Technical Analysis is the study of historical price movements to identify known repetitive patterns and determine future price movements' probabilities through the use of technical concepts, technical indicators, and other analysis tools.
Technical Analysis, in general, is a vast subject as any technical concept used in share market trading and investing falls under it.
Below are some of the crucial aspects of Technical Analysis.
Price chart Patterns
Support and Resistance
Types of Trading
Let us explore all these aspects one by one.
Table of Content
How does Technical Analysis work?
Technical Analysts don't consider any aspects of fundamental factors for their trading. They believe only past information of 'Price' and 'Volume' of a stock is enough to predict the future movements.
Technical Analysis works on a few vital assumptions:
Price consists of all the Information – Any open or hidden information about stock will reflect in the price of the particular stock.
For example, a key person in a company came to know that his company will be benefitted immensely due to a new contract.
Hence, he decides to accumulate some shares with the help of others (insider trading or buying) for quick gains.
His accumulation results in extra volume compared to daily average volume and push the price on the upside.
Hence, a technical analyst can quickly notice these changes in the price and volume.
Price displays different Trends - A price can move in different trends along with time.
There are three types of trend:
A stock price can be on an uptrend for a few months. Later it can change the direction and can move in sideways or downtrend.
Understanding these trends and identification of the change in trend early can offer significant benefits to traders.
History trends to repeat – Only two factors drive the stock market – 1) Greed and 2) Fear.
Irrespective of change in the world's economy and advancement in technology, people make their trading decisions based on emotions. Hence, the same patterns appear again and again.
Technical Analysis vs. Fundamental Analysis
Fundamental analysis focuses more on qualitative aspects such as PE ratio, balance sheet, cash flow, debt-to-equity ratio, etc. They use all this fundamental information to arrive at the Intrinsic Value of a company.
If the stock price is undervalued, then fundamentalists plan to accumulate the shares assuming the price will reach its value in some time.
Technical Analysis focuses on price and volume. Technical traders use only this information to manage their trades.
Is Technical Analysis useful?
When you drive in unknown terrain, it is better to use Google Maps. Because most of the time, it will guide you in the right direction.
Similarly, if you are new to the share market, it makes sense to use technical analysis to guide you in the right direction.
Many people downgrade the importance of technical analysis. But what they forget is traders don't lose money because of technical analysis, but they lose money because they fail to apply proper aspects of technical analysis with discipline.
Different chart Types in Technical Analysis
The price is represented in many chart patterns. Some of the vital chart types are below:
Point and Figure chart
Heikin Ashi chart
The Candlestick chart is the most popular and visually appealing. Hence, it is better to use a candlestick chart for the analysis.
For more information on other chart types, please read 'Different chart types.'
Important Chart Patterns in Trading
Chart patterns are an essential aspect of technical analysis, but people need to study them for some time to identify them in the live market.
A chart pattern is a known shape within the price chart and predicts how the price can move later.
Below are some of the crucial chart patterns.
Head and Shoulder Pattern
Head and Shoulder is a bearish chart pattern.
It has a large peak at the center and two minor peaks on either side of it.
Once the third peak breaks the neckline, it indicates that the prior uptrend is over and the beginning of a downtrend.
Many technical analysts target the height of the head (from the neckline) on the downside.
Inverse Head and Shoulder Pattern
The Inverse Head and Shoulder pattern is similar to Head and Shoulder, but it is a bullish chart pattern.
It has a large peak at the center and two minor peaks on either side of it.
Once the third peak breaks the neckline on the upside, it indicates that the prior downtrend is over and the beginning of the uptrend.
Technical analysts target the height of the head (from the neckline) on the upside.
Cup and Handle Pattern
The cup and handle is a bullish continuation pattern.
It appears in the stocks which are in a strong uptrend. The cup looks similar to the rounding bottom pattern, and it indicates the buildup.
After the formation of the cup, it gives a minor retracement which is nothing but a handle.
The break of the handle indicates all the selling has been negated, and the price is ready to give a good move on the upside.
Technical analysts target the height of the cup (from the neckline) on the upside.
Bull Flag Pattern
The bull flag is also a bullish continuation pattern.
It appears in the stocks which are in a strong uptrend. It forms a 'pole' first, which indicates a swift rally on the upside.
After the formation of a pole, it gives a minor retracement which looks like a flag.
The break of the flag indicates all the selling has been negated, and the price is ready to give a good move on the upside.
Traders keep the height of the pole as their target on the upside.
Bear Flag Pattern
The bear flag is similar to the bull flag but on the opposite side. It is a bearish continuation pattern.
