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Technical Analysis: Meaning, Types of Indicator and Chart

READING

10 mins read

The previous modules have already given you a fair idea about stock markets, financial instruments, and trading basics. So, in this module, we will explore technical analysis in detail as it is a crucial concept for trading.

What Is Technical Analysis?

Technical analysis is a methodology that helps you predict price movements in the future by studying and analysing historical data on price and volume. It allows you to build an understanding of a specific stock or index in terms of – expected risk, expected return, expected hold duration, and buy and sell prices.

By facilitating this understanding, technical analysis helps detect trading opportunities based on the actions and behaviours of other market participants. It also involves these assumptions:

Markets discount everything:

This common assumption holds that all current market prices fully incorporate all available public and private information. For example, if a significant amount of a company's stock is purchased, it naturally leads to an increase in the stock's price. This suggests that the market has already 'discounted' this action by integrating it into the stock's current valuation.

The 'how' over 'why' principle:

Technical analysts often prioritise understanding the 'how'—the mechanism of price movements and market dynamics—over the 'why'—the underlying reasons for these movements. This approach stems from the belief that price actions and patterns are the direct results of market psychology and supply and demand. This makes the underlying causes secondary in the context of trading decisions.

Trend following:

The assumption that 'Price movement follows a trend' is significant in technical analysis. It underscores the belief that prices move in evident trends that are sustainable over time. Once a trend is established, be it upward, downward, or sideways, it's expected to persist. This allows traders to make predictive analyses based on the identified patterns.

Historical patterns tend to repeat:

This assumption is rooted in the psychological aspect of trading. According to the assumption, market participants often react to similar market conditions consistently. This leads to repetitive patterns in price movements. This cyclical nature of market behaviours forms an important aspect of technical analysis and provides a basis for predicting future market movements by studying historical trends.

By recognising and leveraging these assumptions, technical analysts attempt to decipher the language of the market conveyed through price actions and trends. This methodology enables traders to make educated guesses about future market movements and offers a strategic advantage in the highly speculative and volatile world of trading.

Now, let’s explore the role of technical analysis in trading and its key aspects.

Can You Apply Technical Analysis on Any Asset?

Wondering if technical analysis is applicable to all assets?

If the asset in question comes with historical time series data on volume and the following price points, technical analysis can be applied:

Open price (O) – Upon market opening, the first price at which a trade is executed.
High price (H) – Highest price (on a specific day) at which a trade is carried out.
Low price (L) – Lowest price (on a specific day) at which a trade is executed.
Close price (C) – Final price (on a certain day) at which the market closes. It acts as a reference for the following day’s trading and indicates intraday strength and market sentiment.

Since OHLC are the key data points in technical analysis, they are plotted on a chart to summarise and analyse daily trading actions.

However, it is noteworthy that the effectiveness of technical analysis can vary greatly among different asset classes and market conditions. Markets with greater liquidity and higher trading volumes generally provide more reliable data for technical analysis.

Chart Types

In technical analysis, the charting technique must display all the important information comprehensively. So, let’s delve into the commonly-used chart types:

Line chart:

Here, a single line connects all closing stock prices over a certain period. It helps you spot trends and evaluate a stock’s overall performance but provides no insight into intraday fluctuations.

Bar chart:

It helps you visualise each period’s price range and displays all OHLC price points. A bar is composed of a central vertical line (the top indicates the highest price, the bottom indicates the lowest price), a left tick (indicates open price), and a right tick (indicates the close price). This is how it will look for the following price points:

- Open – 65
- High – 70
- Low – 60
- Close – 68

The bar chart, however, is difficult to read when the number of bars grows, or there are multiple charts to analyse.

Candlestick:

This is a modified version of the bar chart. Candles display green bodies to indicate bullish sentiment or when the stock closes higher than the opening price. And they display red bodies to represent bearish sentiment or when the stock closes lower than the opening price. Candlestick charts help you visualise price movement in a trending market and decide on entry and exit points.

