Technical Analysis Principles
Technical Analysis is a method to spot trading bets based on the collective reactions of market participants. The actions of markets participants can be tracked via stock charts and as we plot the cumulative historical data patterns are formed within these charts. The job of a technical analyst is to identify these patterns and develop his view point to forecast future price.
Technical analysis is different from fundamental analysis the difference can be explained as if you go to a restaurant before ordering the food if you ask to taste each dish in some minimum quantity & after tasting the food then decide to order the food you are finding value for your money so this is the case of fundamental analysis while if you go to a restaurant by checking the reviews and the crowd in the restaurant than this is like following the trend this is the situation in technical analysis.
Technical analysis is short term the trades have duration of few minutes, days, weeks or months. A good technical analyst expects small but consistent returns from his short term investments as these trades are short term. If a trade starts giving losses the trader should try to minimize his losses & not hold on to the trade. In technical analysis what matters is the stocks historical trading data (price and volume) and what information this data can provide about the future movement in the stock.
Technical analysis works on the assumption that historical trends repeat itself. This happens because the market participants consistently react to price movements in a similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a down trend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.
Technical analysis works on the assumption that historical trends repeat itself. This happens because the market participants consistently react to price movements in a similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a down trend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself
A technical analyst can drive the price summary of a stock for a day by looking at:
1. Open – When markets open for trading, the first price at which a trade executes is called the opening Price.
2. High – High represents the highest price at which the market participants have traded for the given day.
3. Low – Low represents the lowest level at which the market participants have traded for the given day.
4. Close – The Close price is the most important price because it is the final price at which the market closed for a particular period of time.
The close price serves as an indicator for the intraday strength. If the close is higher than the open, then it is considered a positive day else negative. The closing price also shows the market sentiment and serves as a reference point for the next day’s trading.
In technical analysis there are four data points i.e. OHLC (open, high, low, close) which are plotted in chart form. So if we want to plot the 4 data points for 10days it will result in 40 data points here the complexity of the chart increases if we want to plot a weekly or monthly chart. So to visualize things in a better manner where the charts will convey more information special type of charts called candlestick charts are used for technical analysis.
In a candlestick chart there are different candlesticks present .Each candlestick has open and close price displayed by a rectangular body. Let’s look at the bullish candle (green candle)
It has three parts
1. The Central real body – The real body, rectangular in shape connects the opening and closing price
2. Upper shadow – Connects the high point to the close
3. Lower Shadow – Connects the low point to the open
A bearish candle (red candle)
1. The Central real body – The real body, rectangular in shape which connects the opening and closing price. However the opening is at the top end and the closing is at the bottom end of the rectangle
2. Upper shadow – Connects the high point to the open
3. Lower Shadow – Connects the Low point to the close
If the close is higher than the open than it is consider as bullish trend & if the close is lower than the open price than the trend is bearish. Long bodied candle represent strong buying or selling activity. A short bodied candle represent less trading activity and hence less price movement. The time frame of the chart can depend on the type of the trader it can be Monthly Chart, Weekly chart, Daily or End of day charts, Intraday charts – 30 Mins, 15 mins and 5 minutes chart.
Depending on the technical analyst efficiency he should be able to cut down the noise in the charts and come up with inferences by visualizing meaningful trends in charts.
"A technical analyst knows the price of everything, but the value of nothing.” The price is the end result of the battle between the forces of supply and demand for the company's stock. By focusing on price and volume, technical analysis represents a direct approach. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security. It is used to confirm trends and chart patterns. There can be many interpretations of volume expansion and contraction .A price decline on high volume might “confirm weakness” Or it could indicate buyer depth and signal hidden strength. A price advance on low volume might be a “Suspect move” OR it could indicate illiquidity on the sell-side and signal upside potential. To simply put volume is all about supply & demand - strong markets when the volume is high & weak markets when the volume is low.
- Technical Analysis gives a lesson to traders that history repeats itself because majority traders react to certain situations in a similar way over a period of time.
- Four data points are most important when performing Technical Analysis; they are Open – High – Low – Close.
- Mostly Technical Analysis is used for investing in shorter time frame.
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