How to Use Technical Analysis in the Stock Market?

Imagine entering a car showroom with three models to choose from. How do you decide? You consider factors like mileage, engine, and safety ratings. Similarly, picking a stock or figuring out ‘How to invest in share market?’ involves analyzing several parameters, just like choosing a car. You’ll need to look at fundamental and technical factors to select a stock that aligns with your financial goals. Through this article, let’s look at the technical analysis.

What is Technical Analysis?

Technical analysis uses charts and statistics to understand financial markets and find the best times to trade. Traders use it to spot opportunities based on price changes, volume, momentum, and volatility. The idea behind it is that the actions of all market participants — buying and selling — reflect all relevant information and set a fair market value for the security.

How to Implement Technical Analysis?

A] Assumptions of technical analysis:

The first step to getting started with technical analysis is to understand the three key assumptions:

• Market price reflects everything: This idea, known as the efficient market hypothesis, suggests that the asset’s current price already includes all factors that could influence it. Because of this, technical analysts focus on price movements instead of fundamental factors.
• Asset prices follow trends: Even though there are countless price movements throughout the day, they aren’t random. Instead, they follow specific trends. Technical analysis aims to identify and use these trends to predict future price movements.
• Price patterns repeat: Prices in financial markets are driven by investor sentiments like fear and greed. Because of this, past price patterns often repeat when similar emotional conditions arise again.

B] Technical Analysis Indicators:

The second step in using technical analysis is knowing the technical indicators. When analyzing the stock market, you’ll come across three main types of technical indicators: charts, moving averages, and momentum indicators.

• Charts:

Charts graphically represent stock prices and volumes, helping traders decide on investments. The different types of charts are:

• Line Chart: This simple chart connects the closing prices of an asset over time, making it easy to identify trends, support, and resistance levels. However, it doesn’t show a trading session’s price range, highs, or lows.
• Bar Chart: Widely used in technical analysis, bar charts display the open, high, low, and close prices for each period. This makes it easy to spot trends and make trading decisions.
• Candlestick Chart: An older chart type, candlestick charts visually represent market sentiment and trader psychology. The “real body” shows the price range between the open and close, with wicks indicating highs and lows. Colors like red and green distinguish down days from up days. Candlestick charts also form patterns, such as bullish or bearish, which suggest potential price movements.
• Renko Chart: These charts focus on price movements, filtering out minor fluctuations. They use brick shapes for representation. New bricks form only when prices move a certain amount, making identifying trends easier. While they simplify trends, Renko charts might omit some price details.

• Moving Averages:

Moving averages smooth out price data, providing a clearer trend. This tool helps you identify the direction of a stock’s trend and its support and resistance levels (levels where a stock’s price tends to stop and reverse its direction). Moving averages are customizable, allowing you to choose your preferred time frame. A shorter timeframe makes the average indicator more responsive to price changes, while a longer span makes it less sensitive. There are two types of MAs: SMA (Simple Moving Average) and EMA (Exponential Moving Average).

• Momentum Indicators:

Momentum indicators measure the strength and speed of price movements. They show when price changes occur, helping traders gauge market sentiment. Two common indicators are:

• MACD (Moving Average Convergence Divergence) is a trend-following tool that shows the relationship between two moving averages. Traders use it to spot buy or sell signals.
• RSI (Relative Strength Index): This indicator measures the change in price movements and the magnitude of such changes to help identify overbought or oversold conditions.

Club these indicators suitably and try identifying stock trends using the stock components: the market price, the 52-week high and low, the closing price, and the opening price.

C] Identify Trend:

Once you grasp the basics of technical analysis and understand which parts of a stock chart to focus on, the next step is to look for trends in the stock. Familiarize yourself with the following to identify trends-

• Patterns: Look for any distinct or clear patterns on the stock chart, like upward lines, downward moving lines, or other shapes and patterns, such as forming an ‘M’ or a ‘W’.
• Cycles refer to periods when the price trends in one direction before changing course. For instance, price trends may move in a particular pattern during state elections or policy change announcements.
• Resistance is a price level at which there is likely to be a significant increase in selling activity. When the stock price reaches this level, it often struggles to move higher.
• Support: Conversely, support is a price level where buying activity tends to increase. At this point, the stock price may struggle to drop further.
• Trend Line: A straight line connects two or more price points on a chart and extends into the future. This line helps identify and confirm trends. Trend lines form support and resistance levels that are particularly useful for analyzing stock movements.

Do these components give an accurate analysis?  The accuracy of technical analysis can differ from trader to trader. To check the accuracy of your analysis, try backtesting your strategy with historical data. Compare your predictions with what happened in the market.

Bottomline:

Technical analysis helps you spot patterns, trends, and potential movements in the stock market, but it doesn’t accurately predict future prices. A strong risk management strategy in your trading plan is essential, preferably with expert guidance. This approach minimizes losses if predictions don’t go as planned. Don’t forget to consider the power of compounding when planning long-term investments, as it significantly enhances your portfolio’s growth over time.

FAQs:

• What are the drawbacks of technical analysis?

• Technical Analysis ignores market fundamentals, leading to risky trading decisions when price movements don’t match company performance.
• Subjective interpretations can lead to different conclusions, increasing trading risks and reducing reliability.
• Technical indicators often lag in reacting to market changes, causing traders to miss early trend shifts.
• Technical analysis frequently generates false signals, frustrating traders when expected trends fail to materialize.
• Relying solely on past patterns is risky, as market dynamics constantly evolve, making historical trends less predictive.

• Should I use technical analysis methods or fundamental ones?

Both fundamental and technical analysis offer valuable insights. Since your investment duration could change, using both forms of analysis is worth considering. For instance, you could use fundamental analysis to choose a stock and technical analysis to pinpoint the best entry or exit price.