Reading Stock Charts

Below are some points to keep in mind before you start reading charts:

Uptrend – When stocks show upward movement over a period, with a series of higher highs and lows, it is termed an uptrend.
Downtrend – A downtrend occurs when stocks show downward movement over a period, with a series of lower highs and lows.
Support – The level at which a stock stops sinking in a downtrend before rising again is termed support.
Resistance – This is the level at which the stock’s price stops rising before falling again.
Breakout patterns – A stock chart might show different patterns when a certain trend ends or begins. These indicate entry and exit points as well as signals to buy or sell and are termed breakout patterns. Here are some common patterns:

Reading charts is most effective when you combine different technical indicators. These are mathematical computations based on an asset’s volume or price. Indicators help you understand the market psychology and the demand and supply for an asset. Let’s learn more about them.

Types of Technical Indicators

These are the common indicators investors use to predict price movement, gauge the strength and weakness of a security, or decide when to buy or sell.

Moving Average Convergence Divergence (MACD) – Moving average refers to the average of a stock’s price over a specific period. And MACD helps determine the direction and strength of a trend along with a stock’s momentum. Above-zero MACD indicates a bullish phase, while a below-zero reading signals a bearish phase.
Oscillators – These focus on the market’s momentum and help determine price reversals in a ranging market (where the price shuttles between support and resistance).
Overlays – Overlays provide insights into a stock’s demand and supply, whether it is overbought or oversold, and if any volatility is on the cards.
Momentum – Momentum indicators assess the speed with which the price of a stock changes.
Trend – These help you gauge a trend’s direction by smoothing out the price data and eliminating the noise in bar charts.
Volume – In the context of securities, volume refers to the number of price changes that happen over a certain period.
Volatility – These indicators calculate the deviation of an asset from its mean price and how dispersed the returns might be over time. For instance, dramatic price movement with frequent, unpredictable fluctuations in the short term indicates high volatility.
Breadth – Such indicators provide a holistic view of the health of an index. For example, a rising breadth indicator paired with a rising stock index signals major investor participation in the price hike.

How To Apply Technical Indicators?

Technical indicators help you devise strategies objectively, decide when to enter or exit a trade, tweak or close a trading position, and predict future price movement. Strategies use a combination of multiple indicators. Including one trend and one momentum indicator is generally recommended. Strategies address the following aspects, too:

Type of moving average to use
The extent to which the price needs to move above the moving average
When to enter the trade
Type of order to use while placing the trade
Number of shares to trade
Rules for money management
Rules for exit

Below are some points to consider before selecting or using technical indicators:

Avoid using multiple indicators of the same type, since it may lead to the same information being counted multiple times.
Choose indicators from different categories so that one can be used to validate whether another is generating correct signals.
Consider your investment style and risk appetite before researching indicators and deciding on a combination.
Apply a strategy to past data to evaluate how it would have worked historically. Backtesting can help you develop a viable strategy.
Your strategy must be clear on how to interpret readings and which actions to take.

Trading Based on Technical Analysis

Now that you have a fair idea about technical analysis, it is time to know about trading. As a trader, you must first pick the right approach among the following:

Top-Down Approach

The top-down approach involves macroeconomic analysis, which starts with the overall economy and then moves on to individual securities. The focus here is on reaping short-term gains.

Bottom-Up Approach

The bottom-up approach concentrates on individual stocks rather than the overarching economy. It involves digging into the specifics of a stock that appears fundamentally attractive and determining the best entry and exit points. This method is particularly well-suited for long-term investors.

Once you have zeroed down on an approach, you can follow the steps below:

Develop a strategy by monitoring short-term and long-term moving averages on stock price movements. A signal to buy is when the short-term average crosses above the long-term average.
Identify securities that fit your strategy, ideally those that are volatile and liquid.
Choose a brokerage that supports your chosen securities, offers tools for monitoring key technical indicators, and helps minimise costs.
Track your trades diligently and ensure your trading setup includes necessary functionalities, such as a margin account for day trading to leverage buying more shares.
Utilise the right tools for benefits like automated trading, mobile trading capabilities, or timely notifications.

Before committing to real capital, practise trading with a demo account and assess its features. Start small and be aware of the shortcomings of technical analysis, especially those associated with fundamental analysis.

Technical Analysis vs Fundamental Analysis

While the terms technical analysis and fundamental analysis are sometimes used interchangeably, they are different. Technical analysis focuses on historical trends in prices and volumes, whereas fundamental analysis studies and measures the intrinsic value of securities.

The following tables highlight the pros and cons of each method: