Investors can use Technical Analysis to aid with research and find trading opportunities. Here, we explore price action, charting and technical indicators.
What you'll learn:
- What is Technical Analysis?
- Why is Technical Analysis useful?
- Different methods of Technical Analysis
- What are some useful Technical Indicators?
- Technical analysis (TA) assumes the market is efficient and pertinent information is reflected in the price action. It focuses more on what the stock price is doing, rather than reasons behind it (e.g. FA, news flow)
- Long term investors can use TA to verify fundamental analysis (FA) findings; Short term traders can use TA to find trading opportunities when there are dislocations in the price action
- There are 3 main TA methods to work with: (1) Price Action (2) Charting (3) Technical Indicators analysis.
- TA is subjective and investors should adopt a flexible approach suited for their investment style and time horizon.
What is Technical Analysis?
Technical Analysis (TA) refers to the study of historic price action and data to aid in the analysis of stock’s performance.
It assumes the market is efficient and all pertinent information is in the stock’s price.
The goal of the TA is to examine critical areas of a stock’s demand vs supply, and forecast possible action, based on historical patterns.
This streamlines decision making and helps in timing the entry/exits.
Why is Technical Analysis useful?
TA can be useful for Investors and traders of different investment horizons and time frames.
Long term investors can use TA to verify fundamental analysis (FA) conclusions.
For example, a positive FA analysis should lead to a positive TA trend.
It can also be used to time the entry to an undervalued stock when intrinsic value and market price fluctuates due to weak market sentiment.
Short term investors can deploy various TA indicators to identify specific entry and exit points, as well as use price chart patterns to exploit short term market dislocations.
Different methods of Technical Analysis
Investors may deploy one segment or all of the following methods in their analysis. It is important to understand the assumptions and purpose of each method.
1. Price action: Manual inspection focusing on the stocks’ price action and volume movement to identify key areas of supply and demand. Investors can use different timeframes to interpret the price and volume interaction. For example, charts of monthly, weekly or daily timeframes can be used.
The chart below shows areas where there is increased volume when prices made a big move both on the way up and down. Areas with high volume are interesting as they can act as support or resistance levels.
Source: StockCharts, Candle Volume
2. Charting: Manual drawings can be used to identify key areas of support/resistance lines, trendlines, price channels. Investors can try to identify the trend (trendline) and areas of price congestion (support/resistance). Charting is subjective and there is no universal “correct” way to interpret the chart. It is also important to keep the chart simple.
The chart below shows how a key support level became a resistance level once broken. The significance is further corroborated with increased volume at that level (24)
Source: StockCharts, TA 101
3. Technical indicators: Mathematically derived technical indicators (based on price, volume) give rise to signals on price action. Technical indicators can help to flag subtle changes in the price action that a human eye cannot easily observe. There are 4 main types of indicators, which we will discuss further below
What are some useful technical indicators?
1. Trend (oscillators): Determines if there is a trend in the particular direction. These indicators tend to oscillate between high and lows and hence are also known as oscillators (e.g. ADX, Moving Averages, MACD).
ADX: Average directional Index – used to determine when the price is trending strongly (reference)
Moving average: arithmetic mean of a given set of values over a specific number of days (reference)
MACD: Moving average convergence divergence – trending following indicator that shows the relationship between 2 moving averages. (reference)
The chart below shows an uptrend in moving averages (Simple Moving Average – SMA, Exponential Moving Average – EMA). In TA, the trend is your friend and traders would trade in the direction of the trend.
Source: StockCharts, Moving Averages
2. Momentum: Tells us the strength (or weakness) of a stock price. For stocks moving along a trend, momentum indicators can tell us how strong the trend is. (e.g., RSI, CCI, Stochastics).
RSI: Relative Signal Index – momentum indicator that measures the magnitude of recent price changes to evaluate overbought/oversold conditions (reference)
CCI: Commodity Channel Index – momentum based indicator used to determine when a stock Is reaching overbought/oversold conditions(reference)
Stochastics: Stochastics Oscillator – momentum indicator that generates overbought and oversold trading signals, using 0-100 bounded range (reference)
The chart below shows RSI > 80 indicating overbought conditions while RSI < 20 signals oversold conditions. The RSI can be used as a confirmation to the price rebound(green arrow) when RSI moves > 20, and as confirmation for price correction (red arrow) when RSI moves < 80
Source: StockCharts, Stochastic Oscillator
3. Volume: Shows the stock’s demand and supply at different price levels. Areas with high volume are of specific interest as these are major price points, which can act as confirmation of stock price action or potential inflexion points. (e.g. On Balance Volume, Volume ROC).
OBV: On Balance Volume – momentum indicator that uses volume flow to predict changes in stock price (reference)
ROC: Rate of Change – momentum indicator that measures the percentage change between the current price and the price a certain number of periods ago (reference)
The chart below shows rising OBV indicating buying interest amid sideways price action, signalling accumulation interest
Source: StockCharts, On Balance Volume
4. Volatility: Measures how far the stock movement is away from its mean, high, low-price levels. These help to provide visual inspection on the dispersion away from the norm. (e.g., ATR, Bollinger Bands)
ATR: Average True Range – measures market volatility by decomposing the entire range of the stock for that period (reference)
Bollinger Bands: a set of trendlines plotted 2 standard deviations away from a simple average of a stock (reference)
The chart below shows a surge in ATR as the stock price printed recent low
Source: StockCharts, Average True Range
Take the next step
- Remember, TA is subjective and there is no right or wrong. In deciding on an investment strategy, investors can consider a mix of both TA and FA based on their investment style and time horizon.
- Platforms such as Stockcharts, Investopedia, Investing.com and Tradingview offer useful blogs and learning points on TA.
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