Stock price keeps on fluctuating on a daily basis. someday it moves up, another day it comes down. If you check, it will create a pattern and series on a daily basis. Study of these chart pattern and series of data in terms of price movement of the stock is known as technical analysis. of the stock.
Unlike fundamental analysis technical analysis uses the recent trends of the price movement of the stock. results of the technical analysis are most readily available on the spot. When you are talking about the technical analysis of the stock, it should be purely with the objective of trading. Investing is a different ball game altogether. For technical analysis stock, I personally look into the price movement of the stock. Technical analysis is used by a large number of people who are doing daily(intraday) or swing(short term) trading.
What is technical analysis?
As the word says, it seems to be technical, but its actual meaning is slightly different. It is a method of forecasting a price direction of the stock based on the past data. The idea is to identify the price pattern and stock. Once this pattern is identified, the idea is to determine the future price movement. Technical analysis can be done for stocks, futures and commodities. There can be either uptrend or downtrend. Uptrend means higher highs and lower lows. If the stock is not going any of the sides, it is said that the market is sideways. As I said earlier, it is readily available it is also known as graphical or statistical analysis of the historical data to predict the future price movement.
Let’s understand the main aspect of the technical analysis one by one.
Charts:
Price and volume charts are the most common and widely used tools as a technical indicator for technical analysis. Price on the chart shows the trend of the price of the given time frame, while volume chart indicates the number of shares that are bought and sold in the market for the given time frame. For doing technical analysis, you may choose the line or bar charts. Most commonly used chart type is candlestick chart.
In order to create a candlestick chart, you must have four data points which are open, high, low and close for the time frame you have chosen. the middle thick part is known as the body of the candle. The thin lines above and below the body represent the high and low and are called shadows.
Open = lower left corner of the stick
High = Top of the upper shadow
Low = Bottom of the lower shadow
Close = Upper right corner of the stick
One candlestick is any time frame ranging from 1 minute to one month. You can adjust the time frame in the chart option. Different indicators have a different time frame as per there suitability.
Moving Averages:
Moving averages are used to eliminate the sharp movement of the stock price. Sometimes stock price moves very sharply in any direction. This makes difficult to judge the trend of the price movement. To nullify the impact of such sudden movements, an average of few days are taken for the calculation. Commonly used moving averages are Simple moving average (SMA). SMA can be for 5 days, 30 days, 50 days 100 days, 200 days. Other widely used moving average concept is Exponential moving average(EMA). Moving averages are basically a trend line of past performance which can be used to project the future price movement.
Moving averages are based on the closing price of the day. As the name says “Moving” it means older data points are dropped and new data points are taken into consideration. Below is the example of 5 days moving average for 3 days.
Daily Closing Prices: 11,12,13,14,15,16,17
First day of 5-day SMA: (11 + 12 + 13 + 14 + 15) / 5 = 13
Second day of 5-day SMA: (12 + 13 + 14 + 15 + 16) / 5 = 14
Third day of 5-day SMA: (13 + 14 + 15 + 16 + 17) / 5 = 15
Here you can see the movement of the data points over the period of 3 days. everyday older data is dropped and new data is taken into calculation.
As you can see the moving average is increasing each day, this is because of the older data points are lower than the new data points. Which has a positive correlation with the average.
Support and Resistance
In the financial market prices are driven by supply and demand. As demand increases, price advance and as supply increases, price decline. When supply and demand are equal, price moves sideways.
What is Support?
Support is the price level at which the demand is thought to be strong enough to prevent the price from declining further. At this level, buyers have larger interest and are ready to buy the stock. This helps the price of the stock to prevent from declining further. When the price reaches the support level, demand will overtake supply and prevent the price from falling below the support level. There is no guarantee that the support will not break. Price below support level indicates that there is a selling pressure on the stock and bear has taken over the bull. There could be further fall in the price of the stock.
Support levels are usually below the current price of the stock. Technical analysis doesn’t guarantee you to find an accurate support level. There are examples where the stock is traded at or near the support level.
What is Resistance?
Resistance is the price level at which the supply is thought to be strong enough to prevent the price from rising further. Sellers become more inclined to sell and buyers become more inclined to buy. At this level, it is believed that supply will overcome demand and prevent price rising further.
