What is the importance of technical analysis while picking stocks? We must first understand what technical analysis really is in order to answer this query.
Table of Content:-
- What is Technical Analysis?
- Why does Technical Analysis work?
- How to Perform Technical Analysis?
- Thumb Rules for Technical Analysis
- Wrong Practices while Performing Technical Analysis
- Fundamental Analysis vs Technical Analysis
- Limitations of Technical Analysis
What is Technical Analysis?
Technical analysis is the study of historic price movements with the help of chart patterns and various technical tools and indicators in order to make predictions of how a stock may perform in the future. In order to make good trading decisions and inevitably make money in the market, you must have the ability to perform technical analysis and understand the importance of technical analysis.
Most people who are struggling to create profits or are losing money in the market fail to perform or comprehend the importance of technical analysis and fundamental analysis, and blame the stock market for being too volatile. The capability to perform technical analysis along with fundamental analysis will help you do great in the market by picking the best stocks.
Technical analysis can be done for stocks, cryptos, forex, and other securities.
Why does Technical Analysis work?
In order to understand the importance of techncial analysis, you must appreciate the fact that technical analysis is mainly based on price movements, and that the price movements are not random. Price always tends to move in a pattern and history keeps repeating itself which is why technical analysis works.
Technical analysis works with the right strategy, since there are uncountable strategies and indicators available, mastering one good strategy and using the right combination of tools and indicators will help you do great in the market.
How to Perform Technical Analysis?
Technical analysis is the combination of a variety of strategies put together to interpret the price movements of a stock. Technical analysis helps to predict the future market behaviour by analyzing the past performances and historic chart patterns of a stock using various tools and indicators.
Let’s look at the basics of technical analysis and how to benefit from it.
1. Chart Analysis
The foundation of technical analysis in every market are the candlestick charts which are formed by red and green coloured candles also called the bearish and the bullish candles representing the highs and lows at different times in the market. A candlestick chart is nothing but a visual representation of price trends. A single candlestick is basically made of two parts:-
• The Body
The body of a candlestick represents the time frame during which the price went up or down. For example, a candlestick with a green coloured body, also called the bullish candle represents the time frame during which the price went up or closed above where it opened while a candle with a red coloured body, also called the bearish candle represents the time frame during which the price went lower or closed below where it opened.
• The Wick
The wick of a candlestick represents the highest high or lowest low during that particular time frame. For example, the tip of the wick present at the top of the body of a candlestick also called the upper shadow represents the highest high of that particular time period whereas the tip of the wick present at the bottom of the body of a candlestick, also called the lower shadow represents the lowest low of that time period.
The shape of these candles is important in specifying the buying and selling of the stocks. Here are some important candlestick patterns.
– Shooting Star
A shooting star is a bearish candlestick that is interpreted as a type of reversal pattern that could possibly indicate a fall in price and appears during an uptrend. It has a long upper shadow which is almost double the size of the body and little or no lower shadow. It is formed when the stock opens, advances significantly, then closes near the day open.
– Three White Soldiers
Three White Soldiers is a candlestick pattern that represents a strong reversal in price from a bearish to a bullish trend. The pattern consists of three green candles arranged consecutively in an uptrend. It occurs at the bottom of a downtrend.
– Three Black Crows
Three Black Crows is a candlestick pattern that represents a strong reversal in price from uptrend to downtrend. The pattern consists of three red candles arranged consecutively like a staircase in a downtrend. Each candle has a long body with short or non-existent shadows.
A Hammer is a bullish candlestick pattern that appears at the bottom of a downtrend after a price drop. It resembles a hammer as it has a long lower shadow with a short body at its top with little or no upper shadow. It could possibly indicate a trend reversal that is from downtrend to uptrend but this may not be necessarily true.
– Bullish Separating Line
A Bullish Separating line is a candlestick pattern formed by two candles where the first candle is bearish and the second candle is bullish in a continuation pattern. The two candles are separating in opposite directions as the opening of the bearish candle is equal to the opening of the bullish candle. It appears in an uptrend and indicates the continuation of price in an uptrend following a small pullback.
– Bearish Separating Line
Bearish Separating Line is a bearish candlestick pattern formed by two candles in a continuation pattern. It appears in a downtrend where the first candle is a bullish candle followed by a bearish candle one gap down. It signals the movement of price in the downward direction.
