Introduction to Technical Analysis of Stock Markets
Technical Analysis of Stock Markets refers to the study of market-generated historical data like stock prices, trading volumes, etc. to predict future market behavior.
Fundamental Analysis versus Technical Analysis
Fundamental Analysis is the evaluation of stocks by measuring their intrinsic value. Technical Analysis is to observe the statistical trends of the stock’s price and volumes.
In other words, Fundamental Analysis helps us to determine which stock to buy whereas Technical Analysis helps us determine when to buy a particular stock.
Foundation of Technical Analysis
Know Yourself: Before setting a foot in any particular stock, one should always decide the type of investment and one should not change his/her position in between. The types of investment may be Intraday Investment (1 day), Short Term Investment (2 days to 3 months), Medium Term Investment (3 months to 1 year), or Long Term Investment (1 year+).
Stock Price Analysis: This involves an analysis of four major components of a Stock Price:-
- Opening Price: The price at which the stock first trades on a trading day upon the opening of the stock exchange.
- Closing Price: The price at which the stock last trades on a trading day.
- High Price: Highest price at which the stock traded during a period.
- Low Price: Lowest price at which the stock traded during a period.
Stock Volume Analysis: Volume is the number of stocks that changed hands on a particular day. Price movement is more significant when accompanied by significant volumes on that particular day.
Stock Market Charts
There are 3 major charts used to analyze the price movements of a stock:
Line Chart: It is a graphical representation that connects a series of data points with a continuous line. These data points depict the asset’s closing price. It is an elementary chart as it only analyzes a single parameter i.e. Closing Price.
Bar Chart: A bar chart shows the open, high, low, and close prices for a specified period of time. The vertical line on a price bar represents the high and low prices for the period. The left and right horizontal lines on each price bar represent the open and closing prices.
Bar Charts can be color-coded.
Bullish Bar: If the closing price is above the opening price it may be colored white or green.
Bearish Bar: If the closing price is below the opening price the bar may be colored black or red.
Candlestick Chart: Candlesticks show that emotion by visually representing the size of price moves with different colors. Just like a bar chart, a daily candlestick shows the market’s open, high, low, and close price for the day. The candlestick has a wide part, which is called the real body.
Candlestick Charts are color-coded.
Bullish Candle: If the closing price is above the opening price it may be colored white or green.
Bearish Candle: If the closing price is below the opening price the bar may be colored black or red.
Trends in Stock Market
Trends indicate the direction of movement of a stock price. In technical analysis, trends are identified by trendlines. There can be 3 trends for any assets namely Upward Trend, Downward Trend, and Sideways Trend.
- Upward Trend: The price of the stock follows an upward trajectory. Each successive peak (high) and trough (low) is higher than the ones formed earlier in the trend. Upward Trend is characterized by rising data points such as Higher Highs and Higher Lows.
- Downward Trend: The price of the stock follows a downward trajectory. Each successive peak (high) and trough (low) is lower than the ones formed earlier in the trend. Downward Trend is characterized by falling data points such as Lower Highs and Lower Lows.
- Sideway Trend: The price of the stock follows a horizontal path. It occurs when the forces of demand and supply are nearly equal. Each successive peak (high) and trough (low) are in the same range as the ones formed earlier. Sideways Trend is characterized by Highs and Lows in the same range.
Trend Reversal
A trend reversal is a change in the direction of stock price and its movement in opposite direction, from going up to going down, or vice-versa.
An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows.
A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.
Investment Strategies based on Trends
- Upward Trend (Uptrend): It is recommended to not sell any stock during an Uptrend, one should always wait for a Trend Reversal.
- Downward Trend (Downtrend): It is recommended to not buy any stock during a Downtrend, one should always wait for a Trend Reversal.
- Sideway Trends: It is recommended to wait for a breakout from the sideways trend.
Support and Resistance Levels
Support Level: Support Level refers to the price level that the asset does not fall below, for a period of time. A support level is created by the buyers (bulls) taking charge and buying the stock when it dips to a lower price.
Resistance Level: Resistance Level refers to the price level that the asset does not rise above, for a period of time. A resistance level is created by the sellers (bears) taking charge and selling the stock when it rises to a higher price.
Depending on the price action, these lines can be flat or slanted.
It has been analyzed that the Support Level when broken, serves as a Future Resistance Level. Similarly, the Resistance Level when broken serves as a Future Support Level.
Investment Strategies based on Support Levels and Resistance Levels
- Support Level: It is recommended to buy the stock near Support Levels in an Uptrend.
- Resistance Level: It is recommended to sell the stock near Resistance Levels in a Downtrend.
Trading Breakouts
Trading Breakouts refer to the stock price moving outside the defined Support Level or Resistance Level. In other words, the stock price breaks the previously observed Resistance Level by moving above the Resistance or breaks the previously observed Support Level by moving below the Support.
Trading Breakouts indicate the potential for the price of the stock to start trending in the Breakout Direction.
Trading Breakouts with higher volumes serve as a confirmation for change in trend.
Investment Strategies based on Trading Breakouts
- It is recommended for a trader to take a long position on the stock (buy the stock) after the stock price breaks above the Resistance Level.
- It is recommended for a trader to take a short position on the stock (sell the stock) after the stock price breaks below the Support Level.
And that’s a wrap. We have successfully managed to understand the basic strategies towards Technical Analysis of Stock Markets. We will further understand the Bearish Candlestick Patterns and Bullish Candlestick Patterns in the next article.
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