It appears in the stocks which are in a strong downtrend. It forms a 'pole' first, which indicates a swift fall on the downside.
After the formation of the pole, it gives a slight bounce which looks like a flag.
The break of the flag indicates all the buying has been negated, and the price is ready to give a good move on the downside.
Traders keep the height of the pole as their target on the downside.
Triangle Pattern (symmetrical, ascending, and descending)
A triangle pattern is a consolidation pattern between the trend and indicates the continuation of the existing trend.
There are 3 variations in the triangle pattern:
The above image shows an example of a symmetrical triangle pattern.
Earlier, the price was in a strong uptrend. Then it displayed sideways consolidation for some time.
During the consolidation, it made swing lows and highs within the triangle. At one point, it broke the triangle pattern and continued its rally on the upside.
The above image shows an example of ascending triangle pattern.
Earlier, the price displayed sideways consolidation for some time.
During the consolidation, it made swing lows and highs within the triangle. It made all the highs at the same level, but all lows at a higher level. It is a critical characteristic of ascending triangle.
At one point, it broke the triangle pattern and rallied on the upside. Traders take the triangle's width (from high to low) and target the same level as their target after the breakout.
The above image shows an example of descending triangle pattern.
Earlier, the price displayed sideways consolidation for some time.
During the consolidation, it made swing lows and highs within the triangle. It made all the swing lows at the same level, but all swing highs at a lower level. It is an essential characteristic of a descending triangle.
At one point, it broke the triangle pattern and started falling. Traders take the width of the triangle (from high to low) and target the same level as their target after the breakdown.
We have 1000s of technical indicators in technical analysis. All technical indicators available in the stock market are derived using different types of calculations from the same price information: open, close, high, low, and volume.
Technically, all indicators can be divided into 4 types, as shown below:
Usually, trend-following traders use trend indicators to support their trading views.
Moving averages (MA), MACD, average directional index (ADX), parabolic SAR (PSAR), and linear regression are some examples of trend indicators.
These indicators are designed to show the direction and strength of any stock or index. The direction of the trend can be upwards, downwards, or sideways.
These are all lagging indicators.
These indicators are used to measure the speed (or momentum) of stock in a given period.
Short-term traders focus on stocks that move significantly in one direction to make quick money. For this reason, they use momentum indicators like RSI, Stochastics, CCI (Commodity Channel Index), and Williams %R.
Below are the 2 widely used, essential characteristics of momentum indicators:
Overbought and oversold conditions.
Bullish and bearish divergences.
Usually, overbought and oversold conditions predict the end of a trend and take the trades in the opposite direction of the existing trend.
For example, if a momentum indicator shows an overbought condition for a stock, traders will look to sell it.
Similarly, divergences are used to pick the end of a trend by identifying its weakness and to make trades in the opposite direction of the trend.
Volatility is the relative rate at which the price of a security moves up and down.
A high volatility condition is suitable for short-term traders. Because of this, many volatility indicators such as Bollinger Band (BB), Average True Range (ATR), Donchin channel, and volatility Chaikin have been developed.
The volume plays a crucial role in trading. A trend with a high volume indicates that the probability of the price moving in the direction of the trend is high. Hence, this can be used to confirm a trend or trend reversal.
A few examples are the money flow index, Chaikin money flow, force index, and on-balance volume.
We will explore some of the popular indicators which are widely used/discussed in the trading community.
MACD acts as both trend following and momentum oscillator. Technically it belongs to the momentum oscillator category. However, it is not typically used to identify overbought and oversold situations like any other oscillator.
The MACD fluctuates above and below the zero line based on whether the two MA converge or diverge.
MACD indicator consists of 3 components:
MACD line is drawn after subtracting 26 days EMA from 12 days EMA (MACD line = 12 days EMA – 26 day EMA).
A signal line is nothing but 9 days EMA.
MACD Histogram is drawn using the difference between the MACD line and the Signal line. It is positive when the MACD line crosses above the signal line, and it turns negative when the MACD line crosses below the signal line.
As the name suggests, MACD is all about 'convergence' and 'divergence' of the two moving averages on the chart. Convergence occurs when the moving averages are close to each other. When the moving averages move away from each other, divergence occurs.
Traders use MACD is in different ways. Some of the methods are below:
When the MACD line crosses above zero is considered Bullish, it is viewed as Bearish when the MACD crosses below zero.
When the MACD line crosses above the signal line, it is considered bullish. When the MACD crosses below, the signal line is bearish.
