By Hrishikesh Menon. Edited by Arjun Chandrasekar.
Technical analysis is used by traders to evaluate prospective investments using statistical graphs and charts of stock price movements and volume. This method of analysis is usually used for short-term trades (day/swing trades).
Officially, Charles Dow is known to be the “Grandfather of Technical Analysis” as he compiled and analyzed decades of American financial market data, and came up with patterns and cycles to formulate what is known as the Dow Theory. However, technical analysis had actually been in use for centuries before Dow modernized it; some say technical analysis was first used in Dutch financial markets by a merchant named Joseph de la Vega. In Asia, technical analysis is said to be developed by Homma Munehisa, which eventually evolved into candlestick techniques. Early tech analysis was solely based on analysis of charts, as computer processing was not available. Once behavioral analysis was founded, Paul V. Azzopardi combined behavioral and technical analysis to create Behavioral Technical Analysis. Today, with the rapid innovation in computer processing, new technical tools and indicators are always being discovered.
As stated above, technical analysis focuses on price movements using graphs and charts. To determine price movements, traders usually use candlestick charts. Here is one of our past articles on how to read candlestick charts. As stated in that article, traders look for patterns in the candles such as bullish engulfing, bearish engulfing, double bottom/top, and many more. While patterns are important, that is only one small part of the puzzle; with these patterns come other technical indicators which are required in order to analyze a potential trade.
Volume measures the amount of shares traded of a stock. One of the most important technical indicators is the volume movement. There are several volume related trends but this section will only cover the common ones used by traders. The magnitude of volume in a candle shows how volatile the stock is at that moment. Usually the size of the candle represents the volume; for example if it is a near neutral candle, the volume will be quite low but if the candle is significant in size compared to the previous few, a volume increase is visible. A stock with price increase potential must have a steady uptrend in price and volume. If the price is increasing but volume is decreasing, that indicates a lower interest in the stock therefore a reversal is predicted. An up or downtrend will have exhaustive moves where the price will significantly change with a high volume, indicating the end of the corresponding trend. There is usually a low volume following this. Volume is essential in identifying bullish signs; for example, when volume increases on a falling price, has a slight reversal and moves back down, if the move back down is higher than the previous low and the volume is lower for that move down, that is a bullish sign. In breakouts of price, if the volume is increasing then that is a strong price movement but if the breakout is followed by diminishing volume, that is the sign of a false breakout. There are many other ways to interpret volume and price movements but these are some of the common ones used by most traders.
Common Technical Indicators
Most technical indicators fall into 5 categories and 2 subcategories: leading or lagging. Leading indicators predict price movement, whereas lagging indicators use historical data of the stock to show the performance leading upto the current price. Here are the 5 categories:
Trend indicators: Lagging indicators, analyzes whether a market is moving in uptrend, downtrend, or consolidating. Ex. Moving averages (SMA, EMA).
Mean reversion: Lagging indicators, measures how far up or down a share price will swing before encountering a reversal. Ex. Bollinger bands.
Relative strength: Leading indicators, measures the buy/sell pressure of a stock. Ex. stochastics.
Momentum indicators: Leading indicators, calculates the speed of price change over time. Ex. Moving average convergence divergence (MACD).
Volume indicators: Leading or lagging indicators, compiles the amount of trades in a certain time period and evaluates whether the price movement is bullish or bearish. Ex. On-balance-volume (OBV).
This article only covers a basic understanding of technical analysis and how it is used in trading. There are many more advanced concepts of technical analysis which can be learned and many more to be discovered. Once mastered, technical analysis can help day traders achieve maximum rewards.