How to Perform the Technical Analysis of Stocks?
Created on 23 Dec 2020
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Updated on 11 Sep 2022
Is your stock analysis correct?
Has it ever happened that according to you, your fundamental Analysis of the stock was accurate, still, the stock didn't perform as you expected it would?
The stock price keeps on changing on a daily basis. Someday it surges, another day it plunges. But, if you will notice, it will create a pattern and series daily. The study of these series of data and chart patterns is generally referred to as Technical Analysis.
Every prudent stock trader uses technical Analysis along with fundamental Analysis to understand stocks.
Let's try to understand the technical analysis of stocks, so that the next time you are trading, you can also perform the technical Analysis of that stock.
What is Technical Analysis?
Technical Analysis is a research tool, method or technique, used to predict the probable future share price movement based on the historical trend of the stock, including both price and volume, with the help of charts and other technical indicators.
Technical Analysis applies to any asset class - equities, commodities, foreign exchange, etc.
The time frame in which this method can be applied, ranges from intraday, daily, weekly, or monthly to annually.
Charles Henry Dow is known as the father of Technical Analysis. The "Dow Theory" given by Charles is still used in performing a technical analysis.
Assumptions in Technical Analysis
One needs to know that Technical Analysis is based on the following assumptions-
- Market discounts everything - This assumption tells us that stock prices reflect everything that has or could affect the company. The market is driven by mass psychology. For example, suppose a company insider knows that the quarter results will affect the company's stock prices, so he buys the stocks in large quantities. While he does this secretively, the stock prices react to this action, and a technical analyst will know that it is a good buy.
- Price moves in trend - Trade with the trend is a basic logic behind Technical Analysis. Once a trend is set, the future price is likely to go in the same direction. For example, the recent upward trend in the NIFTY50 Index to 13500 from 7500 didn't happen overnight. It has taken nine months from the March lows of 7500 to reach 13500 in the month of December.
- History tends to repeat itself - In respect to Technical Analysis, prices tend to repeat themselves. This occurs because the market participants react to price movements consistently in a similar way, every time the price moves in a certain direction. For example, in a bull market, market participants become greedy, and they tend to buy the stock irrespective of the high price.
The Trade Summary
The Indian Stock Market is open from 9:15 am to 3:30 pm. During these 6 hours and fifteen minutes, millions of trades take place. It will be impractical to track all the trades happening in the trading hours. Hence, one needs to understand just the summary of the market:
By tracking Open, High, Low, and Close, we get a summary of the market:
Open: The first price at which trade executes when the market gets open is known as the opening price.
High: This represents the highest value at which a market participant was ready to trade for the given day.
Low: This represents the lowest price at which market participants were ready to trade for the given day.
Close: The closing price is the most significant one because it represents the price at which market gets closed in the given day.
Charts used in Technical Analysis
There are four types of charts that can be used during a technical analysis:
- Line Charts: A line chart is created by joining the closing prices of the stock. A dot is created for the closing price of each day, and the various dots are then connected by a line. The line charts can be plotted for various time frames, namely hourly, weekly, monthly, yearly, etc.
- Bar Charts: A bar chart is more versatile as it shows all four key price variables of the day, namely, open, high, low, and close. The image given below shows the bar graph during a positive and negative sentiment during the day:
- Candlesticks Charts: These are among the most important ones, and they are frequently used by traders for technical Analysis. It also shows the four key variables of the day, namely, open, high, low, and close. The graphic below shows the bullish and bearish candlesticks, respectively:
The candlestick is made up of three components:
The Central Body - The real body connects the opening price with the closing price.
Upper Shadow - It connects the closing price with the highest price in a bullish candlestick and opening price with the highest price in bearish candlestick.
Lower Shadow - It connects the opening price with the lowest price in bullish candlestick and closing price with the lowest price in bearish candlestick.
- Points and Figure Charts: They depict the price movements irrespective of the period. They consist of X's and O's that show the price movements in different directions. X's represent the positive movements, whereas O's represent the negative movements.
One X on the graph means one price unit rise and one O represents one price unit falls. If a stock price is increased by three units, a column of 3 X's is plotted.
How to perform Technical Analysis of Stocks?
The Dow Theory has always remained a core part of the technical analysis. It was used extensively even before the western world discovered candlesticks. The Dow Theory was introduced to the world by Charles H. Dow, who also founded the Dow-Jones financial news service a.k.a, the Wall Street Journal.