Image-16 and image-17 show the examples for both methods.
Moving Average Indicator
Moving Averages calculate the mean value of a stock's price movements over a selected period; hence they negate all the short-term spikes or quick moves.
The moving average is a lagging indicator as they are calculated using the past price action. As a lagging indicator, the moving average is the best tool to confirm a stock trend rather than predict future direction or momentum.
There are two types of moving averages:
Simple Moving Averages (SMA) – It takes the candles' closing price, calculates the average over the mentioned period, and plots on the chart.
Exponential Moving Averages (EMA) – It gives more weightage to recent price action and calculates the average of the mentioned period.
SMA is helpful for long-term traders, and EMA is helpful for short-term traders. As the swing trade holding period is between 2 days to 3 weeks, it's better to use EMA.
One simple and effective way to use SMA for swing trading is to watch out for a short-term moving average (like 5 SMA) that crosses a long-term moving average (50 SMA).
When a faster-moving average crosses a slower-moving average from below, it can indicate a big move on the upside in the coming days.
Similarly, when a faster-moving average crosses a slower moving average from above, it can indicate a big move on the downside in the coming days.
John Bollinger develops Bollinger Bands in the mid-1980s, and it consists of 3 different lines :
A 20 period SMA as midline
Two lines as two standard deviations above and below the midline
The distance between bands is based on the standard deviation; hence they contrast and expand based on the price fluctuations, which is nothing but volatility.
If the volatility is high, then the band will expand, and if the volatility is less, then the band would contrast. Hence, these bands also can be used to identify the overbought and oversold condition in any scrip.
When the band squeezes due to low volatility, there is a high probability of a sharp and quick price move in any direction. It is recognized as the 'Bollinger Band Squeeze Breakout' trading method. Some traders use methods for their trading. As the price moves in any direction, the bands will expand slowly.
The price keeps on hugging any band (upper or lower) in a robust trending environment. In case of a sideways move, the price keeps on rotating between upper and lower bands.
To know more about other technical indicators, check 'Top-10 Indicators in Trading'.
Getting Started in Technical Analysis
Technical Analysis is like a big ocean, and it is practically impossible to study all its aspects.
For example, there are 1000s of technical indicators present in technical analysis. But studying all these indicators is impossible, and it is not necessary as well.
The best way to get mastery in technical analysis is by understanding the core principles, picking the top tool that suits you better, and developing your own system after backtesting it with historical data.
Pick a Trading Style
There are many trading types – intraday trading, swing trading, positional trading, or scalping. If you are a working professional between 9-to-5, there is no need to go in-depth about scalping or intraday trading. Such people can focus on either swing trading or any BTST technique like breakout trading.
In contrast, if another person is free during market hours and aims to make quick returns, he can learn intraday trading. Besides, he can also learn different options trading strategies.
Chose one Indicator or Price Action
As you know, we have over 1000s indicators. One can pick either one indicator or price action to improve their trading skills.
One indicator behavior is unique in different market conditions, and getting a clear understanding of how it behaves in different market conditions is gives an edge to the trader.
Price Action Trading is all about studying price in-depth, without using any indicators. Most of the indicators are derived from the price, and the analysis of any indicator also indicates the indirect analysis of price.
A deep understanding of price action helps a trader take the early entries and avoids dependency on the indicators.
Backtest the Trading Strategy
The illusion of knowledge is more dangerous than the lack of knowledge.
A simple understanding of a trading concept or system is not enough to get success in trading.
Detailed backtesting is essential to know the trading system's performance and get an increased conviction in trading.
Many people fail at this stage, as they don't do required backtesting because of laziness, lack of time, or overconfidence.
Money Management Rules
"Even a poor trading system could make money with good money management" – Jack D. Schwager.
In boxing, you will be in the game until you avoid a knockout.
Similarly, in trading, you will be in the game until avoiding big dents to your portfolio.
Hence, avoiding significant losses is the most critical aspect of successful trading. It can be achieved only through simple money management rules.
One simple rule is a trader should not lose more than 2% of his capital if the trade goes wrong. Even if he gets 5 failed trades continuously, he will lose only 10% of the capital and easily survive.
Psychology means the mental factors or emotions governing a situation or activity. So, when we say trading psychology, it implies cognitive factors governing trading.
Four primary emotions revolving around trading are greed, fear, regret, and hope.
Please note, all these factors emerge because of a lack of knowledge.
Backtesting, meditation, and maintaining a trading journal help to achieve a better trading mindset.
What are Support and Resistance?
