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Buying and selling stocks should not be done without a thorough analysis. One very important school of thought that guides stock traders is technical analysis. Technical analysis is a method that relies heavily on a person’s ability to understand trends and patterns. This article will help you learn on how to use this method when trading stocks.
What is technical analysis?
Technical analysis is another school of thought used in stock investing. It refers to the method by which statistics such as price and volume are used to analyze a stock’s current and future performance. It is an intelligent use of charts to identify historical patterns that can suggest a stock’s future directions.
Technical analysis differs from fundamental analysis in various aspects. In a technical analysis, the analyst does not pay attention to the intrinsic value of a stock, unlike that in a fundamental analysis. The price movements driven by supply and demand are the basic guiding principle whether to buy or sell. Technical analysts, who are also known as chartists, do not analyze the components of the markets, only the market itself and its sentiments. Therefore, unlike fundamental analysts, chartists do not look into financial statements but into charts. Their time frame is very short, maybe days or weeks, or even minutes. Fundamental analysts however take into account historical data, going as far back as five years ago if necessary. While fundamental analysis is often used for investing in assets that are believed to increase in value in the future, technical analysis on the other hand is utilized in trading and the goal is to be able to sell it a higher price.
Support and Resistance
The very basic approach used in technical analysis is trend analysis. Once you have looked into the trend, you should be able to determine two important points – the support and resistance. These are points, likened to a barrier, where the stock price, for instance, rarely passes. Support refers to the level through which the price seldom drops. In contrast, resistance is that level which the market or stock has difficulty exceeding. Support signals that point where many traders are willing to purchase while resistance is that level which many would tend to sell. Once the stock, security, or market goes outside these points, it is thought that the movements have shifted and a new set of support and resistance levels are determined.
Traders merely use these levels but usually they are not advised to place orders directly at the exact points of support and resistance because of the volatility surrounding these points. If you are bullish over a particular stock that is moving toward the support level, place it at slightly within a few points above this level. Do not trade until you have determined these two points and take note that these points do not reflect the law, they are mere imaginary lines and you must be quick to adjust once these points shift. If you are planning to buy a stock and its trend exhibits a resistance and the price is moving towards the resistance, wait until the stock breaks the resistance, otherwise, you will lose money when it bounces back to the lower end. Pay attention to recent levels as these are more significant than past trends.
Volume is another tool of technical analysts. Volume simply refers to the number of shares traded over a specified period, usually one day. A higher volume excites investors as this indicates greater activity. Volume helps traders determine if the price trend is weak or not, if it signals a trend reversal or just a tiny bleep. It is important to see price and volume go in the same upward direction. An increasing price should be reflective of growing interest on that particular piece of investment which is ascertained by the growing volume. Be wary if you can see a divergence between the volume and the price. An upward trend in the price combined with a low trade volume can signal a weak upward trend and the stock price may be nearing its peak at least during a specified period of time.
Charts and Other Signals
One of the fundamental support systems of technical analysis is the chart. A chart provides price movements of a stock over a given time frame . The patterns shown in a chart serve as trade signals or opportunities. Analysts determine current trends, likely reversal, and future price movements based on these signals.
Technical analysts use four kinds of charts: the line, bar, candlestick, and point and figure charts. A chart varies from another based on the details that it can show. For instance, a line chart shows only the closing price of a stock for each stock trading day while the bar chart shows both the opening and the closing prices. A typical stock chart shows the prices at the vertical right-hand side while the horizontal part, known as the X-axis, shows the corresponding period or date. To determine the change between two points, just get the difference between the prices of the ending and beginning periods that you have specified.
Below, you will find a picture of a candlestick chart. Red indicates a drop and green indicates increase in price:
Charts present quite noisy patterns in the prices making it difficult for traders to get its overall trend. This is addressed by the moving averages method. A moving average refers to the stock’s average price for a given period. These moving averages are then plotted in a chart to show a smooth price movement.
There are various other metrics used by technical analysts to buy and sell stocks, such as RSI, Bollinger Bands, McClellan Oscillator, and numerous other indicators. However, those more advanced metrics will be covered in another post on technical analysis.
You must remember though that charts only serve as guide for the formulation of ideas; there is no known pattern that could provide a 100 percent assurance where the price is headed. So a great deal is left to interpretation, this is why charting is usually considered not as a science but an art.
Through technical analysis, you can formulate a strategy that can let you gain profits in such a short period of time. Many investors apply this method together with fundamental analysis especially for those who tend to buy and hold, because while the latter provides them ideas about intrinsic values, it does not say when is the best time to buy or sell a stock but a technical analysis does and this is how this method gets its merit.