It’s a debate that never ends technicians on one side, fundamental analysts, on the other. The former believe you only need charts to profit in financial markets. The latter – well – they laugh with disapproval.
But throughout it all, technical analysis has stood the test of time. From traders in their home office to the risk-arbitrage desk of Goldman Sachs, technical analysis skills are still used to gain an edge in financial markets.
So right here, it’s technical analysis explained. We’ll let you know what it is, how it works, and all the strategies you need to know.
Technical Analysis Explained in 4 Steps:
1) What is Technical Analysis?
Technical analysis is an investing strategy using price and volume data. Technicians – as they like to be called – assume stocks are not weak-form efficient. They analyze securities by studying historical supply and demand patterns — for indexes, stocks or any financial asset – to predict where future prices are headed.
The main goal is to gauge investor sentiment. Are they bullish? What are the trends showing? At their core, technicians label investors as emotional and often irrational; by analyzing chart patterns, you can spot this information.
The most exciting part of their strategy is how technicians ignore fundamentals. A company’s revenue. Its Cash flow. All irrelevant. From a technical perspective, you don’t even need to know its name to analyze a stock. As long as you have the chart, you’re in business.
2) What is Technical Analysis Charts?
When getting started in technical analysis, you must be familiar with the charts.
The most common types include:
- Line Charts
- Bar Charts
- Candlestick Charts
Line charts are a visual representation of the technical analysis of financial markets. The detail price history – usually daily — of a stock over a given sample period.
A bar chart extends the data by displaying the open, high, low and closing price. The point here is to assess the stock’s behavior throughout each day and use this information to predict future movement.
A candlestick chart extends the data even further. It conveys the same information as a bar chart but provides a more significant visual aid by forming a thick body in the middle. The green bars positive, pleasant days, while the red bars represent negative days. A slew of green bars indicates a positive future outlook for the stock.
3) What are Technical Analysis Indicators?
With a multitude of tools at their disposal, some indicators include:
- Relative Strength Analysis
- Trend Analysis
- Head and Shoulders Patterns
- Double Tops and Bottoms
- Death Cross and Golden Cross
Relative strength analysis is used very frequently. The goal is to find evidence of outperformance by one stock versus another or one stock versus an index. For example, assume on day-1 Stock A has a price of $15, and Stock B has a $13. If on day-2, Stock A rises to $16 while Stock B only rises to $13.25, Stock A is showing greater relative strength because its percentage appreciation is of a larger magnitude. The goal is to chart this data over long periods, spot a consistent trend and then look to exploit it.
Trend analysis is a lot easier. You follow the herd. If the charts show an upward trend with stock making higher-highs and higher-lows, it signals a buying opportunity. If the opposite occurs where a trader sees lower-highs and lower-lows, he’ll look to enter a short position.
Head and shoulders patterns are used to predict steep upswings and downswings. The shoulders represent a small rally – usually on high volume – and the head represents the highest-high where the stock begins to top-out. It’s a bearish sign and leads to new selling. A reverse head and shoulders are the opposite. When traders see it, they expect a breakout.
Double tops and bottoms represent precisely what their names suggest. A double top is when a stock reaches a new high, falls, tests the new high again, and falls also. It’s a bearish signal sending traders running for cover. A double bottom is an opposite. Instead of failing to reach new highs – here the stock holds its previous lows. This is a bullish signal, showing investors are quick to support the stock at that particular price. Logically, it’s a buying opportunity.
Up next is the cross. It sounds scary, and it is. A death cross is when a stock’s short-term moving average crosses through the long-term moving average from above. It represents how short-term sentiment is waning, which will likely drag the long-term average down with it. A golden cross is an opposite. This is when a stock’s short-term moving average crosses through the long-term moving average from below. It represents positive short-term sentiment and new upside potential.
4) What is Technical Analysis Strategies?
- Trading Support and Resistance
The most basic technical strategy is trading support and resistance. Support represents the price at which investors buy the stock. Resistance represents the price at which investors sell the stock. When you plot price data on a chart, you can see common high and low points rather easily. Once traders spot it, they look to profit off the trend.
- Bollinger Bands
Bollinger Bands use statistical analysis to predict overbought and oversold price levels. First, you plot the stocks short-term moving average on a chart. Second, you calculate — and plot – the moving average plus/minus two standard deviations from its average.
The logic here – assuming a normal distribution – is two standard deviations from the average encompasses 95% of all data within a sample. This means that if the sample repeats itself, there is a 95% probability the stock price will stay within plus/minus two standard deviations of its average. Traders look to profit by buying the stock when the price falls -1 to -2 standard deviation below its average and sell (or short) the stock when its price rises +1 to +2 standard deviations above its average.
- Trading Sentiment
Traders also pay attention to euphoria and pessimism around a stock or within the overall market.
Short interest is at the top of the list. Traders analyze the number of shares borrowed and sold by investors and calculate it’s ratio as a percentage of a stock’s average daily trading volume. The larger the short interest, the more conviction traders have that the stock is headed for new lows.
A second sentiment strategy is analyzing margin debt. This is a contrarian strategy. Again, assuming investors are irrational, technical wisdom believes most people herd-in at the top of a market. Thus, when margin debt is rising, and people are pumping more and more money into stocks, it signals the market is overbought.
The third is a new IPO’s. Private companies go public when they can sell their equity at the highest valuation. This often occurs at the top of an economic cycle, when equity prices are at their highest. When a slew of new IPO’s come to market, this a sign that the top is near, and it may be time to get short.