A break over resistance shows the new willingness to buy the stock at that price. Resistance levels are usually above the current price. Sometimes, Support can turn into resistance and vice versa. Once the price breaks below a support level, the broken support level can turn into resistance. There could be a range of support and resistance. Which is known as support and resistance zone. Instead of exact support or resistance, the zone represents the range of price. Sometimes its good to look at support and resistance range instead of only looking at the absolute support and resistance points.
Momentum Indicators:
Momentum indicators are statistical figures that are calculated based on price and volume data of stocks. They are plotted on the charts to confirm the views. There are two types of indicators. 1) Leading indicator 2) Lagging indicator.
Leading Indicator:
It is a measurement which predicts the economy or market direction in advance. It is worth for an investor to check the major leading indicator because it reveals which aspect of the economy is showing relative strength.
Lagging Indicators:
There is some signal which comes after the stock has started moving in a particular direction, they are called lagging indicators. They confirm that the stock will move in a particular direction.
I will cover the major momentum indicators in a separate upcoming article.
Read it for understanding financial ratios
The Dow Theory
The Dow Theory says the market is in an upward trend if one of its average moving above a previous important high and is followed by similar up move in other averages. The Dow Theory has been around for more than 100 years and it is an integral part of technical analysis. It remains the foundation of the technical analysis.
As per the Dow Theory, the stock market as a whole is a reliable measure of the overall business condition within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of the major trend and individual stocks movement.
Assumptions
Before one can begin t accept Dow Theory, there are numbers of assumptions which needs to be accepted without any reservation.
No one can manipulate the primary trend.
In the stock market, there is a large amount of money is at stake. When such a large amount is at stake the temptation to manipulate is bound to be there. Intraday or secondary movement is prone to manipulation by large institutions. The individual stock can be manipulated. The price of the stock is running up fast and will come down at the same speed to its primary trend. While this manipulation is for the short-term, its primary trend can be revealed in a month’s period. Individual stocks can be manipulated but it is impossible to manipulate the whole market as the market is too big to manipulate.
Market discounts everything
The Dow Theory works on the efficient market hypothesis (EMH). It takes account of all the information available in the market for the particular stock. Future growth, earning potential, company’s management and more are factored in the price of the stock. Even the future trends are also discounted in the price of the stock.
The volume must confirm the trend
The volume if the stock must increase if the price is moving upward, the same way it should decrease if the price goes downwards. Low volume signals the weakness in the trend. If the volume picks up during the pullback, it could be a sign that the trend reversal is happening. Sometime the market would react negatively to the good news. There is a simple reason behind this, the market looks ahead. By the time the news hits the street, it is already reflected in the price.
There are three types of market trends
Market experience the primary trend which is for more than a year or more. It’s called bull or bear market. There are short-term trends within these broader trends, which are known as a secondary trend. They often go against the primary trend, like a pullback within a bull market and rally within a bear market. The secondary trend usually last from three weeks to three months. The third one is the short trend which lasts less than three weeks, usually known as market noise.
Technical analysis vs Fundamental analysis
Fundamental analysis is the study of a security by measuring the intrinsic value of the stock. It takes into account the overall economy and industry condition, financial health, management’s competency, competitive edge, earnings, expenses, assets, and liabilities.
Technical analysis is different from the fundamental analysis and considers only price and volume as the only inputs. The philosophy behind the technical analysis is that all the fundamental aspects are factored into the price, so there is no need to dip dive into them. Thus it doesn’t measure the intrinsic value of the stock. It takes account of the charts to identify the future trend based on the past available data points.
Another important difference is the time frame used for both the analysis. Fundamental analysis is usually for the long-term approach while technical analysis is for the short-term approach. Technical analysis can be used for days, weeks or even for minutes while fundamental analysis looks at long-term say for 1 year, 2 years, 5years and so on.
However, both go hand in hand as fundamental analysis helps to find what to buy at the same time technical analysis tells us when to buy.
I give 50-50 weightage to both fundamental analysis and technical analysis while doing my research on any stock.
I hope the above information will help you to understand the concept of technical analysis. Please share if you like this article.