Support and Resistance are the key price levels in which major bulls or bears present, and sometimes they fight with each other to give a decisive move in one direction.
Support is the price level at which demand is assumed strong enough to prevent a further fall in the price.
At this level, buyers are more inclined towards buying, and sellers are less willing to sell.
Resistance is the price level at which selling is assumed strong enough to prevent the price from rising.
At this level, sellers are more inclined towards selling, and buyers are less willing to buy.
Please read 'How to use support and resistance in trading?' to know more about support and resistance.
Important Candlestick Patterns in Trading
Candlestick charts and their patterns are invented in Japan over 300 years ago, and it is the most popular chart pattern among traders and investors.
If a trader observes candlestick charts over some time, some patterns occur repeatedly. If he develops the ability to identify these patterns and uses it correctly, it gives an extra edge in his trading.
There are thousands of candlesticks patterns present in the technical analysis world. Studying and memorizing all these patterns are practically impossible.
It is better to shortlist the patterns based on the "Impact" and "Repeated Occurrence."
Because if a candlestick pattern has less impact, then it is not helpful. Similarly, if a candlestick pattern is powerful, but if it rarely occurs, then again, it is of no use.
Below are some of the important candlestick patterns in technical analysis.
Image 24 shows how these patterns appear on the chart.
Please read '6 Candlestick Patterns to Step-up your Trading' to know more about these candlestick patterns.
Technical Analysis for Gold
Indians don't think straight when gold is involved. We use gold to express our feelings, and many give priority to gold over other life ambitions.
All technical concepts work similarly for gold as well.
The above image shows the weekly chart gold in MCX Exchange.
The price was moving slowly in an upward slope channel. But once, it broke the upper line, it resulted in a significant move upside.
Hence, traders can use all the aspects of technical analysis in gold trading. In fact, the same concepts can also be applied to silver, Nickel, and all other commodity products.
Best Technical Indicator for Day Trading
Day trading is a lucrative career for many youngsters and side-hustlers as it provides many luxuries such as working from any place, no troubles from the boss.
Nevertheless, it can be challenging for beginners, and sometimes even experienced intraday traders face losses and go through emotional issues.
In intraday trading, one has to buy and sell the stocks (or indices) on the same day.
If a person wants to start with intraday trading, he needs to learn the in-depth technical analysis aspects. One such essential concept to get success in day trading is market profile.
Market Profile is a technical concept with a unique charting technique developed by Peter Steidlmayer when trading at the Chicago Board of Trade (CBOT), and it was open to the public in 1985.
Market profile is a style of plotting "Price" on the Y-axis and "Time" on the X-axis, which forms a bell-shaped image as the body of the profile.
Market Profile assists the traders to read the current market trends as it unfolds. It provides a 3-Dimensional view as compared to the traditional 2D view in Candlesticks charts.
The prominent feature of the market profile is it enforces the traders to study the market dynamics and don't generate any buy or selling decisions.
Hence, Market Profile plays a different role as compared to any traditional indicators in the market.
Please read 'Market Profile – Game Changer in Intraday Trading' to know more about Market Profile.
What are the Good Books on Technical Analysis?
Amazon has millions of books on the topic of 'Technical Analysis.' However, it's tricky for beginners and intermediate-level traders to find good books on Trading and Investment.
Below are some of the good books on technical analysis.
Technical Analysis of the Financial Markets by John Murphy
How to Make Money Trading with Candlestick Charts by Balakrishna M Sadekar
Trade and Grow Rich by Indrazith Shantharaj and Kiran Nayak
How to Avoid Loss and Earn Consistently in the Stock Market by Prasenjit Paul
(All are paid links)
Software for Technical Analysis
Nowadays, most websites provide all the advanced features of charting, scanners, and backtesting. For example, Tradingview, Gocharting, Chartink, Investing, Icharts, Moneycontrol provides most of the technical analysis features.
If a trader is keen to learn more, then the below software is beneficial.
Amibroker – For backtesing and algo trading
Ninjatrader – For backtesting and trading
Metatrader – For backtesting and trading
eSignal – For indicator development and trading
Free Online Course on Technical Analysis
It's important to understand two herds that exist in the market:
1. Smart Money and 2. Dumb Money
'Smart Money refers to FIIs, big sharks who have money & info who give direction & momentum to markets.
'Dumb Money' refers to nonprofessional traders, retail traders who often try to make quick money.
Participation from smart money gives a big move, and following them is always a good idea to get profitable trades.
Hence, picking the right trading course is always important.
If you want to learn more, then you can try the course' Beginners Guide to Stock Market Trading'