Understanding the Basics of Technical Analysis in Stock Trading
Technical analysis is one of the primary methods used for analysing securities and making investment decisions. It may appear complicated on the surface, but it boils down to an analysis of supply and demand in the market to determine where the price trend is headed. In other words, this analysis attempts to understand the market sentiment behind price trends rather than analyzing a security’s fundamental attributes.
Many day traders utilize strategies rooted in technical analysis to help ease the decision making process. This seemingly complex form of market analysis can be intimidating to some, however understanding a few basic principles will help us filter out the noise and develop an application strategy.
Many new traders are more familiar with the fundamental side of stock market, where one analyses the underlying company of a stock to see how profitable they are, what their future potential is, etc. While the information is great for investors, it provides less value to traders who are more focused on short term price action. While there are an endless amount of complex strategies, technical analysis is built on very basic principles.
There are few key things that one needs to know:
- Technical analysts only care about price action. A company’s news events, earnings potential and other fundamentals does not matter. One can assume that all these things are already factored into the stock price.
- Technical analysts examine historical price action to predict future price action.
- Stock charts are main source of data for technical analysts.
Technical analysis is both a science and an art. Day traders analyse historical data, formulate hypotheses and pivot accordingly. In this aspect, it is very scientific. That said, if ten different traders analyse the same stock market, they might all come back with different hypothesis. The art is in the analysis because of which the effectiveness of technical analysis is relative to the skill of the person using it.
There are a few important things to be kept in mind about technical analysis:
- It is not about making a decision with 100% certainty.
- It can be used to account for situations where the analyst is either right or wrong.
The fact remains that no one can predict the stock market with 100% accuracy because it is influenced by human behaviour. They can, however, analyse trends and mitigate risks accordingly. This is no different than any other predictive model.
Technical analysis is a decision making tool used for assisting the traders in making the decisions and not to give them definitive answers. That said this tool can be very effective when applied properly.
There are plenty of advanced strategies in technical analysis, however following are the basic skills that any technical analyst should have:
UNDERSTANDING STOCK’S TREND
A stock’s trend is simply the direction in which the stock’s price is moving. A stock can be in uptrend, downtrend or the period of indecision. Uptrends are characterised by higher highs and higher lows, while downtrends are characterised by lower highs and lower lows. It should also be noted that stocks can have different trends for different timelines. For example, a stock may be experiencing downtrend for the day even though it has been uptrending all year.
If one is focused on intra-day trades, he may not care about what a stock’s daily trend otherwise if the focus is on longer term trades, he may not care about stock’s intra-day trend.
BE ABLE TO PINPOINT SUPPORT/RESISTANCE ON MULTIPLE TIME FRAMES
- Support levels: They are the price levels where buyers overpower sellers. These are thought to be areas where the price will not drop any further.
- Resistance levels: They are the price levels where sellers overpower buyers. These are thought to be levels where a stock cannot increase any further.
These levels can be created in a variety of ways including—
- Static price levels
- Trend lines
- Technical indicators
UNDERSTANDING STOCK’s RANGE
A simple look at stock chart will give a better understanding of stock’s general price range. Day traders look to taking advantage of volatility and significant price fluctuation. A stock with $0.1 intra-day price range provides very little opportunity to most traders.
USE VOLUME AS CONFIRMATION
Technical analysis involves examination of both price and volume. Whereas price can give us an idea of how much people are willing to pay for a stock, volume can be used to measure the significance of price movement.
Use Volume as a confirmation of significance of price action as it means conviction. The higher the volume, the more significant the move is.
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