If you think you have left behind statistics back in high school, well, welcome to technical analysis in day trading. In this article, I am going to guide you through how technical analysis works and why you need to learn it. Don’t worry, I will try hard to break it down in the simplest of terms.
Technical analysis is studying stocks’ past price action, such as price movements to weigh stocks and other trading securities before buying them. The base of technical analysis is that prices of stocks discount everything, history repeats itself, and finally, stock prices typically move in trends.
This is different from fundamental analysis, where traders analyze and monitor a company’s finances. With technical analysis, you go back, but fundamental analysis focuses on a company’s market value and how this influences their shares.
For instance, as a technical analyst, before I make up my mind on which stock to buy and trade, I go back in time and see how that particular stock has been doing in the last couple of hours. However, a fundamental analyst will look at a company's annual financial statement, if it is available, and see how investors and other competitors respond to that. That’s it.
Other than the obvious fact that it helps you buy stocks that might end up being profitable, why do you have to strain your eyeballs studying lines and numbers?
Using technical analysis helps you:
1. Forecast future market trends using chart patterns and indicators.
2. It is a very useful tool that helps to determine entry price, target levels, and stop-losses.
What I am trying to say is that technical analysis allows you to know at what share price you should buy a stock, the volume, if you should trade the stock for a short term or long term, and how to use stop loss measures in such a way that your probability of losing money is less than 50%. I use 50% because you never can tell – the world might decide to end at the exact moment you enter the market.
Yes, with technical analysis you can predict future market trends, but keep in mind that it is not 100% accurate. This prediction doesn’t guarantee that the trade will be successful. Technical analysis mostly protects you from emptying your bank account, even though as a day trader you are always at that point.
Now, when it comes to technical analysis, there are 4 key terms you need to be familiar with.
Support and resistance
I am not just going to explain what they are but how it applies to technical analysis. So, stay with me on this one.
A trend is the direction either a market or stock is heading. Is it up or down? There are technical names for this, and we will get to that soon enough. In the simplest form, a trend shows the performance of a stock for a certain period, like within some minutes, hours, or within a day.
Although sometimes stock prices move randomly, there are periods where there is an identifiable trend.
Trends are indicated with trendline or price movements. Trends move either upwards known as uptrends or downwards as in down trends.
Let’s use this example. Let’s say at 10:30 AM on Tuesday, our example stock was $474.97, and the price increased $480. Then it fell to $475.94. It rose and fell continuously until 2:30 PM when it got to $476.43 before it went below $474.97 at 3:00 PM. From 10:30-2:30, there was an uptrend showing a continuous rise in price and lows. You create a trendline when you connect all the periods – the price either rose or fell. It's like using a line to connect a set of dots just so that the arrow goes upwards. This is an uptrend, showing trend lines and price movement.
Now a downtrend works in the same way but in the opposite direction. You can see how we are able to spot a trend within hours in a day. Like intraday, you can also spot a trend within months.
Let’s use our example stock again; after its IPO price was at $36 in the second quarter, they hit a period of highs and lows soaring to $107.34 in the third quarter. They fell to $60.97 in quarter 4 and rose to $93.40 in quarter 1 of the next year. Now from April to February, there was an uptrend.
Based on the concept of technical analysis, what happened to our example stock intraday or within months after its IPO price is likely to happen again in the future. All of these are presented or laid down on a chart that you either create or is made available by your broker. Well, you have the exact price movement including the time of the movement.
There are three common charts: Line, bar, and candlestick.
A line chart is the most simple of all three. It is the one you see on TV and best for beginners. Line charts display closing stock.
Unlike line charts, the bar chart shows the high, low, open, and closing giving you more details about the stock.
Candlestick charts are the most popular, and they give you enough information like the bar chart but are much easier to read at a glance compared to bar charts. Candlestick is actually more useful as it shows you not only patterns, but the relationship between the patterns.
Charts are the most important element of technical analysis and should be your starting point. With charts, you can easily see a stock's past performance and its present one.
Using charts, you identify trends and draw trendlines – his is how you choose when to enter the market and exit it. Of course, to increase your chances, you need to do more – his is where support and resistance comes in.
