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The stock market is almost synonymous with dynamism. Stock prices are prone to fluctuations every minute, leading to instabilities in one’s investments. So, the right analysis is immensely crucial to ensure a favourable outcome.
Technical analysis is a significant step towards that direction. Today’s blog will take you through the concept, significance and the different indicators available to analyse stocks technically.
What is technical analysis in the stock market?
Technical analysis of financial markets analyses stocks based on past trends, current prices and volumes. It is based on the principle that the future price movements of a stock depend on its current price and historical patterns.
Why is technical analysis important?
- Technical analysis believes that history will repeat. So, analysing how stocks reacted to a particular economic event in the past can help traders assess how the stock may react in a similar event in the future.
- These technical tools follow set rules while deciding the entry and exit positions. The entry and exit points can either make or break a trade. Hence, using a strategic theory to determine them may be better than a random choice of points.
- One of the main features of technical tools is to show trends and the strength of such trends in the stock market. So, it helps traders analyse whether a market is trending upward or downward to make decisions accordingly.
- Technical tools are capable of hinting at potential reversals, which act as warnings to investors to initiate their positions.
Technical indicators
There are multiple indicators which determine various aspects of the stock market. Some of them are as follows:
Charts
Chart patterns are one of the most popular types of indicators that represent the trends of the stock market. Charts use different price levels for a specific period, plotted on a graph to show whether the price is moving upward, downward or sideways. Some technical analysis chart patterns are:
- Line charts – These charts consider the closing prices of stocks each day and plot them on a graph. The dots are then connected with a line that indicates the direction of price movements.
- Bar charts – Bar charts show the open, close, high and low prices of a stock for each day, helping traders analyse how the stock fluctuates through the day.
- Candlestick chart – Similar to the bar chart, a candlestick also shows the four price points of stocks on the graph. However, candlesticks use colours and thicker bodies to plot prices, making them easier to interpret.
Trend strength indicators
Analysing trends alone is insufficient if one does not consider the strength of trends. An investor who formulates strategies on a weak trend will incur losses when the trend goes through an unexpected reversal. Hence, analysing the trend’s strength is essential.
- Average directional index – ADX is one of the most used indicators in judging the trend’s strength. It computes the delta between the current and previous high and the current low and previous low for each day. If the average difference between highs is more than lows, it indicates a strong bullish trend. Otherwise, it indicates a bearish trend.
- Relative strength index – RSI uses a 14-day period to analyse the strength of trends. It computes the aggregate profit and loss over 14 days, to form an index between 0 to 100 that indicates the strength of the trend. An RSI below 30 indicates that the stock is undervalued and oversold. An RSI above 70 indicates that the stock is overvalued and overbought.
Volume indicators
These indicators show investor’s sentiments and demands. They help in analysing whether the market is bullish or bearish on a stock. On-balance volume, accumulation and distribution, volume RSI, etc., are some important volume indicators in technical analysis.
Support and resistance
These are significant points in technical analysis. Support determines the lowest price a stock will reach, after which the price will rise. Resistance indicates the highest point a stock will reach after which it will fall
Limitations of technical analysis
- Interpretations can be subjective, leading to a lack of uniformity in assessing patterns.
- Technical analysis may give false signals, causing incorrect decisions.
- It does not consider the macroeconomic and fundamental factors of the stock.
- Some tools may be complex to understand, making it difficult for new investors to use.
Bottomline
Technical analysis tools are popular among stock market traders. Most traders use them, considering the clarity it provides regarding market trends. However, traders need to acknowledge that these are warning signals and not definite indications of what will happen in the future.
FAQs
It depends on the purpose of your investments. Technical analysis might be suitable for short-term investments, while fundamental analysis indicates long-term trends. If you would prefer to see the detailed background and financials of the stock, fundamental analysis would help you better.
A confirmation candlestick is a candlestick in the chart that helps in confirming a particular pattern. A specific candlestick in the chart hints at the reversal or start of a trend. But, traders wait for the next candle to check if it is following the expected pattern. The following candle is the confirmation candlestick.
A high volume during an uptrend may be a good signal to buy. It suggests that the number of investors interested in the stock is increasing, thereby increasing the demand and price. A high volume in a downtrend may be a signal to hold the stock for the time being.
No tool is an assured sign of future price patterns. All of them, including chart patterns, are hints of what may happen based on past trends. It is always better for traders to use multiple indicators to confirm a trend before taking positions.
The first step in technical analysis is to identify the trend. It is important to analyse whether the stock is trending upward, downward or sideways. While some traders use this information to trade with the trend, others choose to trade against the trend.