If you are in the equity market and want to create wealth for yourself in the stock market, then you must be aware of how important it is to choose the right stock. And to choose the right stock, you must know how to analyze the company issuing the stock. There are mainly two types of analysis for stocks that are widely popular among investors those are Fundamental Analysis and Technical Analysis of stocks.
Various types of tools are used in the technical analysis of stocks by a trader like Japanese candlesticks, technical indicators, etc. It requires knowledge of how to read these indicators for trading. Does it sound a bit technical to you? Don’t be afraid of this, because once you have gone through the series of blogs over complete technical analysis, it will be easy for you to understand things better and make a wise trading decision. In this article, we will restrict our discussion to the Technical analysis of stocks and their related usage for a trader.
Table of Contents
What is the Technical Analysis of Stocks?
Technical analysis of the stocks is used to analyze the price of the stock and also to forecast what the future behavior is going to be. It uses previous data like price, volume, and trend to predict the future stock price. Nowadays the stock market is highly volatile, so it is very risky to predict the price in a short time.
Technical analysis is the understanding of the various chart patterns and selecting the right stocks by studying these patterns accurately. But studying the chart pattern and selecting the right stocks seems a bit confusing. But if you observe the price of the stock for a period, you will find that it is following a trend. The price of the share keeps on changing day by day which includes price movement in both positive and negative directions. Besides following a trend, a formation of patterns also happens in the price. So, the Technical Analysis of stocks is nothing but just studying those patterns and charts with the help of various indicators to take the right trade.
Importance of Technical Analysis in the Stock Market:
Since the technical analysis of stocks helps us to study the chart patterns associated with the price of the stocks, it can help a trader to take important decisions like:
The price of a share at which we should buy or sell it?
How much risk is associated with that trading?
How much profit we can book with that trading
What should be the holding period for shares?
Layman’s way to understand Technical Analysis
Technical analysis is just like we have to have dinner and selecting the best food from the menu for our dinner. Suppose we are on a trip to a Beautiful Hill station in Manali and you have to eat dinner. This hill station has the main market and you will find that there are many restaurants in front of you. You will be having two options with you:
Either you approach every single Restaurant and check its ingredients and taste a bit, then decide the place to eat—it is like the fundamental analysis. Here you have to do research by yourself. Or, you just stand in the middle of the market and watch carefully which restaurant is attracting the maximum crowd. One or two Restaurants will have more crowd because either the restaurant has good taste or low prices. So you can go to that restaurant and taste it, it is like a technical analysis of stocks.
Assumptions behind Technical Analysis:
Before we learn how to do a technical analysis of stocks, let us understand some of their broad features, based on which the concept of technical analysis is formulated.
History Repeats Itself
This is the very first concept behind the formulation of technical analysis and here it is believed that the History of the price repeats itself. It is because in every instance most of the traders take somewhat similar decisions. For example, when the market falls, everyone tries to sell off their trade, and demand for the stock increases when the market regains.
Stock Price follows a trend
It is believed that every stock price follows a trend and the price moves along with this trend only. So, every price movement will give an indication of the next price movement, and being a trader, you must know how to identify these trends.
What is more important than why
Here, the current market price of the share is important and the reason behind its move is not important. Whatever may be the reason behind the price changes followed in the market; technical analysts don’t give weightage to the reason behind this change and will only look at the current price range.
The price of a share tells everything
It means everything related to the share is included in the price of the share. Because as a trader, you believe that everybody else knows the information about the stock you know and so all will take the decision in a somewhat similar fashion. For example, if an insider person knows that the company will have good quarterly results and so the price of a share can go high, he will purchase shares from the open market. But the effect of this purchasing will be seen in the share price as how much trading is happening in the share is also an important part of T.A which will disclose everything to the T.A experts.
Tools used in Technical Analysis of Stocks
Based on these five assumptions, there are some tools that are used in the technical analysis of the stocks. These are:
Charts
Charts play an important role in analyzing the stock technically and Price and volume chart is the most typical tool used as technical indicators. The volume of the chart denotes the number of shares traded i.e. including both bought and sold in a particular trading session. That trading session can be of minutes to hours or of weeks. The chart can be a typical line or bar chart or a Japanese candlestick which is an advanced version of it.
