Stock Trading: How to Use Technical Analysis
When you want to look at investments and identify opportunities, some say the best method is technical analysis. These analytics look at statistical trends based on trading activities. For example, they may analyze historical fluctuations in a stock’s trading price or the volume at which a stock is traded. While fundamental analysts look for “intrinsic value,” technical analysis focuses on discovering patterns with price data and trading signals. They typically use analytical chart tools to evaluate a stock’s potential.
You can use technical analysis with any stock that has historical trading data. However, many technical analysts use this method for opportunities within commodities and forex markets. This is because these markets favor short-term trades and pricing.
Quick Tips on Technical Analysis
- Technical analysts use this method to evaluate stocks and identify investment opportunities. These opportunities are reflected in price movements and patterns found on analytical charts.
- Past trading activity, movements, and changes are the basic indicators for the health of a stock and prediction of future price.
- In contrast to fundamental analysis, technical analysis does not look at a company’s financial statements or quality of product. It only analyzes historical pricing data and stock price trends.
Why Use Technical Analysis
Charles Dow developed technical analysis and the Dow Theory in the late 19th century. While other researchers like Edson Gould, John Magee, Robert Rhea, and William P. Hamilton contributed to the Dow Theory, the basis is quite simple. You can know the value of a stock by studying its patterns and signals over a period of time.
Technical analysts focus solely on the past activity of a stock to inform purchase decisions. If the data shows a stock has steadily increased or experiences a bump in a certain time of year, technical analysts may tip you off to purchase a stock. While some technical analysts combine their work with some intrinsic value information, most of their decisions are based solely on statistical data.
One of the main proponents of this method is the Market Technicians Association or MTA. Advanced technical analysts seek the Chartered Market Technicians or CMT designation as a certification of their skills.
There are two assumptions for technical analysis:
- Markets efficiently show the values representing all the factors that influence a stock’s price
- However, market price movements are not random but move in patterns and trends that are typically repeated over time.
Technical analysts believe that stock prices move in trends. They look at the supply and demand for a particular stock in the market and identify patterns. Analysts say a stock moves in short, medium and long-term trends. Stocks are more likely to move along a path rather than random movements. In addition, price movements are repetitive throughout history. These are often based on market psychology, which shows prices may change due to excitement or fear.
How to Use Technical Analysis to Identify Good Stocks
Technical analysts look at price movements to forecast and predict stock prices. It can also be used for bonds, futures, and currency trading. While technical analysis looks mostly at patterns and price changes, other analysts may look at open interest figures or trading volumes.
There are certain indicators and tools used to spot stock patterns. These include:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Moving averages
- Support and resistance levels
Tools for Technical Analysis
There are a variety of tools used by technical analysts, and while some of these rely on math, you can simply use charting software to look at patterns as well. These are some of the best tools to understand technical analysis currently.
The OBV is used to measure the flow of volume in positives and negatives over a period of time. You can calculate this number by looking at the total of up volume and subtracting the down volume. Up volume is defined as how much volume is conducted on a day when the price grew momentum or rallied. When the price falls, you are looking at down volume. Each day, you can calculate the on-balance volume. When OBV is on the rise, buyers are willing to purchase and push the price higher. When OBV is sinking, the selling volume is outpacing purchase volume, which indicates there will be lower prices. It could mean a good time to buy if you compare to other signals and see a future growth.
Simple Moving Average
The SMA gives you a daily average of the stock’s price over the last “X” number of days. Simple moving averages typically span 20 days, 50 days, or 200 days. That provides the most accurate information at different time stamps. These SMAs may provide resistance or support, and where these numbers cross indicates signals to sell, buy, or cover. While there are certain variations in moving averages, the simple ones are best for most traders.
Moving Average Convergence/Divergence
The MACD is another indicator that technical analysts use to identify a new trend, such as a bullish or bearish flux. There are typically three numbers that you look for on a MACDchart. The first number shows a sequence of periods that can calculate a “faster-moving average.” This means a stock is rising hot.
The second number shows the number of periods used for a slower moving average. This may indicate long-term growth.
The last number is the amount of baars that calculates the moving average of the difference when comparing the faster and slower moving averages. Where the two lines intersect typically indicates a new trend.
Relative Strength Index
The RSI is a bit trickier. This number looks at gains and compares them to losses. A chart is then created that shows which one is greater and what the magnitude of the trend will be. If you see an RSI chart that shows a stock climbing rapidly, then it means the stock’s gains are outpacing its losses on a day-to-day basis for the time period. Typically this period is 14 days. RSI is measured based on a scale of 0 to 70. The numbers 30 and 70 also have significance. If a stock is measured at an RSI over 70, then it is overbought. If a stock is below 30, then it is oversold. If you notice a stock is rising towards 70, it could mean that the stock has an upward trend, but you want to check this with another indicator to ensure that it is not being overbought.
Criticism of Technical Analysis
The main criticism of this method comes from the efficient markets hypothesis (EMH). This principle states that the market price already shows all current and historical information available. Essentially, there is no way to take advantage of a stock trend through patterns or mispricing. In addition, EHM economists believe that history does not repeat itself, but instead, stock prices move according to a random walk.
In addition, technical analysis does not work for all types of stocks. Technical traders may place a stop-loss order when looking at a 200-day moving average for a particular company. However, if all the stock traders notice this trend, then the stock reaches this price and a large number of sell orders will change the price anyway. This pushes the stock down, so the technical analysis is a self-fulfilling theory.
Final Word: Evaluating Stocks with Technical Analysis
Statistics can be tricky, but it’s the basis of technical analysis. By looking at market data, you can see historical returns, volume of trades, and stock prices. While fundamental analysis looks at the long-term value of a stock, technical analysis is more concerned with reviewing patterns based on performance.
If you like to evaluate data and take an active stance to trading, such as a short-term investment, then you may value technical analysis more than fundamental analysis. In addition, technical analysis uses multiple charts and can spot opportunities to purchase or sell a stock before the trend becomes too popular. However, great traders look at fundamental factors too. These are often good indicators to back up a new trend developing based on technical data.