Technical Analysis Pt. 3: Trends & Indicators
Welcome back to your introduction to technical analysis. If you have not read last week’s article we advise you to take 10 minutes and read the first part of our introduction to TA to get a better understanding of this week.
We will start by summarising last week very quickly by looking at the following chart:
By analysing the period after the lowest low, one can identify an upward movement in price. So how could an investor gauge that this price increase is a temporary one? As was explained in more detail last week, the investor can increase their certainty by studying the length of the wicks. In short, the longer the wick the higher the trading volume. For example, if the volume of trades executed is increasing proportionately with the price, the trader will feel safer to execute a long trade on that stock. However, as also stated in previous installments, one can never be 100% certain and should be cautious, as it remains a trade based on speculation.
Other important aspects discussed last week were the SMA and the EMA. One can see on the chart above that the SMA support is close to be broken through and that the bearish volume is increasing. A realistic decision would be to go short on this S&P500, because basic TA analysis indicates that the price is falling, while the trade volume is increasing day by day. The fact that the SME support has been broken further indicates that prices have peaked for the coming period.
Forecasting the trend of the share price will help an investor establish just how hectic they will have to be while trading. If one choses to trade with the trend, trades will be much longer than if the investor choses to trade against the trend. Intuitively, this makes sense, because regardless of a future uptrend or downtrend, price fluctuations are a given. If an investor decides to trade against the trend, they will seek to benefit from these fluctuations instead of the trend and thus, the trades will be shorter.
So how can one recognise an uptrend or downtrend?
The basic notion behind an uptrend is that one can identify both higher highs and higher lows than historical figures. This is depicted in the chart below:
Starting from May, every month highs can be identified which are higher than highs in the previous month. Furthermore, the lows are also higher than the lows in the previous periods.
The following chart shows a downtrend:
As can be seen in the chart, the November low of 2.631 is higher than the lows in the months following. This is labelled as a downtrend.
Here, if the investor chooses to trade against the trend, they may aim to enter a long position at a low. As can be seen, the price increase periods are much shorter than the price decrease ones and thus, an investor must be more active and reactive while trading. The trader will look for oversold or overbought shares and thus use an indicator such as RSI which will be explained in more detail later.
Which chart should you use?
As a daily trader, one should use the hourly or shorter chart. Long-term traders should rather opt for the daily, weekly or even monthly charts.
If one chooses a daily chart, the higher lows and higher highs, for example will be based on a 24-hour time frame.
Indicators are what we would call a complex way to represent market data. They take price information, manipulate it and present it in a different way in order to guide trades.
Different indicators will have different goals, but always use the same price data to make calculations and manipulation of the data the only area of change for the outcome of a certain indicator.
An important aspect to be aware of is that indicators are descriptive and not predictive. Shortly, they summarise what happened but do not tell you what will be happening in the future. Because of that, the assumption that indicators are always lagging behind can be considered as true.
Different indicators will have different degrees of complexity. As there are hundreds of different indicators and new ones being elaborated regularly, we advise investors to stick to one and develop an in-depth understanding. This will enable close analyse of changes in value.
One example of an important indicator is the RSI, or the relative strength indicator. This presents the investor with a value that can range from 0-100 and will indicate whether a stock was overbought or oversold. A value close to 100 will indicate that a stock has been overbought and, on the other hand a value close to 0 indicates that it has been oversold.
Sequentially, the investor can act upon that by buying oversold and selling overbought.
The RSI indicator always uses 14 periods for its computations. If one takes a 5 minutes chart, the RSI will take data from 14 times 5 minutes. If one takes a daily chart, the RSI indicator will compute it by using the past 14 trading days.