The term technical analysis in stock market is a term used to describe the analysis of data to predict probable future price movements of security – such as a stock or currency pair.
According to technical analysis, the collective behavior of all market participants — buying and selling — accurately portrays all relevant information for each traded security, and consequently, assigns the security its fair market value.
Broad Features of Technical Analysis in Stock Market
Let’s first understand some of its broad features before learning how to do technical analysis of stocks:
A RECURRING STORY:
Historically, price trends tend to repeat themselves over time, according to technical analysts. To do this, they consider historical stock charts, the price, and volume of the stocks, and then, using trends, they determine how the stock will move in the future. Accordingly, they pick stocks that they believe will appreciate and sell those that they believe will decline.
FUNDAMENTAL VS. TECHNICAL ANALYSIS:
An approach based on technical analysis is different from an approach based on fundamental analysis. Fundamental analysts examine the income statement and balance sheet of companies to assess their growth potential. The company should also be monitoring other factors that will lead to increased earnings in the future, outside of these financial statements. You could, for example, keep track of the new businesses that are being invested in by the company, new markets that it is entering, and new technologies it adopts, etc.
The technical analysis does not believe in this approach. The stock market moves around in circles, according to it. Making sound investments is easier if you know which section of the circle the price is currently in. You would use some analytical tools to determine the current stage of the price pattern. The type of chart, the momentum indicator, and the moving average are among those. In subsequent sections, we will examine these in more detail.
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A step-by-step guide to performing technical analysis in stock market
Choosing the Right Approach
Generally, there are two ways of approaching technical analysis: bottom-up and top-down. Short-term traders often use a top-down approach, while long-term investors use a bottom-up approach.
The top-down analysis examines the economy as a whole before examining the security. Traders would start with economies, then sectors, and finally companies in the case of stocks. In this approach, traders focus on short-term gains rather than long-term valuations. For instance, a trader may be interested in stocks with a break out from their 50-day moving average as a potential buyer.
Bottom-up investing focuses on individual stocks rather than macroeconomics. It involves exploring potential entry and exit points for stocks that appear fundamentally interesting. If an investor finds an undervalued stock in a downtrend, they can use technical analysis to identify an ideal entry point for the stock, which could be following a bottoming out process. Trading decisions are value-driven and they intend to maintain a long-term perspective.
Apart from these considerations, traders may prefer using different types of technical analysis. Simple trendlines and volume indicators are commonly used by day traders, but chart patterns and technical indicators are often used by swing or position traders. It is possible to design an algorithm using a combination of volume indicators and technical indicators that is entirely different from a trader designing an automated algorithm.
To begin with technical analysis, there are five key steps.
1. Develop a trading strategy or system
Identifying a trading system or strategy is the first step. For instance, a novice trader might choose to follow a moving average crossover strategy in which two moving averages (50-day and 200-day) are tracked on the price movement of a particular stock.
According to this strategy, if the 50-day moving average is above the 200-day moving average, it is indicative of an upward price trend and a buy signal. For a sell signal, the opposite is true.
2. Securities Identification
The above strategy is intended for highly liquid and volatile stocks, not illiquid or stable ones. In this case, you would need to choose a moving average of 15 days or 50 days according to the stock or contract.
3. Finding a Good Broker
Find a trading account that supports the type of security you want to trade (e.g., common stock, penny stock, futures, options, etc.). To avoid eroding profits, it needs to offer the necessary functionality for tracking and monitoring the selected technical indicators. A chart with moving averages on candlesticks would be appropriate for the above strategy.
4. Keeping track of and monitoring trades
Depending on the strategy, traders may require different levels of functionality. Day traders will, for example, need a margin account that gives them access to Level II quotes. In our example above, however, a basic account may be a better value.
5. Add Additional Software/Tools
It may be necessary to add other features to maximize performance. Trading on the go is a necessity for certain traders, while others may use automated trading systems to execute trades for them.
Technical Analysis Limitations
Analysts and academic researchers expect the EMH will demonstrate why historical price and volume data will not provide any actionable information. Similarly, business fundamentals do not provide any actionable data. Weak and semi-strong forms of the EMH known as these viewpoints.
Technical analysis is also criticized because history does not repeat itself exactly, so studying price patterns is of dubious importance and can be ignored. A random walk seems like a better way to model prices.
Third, some technical analysis works in some cases; however, it does so primarily through self-fulfilling prophecies. As an example, many technical traders place stop-loss orders below the 200-day moving average of a particular company. There will be a large number of sell orders if a large number of traders do that and the stock reaches that price, confirming the movement traders predicted.
This will lead to other traders selling their positions as well, strengthening the trend. A short-term sell-off may seem self-fulfilling, but it may not affect asset prices in the weeks and months to come. If enough people follow the same signal, they could cause the movement predicted by the signal, but they can’t drive prices over the long run.