During his time, he wrote a series of articles starting from the 1900s which in the later years was referred to as 'The Dow Theory'. William P Hamilton compiled these articles with relevant examples for 27 years.
Following are the theories which explain how technical analyst use them
1. The Stock Market reflects all known information - According to this theory, the stock market discounts everything which is known and unknown in the public domain. If a sudden and unexpected event happens, then stock markets react quickly to represent the accurate value.
This is why a technical analyst does not consider any financial information for Analysis. They don't relate themselves with any information such as P/E Ratio, Statement of Profit and Loss, or any other information like a fundamental analyst.
2. Price Movements can be predicted - According to this theory, the price movements of a stock can be predicted and charted. It is known to all that prices move randomly, and there isn't any fixed pattern.
But according to this theory, this does not happen always; price movements repeat themselves sometimes or move in a predicted trend. Once a market participant understands this trend, they can make money in the stock market. One can go with buying at a lower level and selling at a higher level.
3. History repeats itself - This theory tells that history tends to repeat itself in the stock market. Market participants tend to react in the same way they had reacted in the past due to the same situation, news or company announcements.
Hence, a technical analyst uses the information on how traders reacted in the past and what was the effect on the stock.
4. Focus on the short term - As the purpose of fundamental analysis is an analysis for long term investment, the purpose of technical analysis is for a short-term investment. A technical analyst focuses on the shortest span ranging from one month to even one minute.
If a market participant wants to make money in a short period, they should use technical analysis for this purpose.
5. Use charts to understand the trend - A technical analyst uses charts to understand the trend in the market. A chart depicts a lot of things about the trend of price movement.
It can easily predict the future movement of the current trend. Trends can be differentiated based on duration and types.
6. Uptrend - The upward price movement is known as Uptrend. Everyday stock prices surge to a new high and then plunge to low as they did in the past. Market participants should identify this high, as it is not everlasting; it can be high on the last day, week or month.
A steady high and low price shows the positive nature of the stock. The positive nature indicates that one can buy this stock as this is in an upward trend. So, whenever the stock will fall, the market participant takes it as an opportunity to buy the stock.
7. Downtrends - The downward price movement is known as Downtrend. The stock will fall continuously. One can notice that not only peaks are lower, but troughs are also lower.
It means that market participants are sure that the price will fall further. So, they wait for a little surge in the price to sell their existing position. A prudent investor never prefers to buy any further if the stock is in a downtrend. This will be a loss-making situation for short term investors, but a long-term investor will wait for more price fall.
8. Horizontal Trend - Horizontal trend is a situation where there is not any fixed trend. Market participants are unable to find any specific situation in this trend. Only peaks and troughs are constant. One can't decide whether to buy or sell.
9. Support and Resistance - By analysing charts, a market participant can identify a certain price level that tends to prevent any further fall in the share price before rising again. This is known as support price.
Price levels that continue to provide rejection and causes the price to fall after testing are known as Resistance.
Support and Resistance are price levels from where a trend can be expected to pause due to a concentration of demand. By identifying support and Resistance, one can identify the target price. On a standalone basis, a market participant can use support and Resistance to identify the entry point of trade as well.
10. Trade Volume - Volume measures the total amount of shares traded in a given duration of time. It is used as a measure of interest that presents significant price action.
High volume indicates a breakout or breakdown followed by a sustaining trend in prices. Breakout results in higher trending prices, whereas breakdowns result in lower trending prices.
The volume of the stock must increase if the price is moving upward; similarly, the volume should decrease if the price goes downwards.
11. Moving Average Technique - Moving average is one of the oldest and most frequently used technical indicators around the globe. It is calculated to remove sharp, frequent fluctuation in the stock market.
Moving Averages are based on the events that have occurred in the market in the past. There are three kinds of Moving Average- simple, weighted, and exponential, and it is a lagging indicator.
12. Indicators and Oscillators - Indicators are a calculation of technical Analysis which supports the trends of price movement. It helps market participants to decide whether to buy or sell.
Leading indicator is useful in horizontal trends when a trend is not fixed. The lagging indicator helps in cross-confirming that the price will move in a particular direction.
One should keep in mind that no technical indicator is perfect. None of them gives 100% accuracy every time.
A prudent market participant always watches warning signs that signals from their chosen indicators can be faulty. Technical Analysis certainly improves the profitability of a market participant. Hence, a proper selection of technical analysis is an integral part of trading for attaining the highest possible success rate.
One should choose an experienced person to guide them, or one can also attain a course from a prominent institute for a detailed understanding of the different methods of Analysis.
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