– Tweezer Top
Tweezer Top is a bearish trend reversal candlestick pattern where two candlesticks, with the first one being a bullish candle and second one being a bearish candle appear back to back at the end of an uptrend with almost similar highs following an advance. A bullish candlestick formed on the first day looks like a continuation of the ongoing uptrend but the high of a bearish candlestick that appears on the next day indicates a resistance level which leads to a trend reversal.
– Tweezer Bottom
Tweezer Bottom is a bullish trend reversal candlestick pattern where two candlesticks, with the first one being a bearish candle and second one being a bullish candle appear back to back at the end of a downtrend with almost similar lows. A Bearish candlestick formed on the first day indicates the continuation of the ongoing downtrend but the low of a bullish candlestick that appears on the second day indicates a support level which leads to a trend reversal.
– Bullish Engulfing
Bullish Engulfing is a bullish reversal candlestick pattern that appears at the bottom of a downtrend and indicates a possible buying opportunity. It is formed when the body of a small red candlestick appearing on the first day is overlapped by a long green candlestick that appears on the next day.
– Bullish Harami
Bullish Harami is a candlestick pattern that indicates trend reversal in a bear price movement. It consists of two candlesticks where the red candle that appears first indicates an ongoing downtrend, and the green candle that appears on the next day represents a slight uptrend which marks the reversal in the price trend.
– Dragonfly Dogi
Dragonfly Dogi is a type of candlestick pattern that indicates the reversal of price moments from bearish to bullish or bullish to bearish depending on the historic price trend. It resembles the shape of ‘T’ as it has a very short body and a long lower shadow as the prices during open, high and close are equal or very close to each other.
– Morning Star
The Morning Star is a bullish, three-candlestick pattern. It indicates a reversal in the price patterns and appears at the end of a downtrend and marks the beginning of an uptrend. The first candle is a long bearish candle which is followed by a short candle which may be bearish or bullish and a third long bullish candle.
A large number of these candles are put together to interpret what the stock is likely to do next by identifying the trends and areas of value along with entry patterns to add accuracy to the trade. These candles when put together form a candlestick chart forming a variety of patterns that help in predicting the future price movement.
We recommend using tradingview.com for analyzing charts and candlestick patterns.
Here are some of the important chart patterns generally noticed while analyzing the candlestick charts.
– Bullish Rectangle
A Bullish Rectangle is a continuation pattern that occurs during an uptrend when a price is temporarily paused. The price, after bouncing temporarily between two parallel levels, breaks the resistance line to move into an uptrend. It often signifies a buying opportunity.
– Bearish Rectangle
A Bearish Rectangle is a continuation pattern formed when the price consolidates for a while during a downtrend. The price here, after bouncing between two parallel levels, breaks the support line to move into a downtrend. It often signifies a possible selling opportunity.
– Bullish Pennant
A Bullish Pennant is a continuation pattern that resembles a triangular flag and has two converging trend lines. As the price moves sideways, it marks a temporary pause in the movement of price halfway during a strong uptrend. It occurs just after a sharp rise in price, gradually making lower highs and higher lows and then breaks the resistance line to continue further in an uptrend. It may signify a possible buying opportunity.
– Bearish Pennant
A Bearing Pennant is a continuation pattern that also resembles a triangular flag, with two converging trend lines. As the price moves sideways, it marks a temporary pause in the movement of price halfway during a downtrend. It occurs just after a sharp fall in price, gradually making lower highs and higher lows and then breaks the support line to continue further in a downtrend. It gives you a chance to make a short trade by indicating possible selling opportunities.
– Bullish Triangle
A Bullish Triangle is a bullish continuation chart pattern formed by two converging trend lines with the above resistance line being flat while the bottom support line slopes upwards. Bullish Triangle is also used by traders to spot reversals in the price trend. It is formed as a result of bouncing of price back and forth several times until the price breaks the resistance level above and continues in an uptrend.
– Bearish Triangle
A Bearish Triangle is a continuation chart pattern formed by two converging trend lines with the bottom support line being flat while the above resistance line slopes downwards. It is also used to spot trend reversals. It is formed when the price bounces several times until it breaks the support line below and continues in a downtrend.
– Rising Wedge
Rising wedge is a continuation chart pattern usually observed in bear markets indicating a possible reversal in the price trend. It begins at the bottom of a downtrend and slopes upward so the price of that particular stock begins to rise over time. At this point, the wedge is typically wider and contracts to get narrower as it progresses into an uptrend.
– Falling Wedge
Falling Wedge is a continuation chart pattern usually observed in bull markets indicating a possible reversal in the price trend. It begins at the top of an uptrend and slopes downward so the price of that particular stock begins to drop over time. At the top of an uptrend, the wedge is typically wider and contracts to get narrower as it progresses into a downtrend.