With support and resistance, you can properly define three things:
Entry time and price
Exit time and price
You can see why technical analysis should be your side chick. It gives you a better chance at making profit and also making less mistakes.
If you are equipped with those three pieces of information you are on your way to buying lamborghinis and selling them again once the market turns against you. If you are able to identify support and resistance levels, then you will have those three pieces of information.
Support is the point in price movement on a chart where demand is so strong that a stock price won’t fall below that figure. Let me ask a question. When are you more likely to buy a stock? It will be as the price continually falls. Well, when this happens, I am not going to sell because there is nothing to gain.
However, as more people flood the market hoping to buy cheap and sell for profit, demand for the stock is suddenly higher and supply is low. At this point, the price will cease to decline. This is support.
Resistance is the other way around. Sellers flood the market, but there are not enough buyers. This restricts the price rising further. That point at which it stops rising is the resistance level.
Let’s use this example so you will see what I am talking about.
Our example stock started from $109.68 at 11:35 AM and began declining until it got to $108.66 at noon. This is the support level because it stopped declining and went up instead. This is the point you enter the market. It kept rising after an hour at $110. This is resistance as the price didn’t go above this point. What you do now is sell your stock.
One way to identify support is to notice the volume of example stocks that were traded. Low volume indicates support levels, and an increase in stocks available shows resistance. This leads to drawing a trendline for the uptrend or downtrend.
However, prices might still go above resistance levels or fall below support levels. At this point, you need entry, exit time, and price with a risk management strategy.
Now, you can implement stop loss on support trend lines or resistance. Stop loss is the maximum amount I can lose. How can you do this using support and resistance levels? Let me tell you how.
It makes more sense to set stop loss a bit below support levels and above resistance levels. So, let’s say support levels for our example stock is $50, set stop loss at $49. If resistance level is at $60, set stop loss at $61.
Stop loss will help keep you from going broke. However, with indicators, you can now salvage opportunities in the market. Besides, with indicators you can better pinpoint support and resistance levels, especially entry and exit points. In trading, there are a few times, not all that much, that you hit big. Making use of indicators can help you identify the opportunities for that.
Here are three common indicators:
Relative Strength Index, RSI
Moving Averages, which is often in intraday trading.
Moving Average Convergence Divergence, MACD.
Let me show you how indicators relate to everything I have explained so far. Before I jump into that, know that there are several indicators out there. Your focus shouldn’t be going for what some guy or girl says is the best and works well. You should instead learn about each indicator, how they work, and pick whichever you think you can handle.
Now, let's get back to how indicators work and relate to trends, charts and support and resistance.
Indicators like RSI will further access ORCL support and resistance levels on a trend. How? First, RSI indicators are reliable especially for people like me, day traders. RSI represents an asset’s relative strength.
Now, after choosing a timeframe or better still a trend for ORCL, next is to configure RSI on a chart that represents ORCL price movement for that period. With this, the support and resistance level is more visible. Using RSI with moving averages will help you better define these levels.
However, it could also lead to mixed indicator signals. There are cases where the RSI indicator relays a buy signal and MACD shows a sell signal on a chart. How are you going to make a decision through this?
There are also some instances that just as two indicators might be saying two different things, two technical analysts may have contrasting views about the same stock. The reason could be that both analysts used different technical analysis methods.
Technical analysis is a whole new world on its own and can be challenging to understand. This is entirely down to too much information about it. You have different charting patterns, different indicators, and understanding the concept of support and resistance and its impact on defining trends.
Instead of trying to digest all the knowledge, focus on an approach. You can develop your own strategy or trading system. You don’t need to study all the charts there are, and use all the indicators before you determine entry or exit points. I am no doctor, but doing all of that will certainly give me a migraine.
The logic behind technical analysis is that since selecting the right stock, including its entry price, puts you in a position with a high potential for profits, studying charts and using indicators will help you better in determining this position.
Of course, there are other benefits such as how it provides lots of important information about a stock at a go and helps put in place risk management measures such as stop losses. This makes technical analysis a really useful instrument that novice day traders can use having not learned the ropes of the stock market.