Technical analysis aids you in understanding market trends so that you can make informed investment decisions, says Rupak De, senior technical analyst at LKP Securities.
Those of you interested in the stock market would have heard the term 'technical analysis'.
This is a method used to understand probable future price movements of shares based on historical data.
Traders use charts to spot trends and patterns in prices.
There are three types of trends: Uptrend (when the prices go up), downtrend (when the prices go down) and sideways (when prices move within a range).
Technical indicators and chart patterns help traders make decisions.
Support and resistance levels show potential price reversals.
Harmonic patterns seek to identify reversal points based on geometric patterns.
Remember, while technical analysis can be helpful, it can't predict prices with certainty so using risk management strategies are a must for any trader.
Understanding technical analysis
Technical analysis is a method used in the financial markets to evaluate and predict the probable future price movements of assets such as stocks, commodities and currencies based on historical price and volume data.
The primary assumption behind technical analysis is that market prices move in trends and makes patterns as they move and that these patterns can be identified and analysed to make informed trading decisions.
Technical analysts use price charts to visualise historical price movements of a particular stock or market.
The most common types of charts are line charts, bar charts and candlestick charts.
Importance of trend analysis
Recognising trends in the stock market is crucial for investors and traders as it can help in their investment/trading decisions.
Technical analysis, which involves analysing historical price patterns, is commonly used to identify trends and potential turning points in the market.
Trends in the stock market refer to the general direction or movement of stock prices over a specific period of time.
These trends can be categorised into three main types:
Uptrend: An uptrend occurs when the overall movement of stock prices is upward over an extended period.
During this trend, each successive peak is higher, and each trough is lower, than the previous one.
Uptrends indicate a bullish market sentiment where investors are optimistic and buyers dominate, leading to rising prices.
Downtrend: A downtrend, on the other hand, happens when stock prices are consistently moving downward over a prolonged period.
During this trend, each successive peak and trough is lower than the previous one.
Downtrends signify a bearish market sentiment with investors being pessimistic; sellers remain in charge, resulting in falling prices.
Sideways (or range-bound) trend: In a sideways trend, the stock prices fluctuate within a relatively narrow range with no clear upward or downward direction.
It is a condition where the peaks and troughs are roughly at the same level, creating a horizontal or sideways pattern.
Sideways trends occur when the market lacks a clear catalyst for sustained movement in either direction; investors tend to remain at the sideline.
These are mathematical calculations based on price, volume or open interest data.
Technical indicators provide additional insights into market trends, momentum, volatility and potential reversal points.
Some popular technical indicators include Moving Averages, Relative Strength Index, Moving Average Convergence Divergence, Bollinger Bands, Stochastics RSI Oscillator, etc.
Technical analysts identify various patterns formed by price movements on charts. These patterns can indicate potential trend reversals or continuation.
Examples include Head and Shoulders, Double Tops/Bottoms, Cup & Handle, Rounding Bottom and Triangles.
Role of volume
According to the Dow Theory, trading volume should confirm the direction of the trend.
In an uptrend, a higher trading volume should accompany rising prices and, in a downtrend, higher volume should accompany declining prices.
Lower volume during corrections may indicate a potential trend reversal.
Support and resistance levels
Support and resistance levels are important concepts in technical analysis used by traders to identify potential price levels where a stock, currency or any other financial asset may experience reversals or significant price movements.
These levels are determined based on historical price data and play a crucial role in making trading decisions.
A support level is a price level where the price of an asset tends to find buying interest, preventing it from falling further.
It is considered a floor or a price-level where there is enough demand to outweigh selling pressure.
A resistance level, on the other hand, is a price level where the price of an asset tends to encounter selling pressure, preventing it from rising further.
It acts as a ceiling or a price-level where there is enough supply to outweigh buying interest.
Fibonacci retracement is a technical analysis technique that uses Fibonacci ratios to identify potential support and resistance levels. Fibonacci ratios are based on the Fibonacci sequence, which is a series of numbers that appear frequently in nature.
Fibonacci retracement levels are used to identify possible levels where the price of an asset may retrace or pull back after a significant price movement.
Harmonic pattern trading is a popular trading strategy in technical analysis that seeks to identify potential reversal points in financial markets based on specific geometric price patterns. These patterns are based on Fibonacci ratios and have a harmonic structure, which is why they are referred to as harmonic patterns.
The strategy uses specific price structures that are found in various financial instruments, including stocks, currencies (forex), commodities and indices.
In conclusion, technical analysis is a powerful tool used by traders and investors to analyse historical price data and identify patterns, trends and potential price movements in the stock market.
By studying charts, using various indicators and applying principles like the Fibonacci retracement, analysts can gain insights into market behaviour and make informed trading decisions.
Technical analysis can be a useful tool for understanding market trends and making informed investment decisions.
However, it is important to remember that no analysis, whether technical, fundamental can predict future price movements with absolute certainty.
Therefore, it is essential to incorporate a robust risk management strategy into your trading and investment plan. This will help you to minimise your losses in case your predictions are incorrect.