– Double Bottom
Double Bottom is a bullish reversal chart pattern that indicates momentum and any change in price trend. It is observed at the bottom of a downtrend and resembles the letter ‘W’. The price drops to a new low, bounces back slightly higher and then returns to a new low. The price then rises sharply, indicating a bullish reversal.
– Double Top
Double Top is a bearish reversal chart pattern that is formed from two consecutive rounding tops after an uptrend and resembles the letter ‘M’. It often leads to a bearish reversal after an asset rises to its new high, bounces back slightly lower and then returns to a new high. The price then declines sharply from this point indicating a bearish reversal.
– Bullish Flag
Bullish Flag is a continuation chart pattern in technical analysis that occurs during a strong uptrend creating a brief pause after which it continues into an uptrend once again. It is called the bullish flag as it resembles a flag on a pole. An initial rise in price is observed, after which a slight decline occurs through the consolidation area. The price then breaks through the resistance level into an uptrend.
– Bearish Flag
Bearing Flag is a continuation chart pattern in technical analysis that occurs during a downtrend after a brief pause in its downward March after which it continues into a downtrend once again. It is called a bear Flag as it resembles an inverted pole on a flag. The price action declines during the initial trend move and then rises through the consolidation area after which it breaks out through the support level to continue into a downtrend.
Trading Indicators are formulas added to the current and historic price data to form a mathematical equation in order to plot lines and histograms on your chart. The purpose of these indicators is to simplify what the stock is doing as a candlestick chart may be very confusing at times, these indicators are simply meant to clear up that noise.
Indicators play a salient role in trading strategy as it provides clarity and helps us identify the trends and areas of value, find the entry points and even determine where to place our stop loss and targets.
These indicators help us maintain consistency during different market conditions. Here are some important indicators.
– Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence is a type of indicator that is used in technical analysis to analyze the changes in strength, momentum, direction and duration of the stock’s price movement to derive the relationship between two moving averages. The distance between MACD and its signal line is represented as a histogram which is used to identify if the stock is bearish or bullish.
– Moving Averages
Moving Average is a tool in technical analysis that calculates the averages of the closing prices within a particular time frame to analyze data points in order to identify a trading opportunity. It is used to clear out the ‘noise’ on a price chart due to random fluctuation in price during short-term periods. Moving Averages acts as Support and Resistance for the ongoing price trends.
– Bollinger Bands
Bollinger Bands is an indicator in technical analysis used in conjugation with moving averages in pairs with upper and lower bands to analyze the price volatility. Bollinger Bands are placed above or below the moving average of two standard deviations. The bands widen when the price volatility increases and narrow when the price volatility decreases.
Fractals is an indicator in technical analysis that is used on a candlestick chart to spot reversals points in the price trend. Fractals analyze the daily randomness in the price movement and spot the recurring pattern. It is a five candle reversal pattern that helps the traders to predict the direction in which the price will continue to move. It is best to use fractals in combination with other indicators.
– Stochastic Oscillator
Stochastic Oscillator is an indicator in technical analysis that indicates momentum using support and resistance levels. It attempts to predict any turning points in the price trend by comparing the stock’s closing price to its price range over a certain period of time and reflects the regularity with which the price closes near its recent high or low.
– Average True Range (ATR)
The Average True Range (ATR) indicates the price volatility of the stock based on the 14-day simple average moving of a variety of predefined range indicators. A stock of high ATR has high volatility, and a stock of low ATR has comparatively less volatility. Even if ATR does not show the direction in which the breakout is going to occur, it can be used to measure the strength or weakness of the trend.
Volume is the total number of shares or contracts traded or exchanges for a specific stock in a single transaction during a trading day. It measures the market’s activity and liquidity. In a stock market, a volume indicator is used to confirm trends. The volume indicator is usually displayed at the bottom of a stock chart as a histogram and the bar of this histogram represents the total volume traded during a particular time period.
SAR is a parabolic indicator in technical analysis used to determine the direction of price trend and any potential reversals in the price movement. It is graphically shown as a series of dots placed above and below the price on the chart for a specific stock. Any reversals in the direction of price can be spotted based on the position of the dots.
– Donchian Channels
Donchian Channel is an indicator in technical analysis which measures the volatility of the market price by considering the area between the highest high and lowest low for a chosen ‘n’ period. It consists of three lines formed by the moving averages, the upper and lower bands with a mid-band as an average of the two bands.
