Technical analysis is a method of analyzing and forecasting price movements in financial markets via the use of historical price charts and market information.
There isn’t a sport bigger than cricket in India. How we loved watching the legends perform. But it wasn’t just the game, we loved every bit of it — memorizing the stats of players and team and throwing it in conversations to sound like analysts.
Bar graphs of the over-by-over progress of the team, line charts to compare the run chase, pie charts telling where the batsman scored most runs, and the mother of all: Duckworth-Lewis.
The point is, with such statistics available, even the spectators were able to determine how the match would progress while accounting for the unpredictable performances. That is what a technical analyst does. With chunks of data, a technical analyst would make informed calls on buying and selling a stock. Let’s dive deep into it.
- What is Technical Analysis of Stocks?
- Types of Technical Analysis
- Technical Analysis Indicators
- Advantages of Technical Analysis
- Disadvantages of Technical Analysis
- Quick Summary
What is Technical Analysis of a Stock?
Pick up a chart of a stock’s price movement for the last 15 trading sessions. Pick another chart of the volume of trade of the stock. When an analyst looks at these charts he/she analyses the movements and decides what to do with the stock.
The general idea is that technical analysis depends on the historical movement of the stock. While each day is new, a deep analysis of the stock movement with respect to how the market was doing on a given day can reveal a trend about the stock.
The analysis depends on the volume of the trade as well, which is simply the demand and supply of the stock. So if the demand for the stock seems more, the analyst will know that the price is ought to go up.
Types of Technical Analysis
Technical analysts depend heavily on various types of charts to make predictions about the stock movement. Here are a few examples:
The Line chart
The line chart uses only one data point to form the chart. In technical analysis, a line chart is used to plot the closing price of a stock and analyse how the stock has been performing. Now, a line chart can be plotted for various time frames.
It can be used for intra-day trading by plotting the hourly movement of the stock. It can be one for days, weeks, months, etc.
It is very simple to understand and analyse. However, the line chart does not provide much information. Since only one element is in use, it can’t give much in-depth analysis.
The Bar Chart
The bar chart has more elements to it. It tells us about the four prices: Open, high, low, closing. The bar chart has three elements to it.
The central bar: This shows us the high and low price of the day. The top of the bar is the highest value of the stock in a day. The bottom is the lowest point of the stock in a given day.
The left mark indicates the opening price of the day while the right one indicates the closing of the day.
The length of the central line defines the range of price in the day. Longer the line, the bigger the range. However, this type of chart lacks a certain visual appeal to it. It is useful but tiresome to analyse.
The Candlestick chart comes very close to the bar chart. In a bar chart, the opening and closing prices are shown by a tick on the left and the right sides of the bar. The same is done by a rectangular body in a candlestick chart.
The candlestick is a rectangle over a straight line. The rectangle connects the opening and closing price. Meaning, the top of the rectangle is the closing price, while the bottom is the opening price. The line going over the top of the rectangle reaches the day’s high. The line coming out from the bottom of the rectangle reaches the day’s low.
Now, the more important thing after understanding the structure of the candlestick is the time frame. An analyst can set any time frame required. Since technical analysis is mostly done for the short-term, let’s understand how candlestick would look in intraday trading.
Suppose you set the time frame for 5 minutes. The opening price would be set at the 1st minute, while the closing price would be set at the 5th minute. The high and the low would be represented as usual, just that they would be for those 5 minutes only. If the chart is set to show data every 5 minutes, an analyst would get 75 candlesticks per day.
Volumes tell an analyst how much buying and selling is going on. Depending on the price of the stock and the volume of the trade, analysts can tell if the market is bearish or bullish. If the stock price increases and the volume of the trade also increases, then the market is bullish.
However, if the price is falling and still the trading is up, then the market is bearish. It is better to look at days of data in terms of volume to make a better analysis.
These are pattern-based signals generated by the price, the volume of the stock. Analysts look for these indicators in historical asset price data to predict entry and exit points for the given stock.
Some of them are as follows:
One of the most used technical tools is the 200-day moving average. All you have to do is plot the 200-day moving average on the price chart. When the price of the stock rises above the moving average line, it’s a buy signal, and when the price falls below the moving average line, it is a sell signal. You can also look at the 50-day moving average or the 10-day moving average.
Bollinger band consists of 3 lines; Upper Limit, Lower Limit, and a Moving Average. These lines represent the standard deviation of the stock.
In simple words, the Bollinger band looks like a cloud and the stock is supposed to trade within this cloud. If the stock moves out of the upper limit line, it indicates that the stock prices may fall in the future. Hence you should short sell. And if the stock moves out of the lower limit line, it indicates that the stock prices may rise in the future indicating a buy signal.
Relative Strength Index
Relative Strength Index looks into recent gains and losses to check if a stock is overbought or oversold. RSI is plotted on a scale of 0-100 and mostly takes into account the 14-day period. An RSI of 0 means that the stock price has fallen in all of the 14 trading days. An RSI of 100 shows that the stock price has rallied in all of the 14 trading days.
The stock is considered overbought when RSI is above 70. This is the time to sell. An RSI of less than 30 indicates the stock is oversold. This is the time to buy.
Advantages of Technical Analysis
- It is based on raw day-to-day and in some cases hour-to-hour data
- It is very precise and useful for short-term trading
- Various tools help in understanding the nature and behaviour of the stock
Disadvantages of Technical Analysis
- Complex and not easy to grasp in one go
- Totally dependent on historical data, which may not predict the future correctly
- Wrong reading can incur heavy losses
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
- Technical analysis is based on historical performance of stock .
- Line chart , bar chart , candlestick , volumes are types of technical analysis.
- Moving averages , Bollinger brands , relative strength index are types of technical indicators.
- Advantages of technical analysis are that it based on day to day raw data , precise and useful for short term trading, various tools help in understanding the nature and behaviour of the stock .
- The only disadvantages are that it is complex , totally dependent on historical data and wrong reading can lead heavy losses.