Technical analysis of a stock is a way of analyzing market data that involves identifying trends in stock price movements over time. It’s used by traders to predict future prices and determine when to buy or sell stocks.
It helps investors understand whether a stock is likely to rise or fall in value in future. Thus, it makes one of the trading strategies employed by the traders to trade stocks.
This step-by-step guide to technical analysis of stocks shall help you understand how to research a stock by reading charts and take informed trading decision!
Understand The Basics of Technical Analysis
There are two main ways to use technical analysis of stocks: reading chart patterns and using technical indicators on stock charts.
Before you start your stock research for trading, you must know various chart patterns, candlestick patterns and the technical indicators.
Chart patterns have their implications in indicating the probable direction in which stock may move in future. The bullish patterns are signal to buy stocks while bearish patterns indicate to exit an existing buy position or short sell stocks to make gains from declining stock prices.
Technical indicators act as complimentary to chart patterns. They further support the probability of price movement direction and momentum as seen in patterns.
There are plenty of indicators, but you must know the basic commonly used indicators and their applications. These are relative strength index (RSI), moving averages and moving average convergence divergence (MACD).
Looking at charts with patterns and indicators lets you know if you should be buying or selling the stock. It becomes very easy to spot trading opportunities when you are familiar with these tools and keep reading charts regularly.
Analyze Price Action
Price action is the method of analysis of stock price movement over time on the technical charts. It forms the basis of technical analysis of securities.
To analyze the price action, first identify the trend in stock price. Any stock moving in a trend is expected to continue to do so unless trend is changed by a major event. The event can be political, earnings report or any company management related news.
Your goal is to identify the trend and participate in it till it lasts. There are three ways to find a trend:
- Peaks (highs) and troughs (lows) on the chart
- Moving averages
- Trend lines
A stock making higher tops and higher lows is in uptrend. You should look to buy these stocks at dips. Lower tops and lower lows indicate downtrend in stock price. These are ideal candidates for short selling.
Moving averages and trend lines on charts are other ways to find trends in stock prices. The direction of these lines is an easy way to spot a trend.
Then, you should find support and resistance levels to get your entry and exit prices in a trade. These technically valid levels can be effectively found by the tops, bottoms, moving averages and trend lines as we talked above. You should note them down as your stop loss and target levels for a trade.
Identify Trends and Patterns
Trend lines are one of the easiest ways to identify trends. They’re also very helpful when identifying support and resistance levels.
You can use them to determine whether a stock has been moving up or down. If the line is rising, then the stock is likely to continue moving higher. Conversely, if the line is falling, then the stock is more likely to fall.
A moving average (MA) is a technical indicator commonly used in technical analysis. It is used to help smooth out price data by creating a constantly updated average price. A rising moving average line indicates that the security is in an uptrend, while a declining moving average line indicates a downtrend.
Your job is to buy stocks at dips towards these lines which are moving higher. They act as a support. If breached comprehensively, you should exit the trade. For falling stocks, you may short sell them along the falling lines.
Technical analysis involves identifying trends and patterns in financial markets. This is done by looking at past data and making predictions based on what has happened before.
It’s not an exact science, so there will be some guesswork involved. However, with practice, you’ll become more skilled at spotting trends and patterns.
Determine Support and Resistance Levels
Trendlines are another way to analyze price movements. They’re used to determine whether a stock is trending up or down.
To find trendlines, take the closing prices of a stock and plot them on a chart. Then draw a line between the two points where the price closes at its lowest point and highest point. This will give you a trendline.
The charting software help you draw moving averages for any time period you want to. You may choose the one appropriate for your trading time frame. For example, for short-term, medium term and long-term, you may choose 20 day, 50 day or 200 day moving averages.
Once you’re familiar with the basics of technical analysis, you can use these techniques to help you make better investment decisions.
One of the first things you need to do when analyzing a stock is find support and resistance levels. These are points at which the price of a stock tends to fluctuate.
If the price rises above the level, then it’s likely to continue rising; if it falls below the level, then it might fall further.
Trade Based on Technical Analysis Levels
If you’re looking to trade based on levels, then you need to understand how to read charts. Trading based on technical charts gives you an edge. You should build a system or strategy to find your trades on the basis of charts.
This system lets you know what the criteria are you need to be fulfilled to enter a trade. You may build a simple system of charts with indicators such as moving averages and RSI. Stocks trading above a certain moving average with RSI in buy zone are good stocks to buy.
It is important that you learn how to use indicators such as moving averages and relative strength index (RSI).
Know When to Buy or Sell.
Support and resistance levels are often used as entry and exit points for buying and selling stocks. These levels indicate demand and supply for the stocks on the technical charts.
A stock trading at support level is likely to attract demand from investors. Buyers may come and start buying leading to rise in stock prices.
Resistance is level for supply. Hence, sellers get activated and start selling the stocks. Sellers can be the investors who bought the stock at lower price and are booking profits. They can be short-sellers in a bid to make money from falling prices.
You can find these levels by drawing trend lines, technical indicators, moving averages and chart patterns we just talked. They can also be used to determine whether a stock is overbought or oversold.
Learn About Charting Software for Technical Analysis
Learning technical analysis is important aspect of trading stocks. Majority of the traders lose money because they start trading before learning the basics of trading.
Knowing the basics of chart reading keeps you ahead of majority of the traders in the market. It gives you confidence to stay calm during volatility in the markets. You have to build your system or a strategy and stick to it with discipline.
There are lots of different charting software programs available online. However, not all of them are suitable for beginners. If you’re looking for an easy-to-use program, try using Google’s free finance tools or Tradingview charts.
Final Thoughts
Technical analysis of a stock is method of predicting the direction of stock price movement in different time periods. It is important to know the basics of analysis to successfully trade the stocks.
The analysis involves using simple technical tools and techniques to find appropriate stocks to buy. Identifying the trend and trading the stocks in the direction of trend using support and resistance levels as your stop loss and target price is the most simple, effective and profitable way to trading stocks.