3. Support and Resistance
Support and resistance are predetermined levels used in the technical analysis of stocks which help the traders to understand any reversals and breakouts in the movement of price. Support and Resistance help traders determine the direction of the price movement in the market and the timings to enter or exit a trade considering both profit and loss.
Support is a price level that prevents the price from falling further during an expected downtrend. The support level is represented by a horizontal line which is always below the present market price of that particular stock. It plays a significant role in technical analysis as maximum buying demand is expected since price is likely to bounce back from this level.
Resistance is a price level that prevents the price from rising further during an expected uptrend. The resistance level is represented by a horizontal line which is always above the present market price of that particular stock. It also plays a significant role in technical analysis as it acts as a trigger to sell a particular stock.
Thumb Rules for Technical Analysis
• Decide your Trading Style
Before you enter a trade, you need to have a clear view regarding your trading style, whether you want to be a short term, medium-term or long term trader. You must also consider the risk factors involved, including profits and losses.
There are over hundreds of indicators available but you will need only a few indicators that match your trading style.
• Trend is your friend
You must always trade in the direction of the trend, that is buy when the market begins to rise and sell when the market begins to fall. Relying solely on the importance of technical analysis can sometimes lead to you losing money in the market.
• Risk Management
One infamous reason why people lose their money in the market is because they do not manage risks. A smart trader always defines the risk that is affordable before entering a trade. Besides knowing the importance of technical analysis, you must also learn how to manage your funds and manage risk inevitably.
• Never Catch a Falling Knife
Catching a falling knife means to break rule no. 2, which in turn means that you’re trying to go against the ongoing market trend which is not a healthy practice for a good trader. Buying a stock during a strong downtrend expecting a rise in its price after a certain period of time has its own risks involved.
• Using the Stop Loss Order
Stop loss is one of the most important tools in trading. An order for stop loss can be established with a broker to purchase or sell a certain stock as soon as the stock hits a predetermined price. Traders also have the option of setting up a trailing stop loss, a stop loss that moves along with the stock price to lock in your profits and safeguard them.
• Give Important to Price
Price is the most important aspect of technical analysis, therefore a smart trader must not ignore it simply by adding a number of indicators to your chart.
Indicators are only meant to help you understand the price better.
• Do your Homework
Since the market acts differently every minute, you cannot rely on any other trader’s advice. You must do your homework and learn to pick the best stock for yourself as this will help you decide with conviction when to buy and sell stocks at the right time to gain good profits or avoid loss beyond a certain level.
• Master One Strategy
Depending on your trading style, you must master one strategy that will help you make good trading decisions regarding entry and exit from a trade. Remember, “A jack of all trades, master of none” does not work in the stock market.
Wrong Practices while Performing Technical Analysis
• Learning all Tools and Indicators
While studying the importance of technical analysis, many traders waste their time trying to learn all the indicators and tools and tend to ignore the actual price movement. Using too many indicators and tools will only create more confusion and lead to wrong trading decisions by giving contradicting results.
• Giving Less Importance to Price
Price movements are the most important aspect of technical analysis to determine the future of a stock. Relying solely on tools and indicators isn’t a good practice, fundamental analysis (along with other factors) must also be taken into account.
• Hope and Hold
Never try to hold on to a falling stock with the hope and reliability on the importance of technical analysis that it may rise in the future. Go with the trend and know when to buy and sell at the right time. The stock market is all about the right timing and right strategies.
Fundamental Analysis vs Technical Analysis
Fundamental analysis is a strategy of analyzing the economic and financial conditions of a company or a business to measure the intrinsic value of a stock based on the company’s financials, annual reports, balance sheets, cash flow generation, the potential to grow in the future and the overall visibility of earnings.
On the other hand, technical analysis is solely based on the analysis of volume and charts to identify the trends and patterns of price movement in order to predict the future price of a particular stock. Fundamental analysis mainly helps for long term investing while technical analysis can be useful for short term trading to pick good stocks.
A combination of fundamental and technical analysis can be used to further tighten your grasp while cherry-picking stocks.
Limitations of Technical Analysis
Technical analysis may not always work to make a successful trade. Different indicators may give contradicting signals regarding buying and selling of a stock which creates confusion. Since technical analysis is all about probability and prediction, it does not guarantee a successful trade in all cases.
Therefore, understanding the importance of technical analysis alone does not assure your success as a trader but a combination of fundamental and technical analysis is a much smarter way to analyze the market in order to cherry-pick the best stocks.