Predicting the stock market fluctuations through a method called technical analysis. Sounds too good to be true? I thought so as well, but there is something about the talk. Obviously, no one is able to predict market fluctuations consistently and accurately, however, technical analysis offers the closest approximation possible. It can be a great tool to help you in your investment journey.
Investing in the stock market can seem like a daunting task. We have seen investors such as Warren Buffett, who play the long game with a value investing strategy, and others like George Soros, who is known for his risk tolerance and aggressive investing style. Technical analysis is a strategy that provides an intriguing blend of both of these approaches.
So, how does one tap into this seemingly sophisticated approach and make sense of the charts and indicators? Let’s have a closer look at the art of technical analysis and go through a step-by-step guide to help you navigate this exciting investment method.
Understanding the basics of technical analysis
Technical analysis is a way to predict future price movements of stocks by examining their past patterns. There is a broad range of tools to enable this analysis for investors – typically they are available through your trading platform.
Technical analysis works on three key principles:
1. Everything is in the price
This means that the price of a stock already reflects all the information that could impact it, whether it is a company’s financial state, the economy, or even the mood of the investors.
2. Price moves in trends
There is an element of herd mentality that is being leveraged with this approach to investing. Once a price starts moving in a certain direction, either up, down, or sideways, it tends to continue moving that way.
3. History repeats itself
People are creatures of habit. We tend to react to situations in similar ways over time. This also applies to the stock market. Investors’ reactions to certain market situations often create similar price patterns over time.
This approach stands in contrast to another popular approach known as fundamental analysis, which focuses more on a company’s financial health and market conditions. You can learn more about investing with fundamental analysis here.
Drawing your stock journey with charts
Charts are the treasure maps of technical analysts. They use different types of charts to visualize and understand price patterns. The most common types of charts are line charts, bar charts, and candlestick charts.
Take the candlestick chart for instance, popularized by legendary rice merchant turned trader, Munehisa Homma. Each candlestick represents the open, high, low, and close price of a given time period. If the close price is higher than the open price, the candlestick is often white (or green), and it’s considered a bullish period. If the close price is lower than the open price, the candlestick is typically black (or red), indicating a bearish period.
Spotting trends
Imagine watching a flock of birds in the sky. If they are moving in a certain direction, there is a high likelihood they will continue in the same direction. The same goes for stock prices. If they have been moving in a certain direction, they are likely to continue moving that way.
This is where trend lines come into play. These are lines drawn on charts to help identify the direction in which the stock price is moving. If the trend line is going up, the stock is in an upward trend. If it is going down, the stock is in a downward trend.
A trend line is a straight line that connects several points on a price chart. It visualizes the general direction of a stock’s price over a period of time.
There are three types of trends you can spot:
1. Upward trend
An upward trend is when the stock price shows a series of higher highs and higher lows. You can draw an uptrend line by connecting at least two of the lowest points (lows) on the chart. As long as the price does not fall below this line, the uptrend is considered intact.
2. Downward trend
A downward trend is when the stock price exhibits a series of lower highs and lower lows. In this case, you draw a downtrend line by connecting at least two of the highest points (highs) on the chart. Until the price breaks above this line, the downtrend is considered intact.
3. Sideways trend
If a stock is not making higher highs and higher lows or lower highs and lower lows, it is likely moving sideways in a horizontal trend.
Technical indicators
At this point you might be thinking – Great, but how do I know when these trends will change? Let us move on to a more advanced tool; technical indicators. They are like the GPS of your stock investment journey leveraging technical analysis and guiding you in making decisions. Be mindful that indicators can rarely stand alone, so make sure that you use a couple of indicators to balance your decision-making process.
While there is a myriad of technical indicators available, let us focus on two of the most acknowledged types:
1. Trend-following indicators
As the name suggests, these indicators help you identify the direction of the trend. Moving averages (MA) is a popular trend-following indicator that shows the average price of a stock over a certain period, helping you spot the overall trend.
The moving averages are also used to spot golden crosses and death crosses, which serves to indicate whether stock prices are likely to head upwards or about to drop.
Learn more about golden crosses and death crosses used in technical analysis.
2. Oscillators
Imagine a pendulum swinging back and forth. When it swings too far in one direction, it is likely to swing back the other way. Oscillators work in a similar way. They can help you see when a stock price has swung too far in a direction and is likely to swing back. Examples include the Relative Strength Index (RSI) and the Stochastic Oscillator.
For example, if we consider the RSI, then once it reaches above 70 the stock may be overbought, and when it falls below 30 it may be oversold. When a stock is overbought it is an indicator to sell, and once oversold it is an indicator to buy.
Conclusion
Now that you’re equipped with the right knowledge and tools, it is time to dive into the action. Remember, start small and be disciplined. Investing is a marathon, not a sprint.
Technical analysis is a potent tool in your investment arsenal. It allows you to make calculated decisions, which reduces the influence of emotions on your trading choices. As you begin your journey, pick out a select handful of technical indicators that you prefer, and remember to practice, remain patient, and stick to your strategy. Happy investing!
