Technical Analysis Pt. 1: Introduction
Technical analysis, frequently abbreviated to TA among the jargon used by investors reflects on past price movements of shares, changes in trading volume and chart analysis to predict future share prices. It concentrates on psychological factors of traders rather than macroeconomic influences and thus is used mostly for short-term trading decisions.
Technical analysis is frequently compared to fundamental analysis. While the latter uses earnings reports of companies, interest rates levels and competitors to assess share price development, technical analysis focuses on historical charts and graphs.
Two types of charts:
Within technical analysis, one can use line charts as well as candlestick charts.
The so-called line charts simply map out all closing prices (the share price at the moment markets close) and link them with a line to showcase the historical trend followed by certain securities. On the other hand, candlestick charts are far more precise as they map out the opening, closing, high and low of the timeframe selected by the investor. This can range from a few minutes to multiple years depending of the purpose of the analysis. In other words, the investor can select which timeframe the candlestick will represent depending on what you are looking for and how much in details you want to delve into. This information will gain more clarity in the next section.
How to read a candlestick?
If you visit a broker and select the candlestick chart, you will be presented with two types of candlesticks: red ones and green ones. The green colour simply means that the closing price is above the closing price. Vice versa, the red one means that the price has fallen over the selected timeframe. A commonly used term for this is that the security ‘followed a negative trend.’ The two lines above and below the main body are called tails, wicks or shadows. These exist to help you assess the market psychology. For instance, if the wicks are very long compared to the main body it is an indicator of volatility. In other words, the future price development of the security is hard to predict and does not follow overall market development. Using topics discussed previously in the market basics series, a risk-averse investor may think of hedging his investment by purchasing options or convertibles as their prices tend to benefit from volatile times.
So why are candlesticks used in investment banking?
The purpose served by candlesticks can be best discussed using the following chart.
Starting at the bottom left of the chart, we can see a bullish movement characterized by the first upward sloping line. By drawing a horizontal line from the far right of the graph which touches the peak of this first upward price movement (indicated by the green arrow), you will be able to see if the high was broken (the price continued to grow from here) or not which will help you assess if the trend will continue or not. The level at which this line is drawn is known as the “resistance” of the security. In this case, the resistance level is indicated by the red line.
This first 3-point move will tell us if we are in a bullish or bearish market. After this we have to determine our so-called “support level” which we get by drawing a horizontal line touching the second point (A.K.A. low of pullback, indicated by the red arrow). In this case, the support level is indicated by the blue line.
Going forward. you continue working with these two lines to determine resistances or supports, which will tell you when to be skeptical about a trade and when to buy. Although this strategy will not be 100% accurate, it will help you stay consistent in your strategy. A typical move is to wait for the market to break your resistance (you will go long) or to break your support (you will go short).
In our opinion, you should objectively select how you use TA:
The first common argument against using the technical analysis approach is that most indicators are simply mathematic formulas applied to the available price data of the stock. This can be confusing as, for example traders may believe that the stock is not moving up as fast as expected and thus will think that it is losing its momentum. Here, the investor must look at the data objectively and compare with the other data, as any upward move will look weaker after an intense jump that happened before. To do so, the investor can adapt the time frame accordingly to be sure your analysis fits the current volatility of the stock.
Having said this, patterns in investing do form over and over again. Emotional responses of traders have been the same for a long time and you can see this on many long-term charts. Look at this DOW JONES chart for example:
You can see that approximately every 10 years, a small correction occurs. As indicated by the blue arrows, this happened in 1987, 1998, 2007. After an all-time high in 2018 and it entering so-called “correction territory”, we are currently experiencing a downward trend.
Stay tuned for a continuation on technical analysis next week and a step by step guide on simple basic trading based on TA.