend. The market trend is the overall direction of a market or asset price. Trends can be long term, short term, or intermediate. It is important to understand trends so you can trade with rather than against them.
Trend Lines and Channels
Trend lines are simple yet highly effective tools that aid in determining and following trends. An uptrend line is drawn along the lows of an upward-sloping trend, while a downtrend line is drawn along the highs of a downward-sloping trend. Channels are formed when parallel trend lines can be drawn above and below a price trend.
Support and Resistance
Support and resistance are concepts in technical analysis that suggest the movement of asset prices will tend to stop and reverse at certain predetermined price levels. These levels are denoted by multiple touches of price without a breakthrough of the level.
Support and Resistance Levels
Support occurs where a downtrend is expected to pause due to a concentration of demand. Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply. Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
Conclusion
Technical analysis is a powerful tool for traders and investors to understand market trends, predict future price movements, and make informed trading decisions. By mastering chart patterns, technical indicators, candlestick analysis, volume analysis, trend analysis, and support and resistance concepts, you’ll be well-equipped to navigate the complex world of financial markets.
Remember, while technical analysis can provide valuable insights, it’s important to use it in conjunction with other forms of analysis and risk management strategies for the best results. Continue to practice and refine your skills, and always stay informed about the latest developments in technical analysis techniques.
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