Nowadays the Japanese candlestick chart is mostly used by traders because of its simplicity and the information it contains. We will discuss candlestick patterns or charts in detail in the upcoming section on the technical analysis of stocks. There are mainly three types of charts used in the technical analysis of stock:
Line Chart
Bar Chart
Japanese candlestick chart
Trend lines
Trend lines are just simple lines that are formed by connecting various points on these charts by the trader for analyzing the stock. Charts are not used alone but are used together with the trend lines to enhance the effectiveness and accuracy of the trade by the traders. The trend line is used to indicate the direction of the stock’s price movement. The trend line is important for both trade identification and confirmation.
The trend line will have two indications, first in an upward direction which is known as an uptrend. That means the movement of the value of a stock is following an uptrend i.e. price will further go high. Second, is in a downward direction which is known as a downtrend which means the price will further go down or low.
Momentum Indicators
Momentum indicators indicate the momentum of the stock price movement. These are statistical figures that are calculated based on the price and volume data of stocks. Momentum indicator as a supporting tool with the Charts and moving averages gives you a complete pen picture of any stock.
Some momentum indicators indicate to you in advance the change in price movement that is going to occur and which is expected by the trading experts. Such indicators telling the information in advance are called leading indicators. While there are some indicators, which indicate the predicted change in price movement at a later stage when the stock starts moving in that direction. Such indicators indicating to the trader at later stages are called lagging indicators.
Momentum Indicators are normally used with the moving average indicators to confirm the movement of price for a stock. When a stock price starts rising within a moving average, that means it is somewhat confirmed that it will continue to move as predicted. Popular momentum indicators include
Moving Average Convergence Divergence (MACD), and
Relative Strength Index (RSI)
We will discuss some of the important momentum indicators in our subsequent articles.
Moving Average
Every time it is not so easy to identify the trend in the market for a stock price. Sometimes the price of a stock can vary abruptly in a short span of time with fluctuations. In this scenario of heavy fluctuations, it becomes very difficult to identify the accurate trend of the stock price in which direction the price is going. Moving Averages are another tool used in technical analysis by traders and they can be helpful in such times when fluctuation is high in the stock price.
There are different types of moving averages like Simple Moving Average (SMA), Exponential Moving Average (EMA) linear weighted average (LWA) which a trader uses in their trading.
Moving averages help to identify the trend by removing sharp, sudden fluctuations in a stock chart. These sudden and abrupt movements in the stock price make it hard to identify a trend. So this tool calculates an average price for some days and compares it with averages of some past days so as to help a trader discover a broad trend in the market. This type of moving average is called a simple moving average (SMA).
But it must be kept in mind while calculating moving averages that moving averages are calculated for longer durations and not for a short duration of timeframe. Usually moving averages are calculated for more than five days Ten days and one-month timeframes are more common.
Salient features of Technical Analysis
Technical Analysis of stocks is gaining popularity in recent times with the advancement of processes and usage of digital technology. But this analysis part of stocks has its own pros and cons which we as a trader must be aware of prior to using it in our trading.
Only for the short term
Technical analysis is for short-duration trade only and it is used to identify the quick trades and it must not be used for long-term investment. For long-term investment, fundamental analysis is there to screen out the best stocks which can perform great in long run. But yes, technical analysis can indicate the best entry and exit time for long-term investment in any trade.
Return per Trade
Since technical analysis is done for shorter trades by the traders, it is associated with smaller profits and not a large profit as it happens with long-term investment. So, here a small but more number of returns is earned by the trader from the stock price movements. To be a wise investor, you must book these smaller profits and invest them for long-term investment when stock gets available at a discounted price.
Volatile hence Risky
Since the stock market is highly volatile, identifying good trade is not so easy. Here, using technical analysis, if you can book profits then you can lose a big amount as well. A highly volatile market throws a risky environment for a trader as well. So to turn the stock market in your favor in shorter trades, you must have proper understanding and enough patience.
The holding period must be small
In the technical analysis, traders try to book smaller profits so the holding period must be small i.e. between 1+ days to a few weeks only.
Bottom Lines
Technical Analysis of Stocks are used for short-term trading or to locate the best entry and exit price points in long-term investments. But it needs careful observation and detailed knowledge of technical indicators associated with trading. You must keep checking the official website of the National Stock Exchange for any stock-related information to improve accuracy. You should be disciplined enough to maximize your profits by managing your losses and keeping the Risk Reward Ratio in mind. It will help you in taking the right entry and exit in a timely manner, making your trading experience good.