Technical analysts believe that past market conditions and price movements can serve as the indicator for future market conditions and related price.
One must understand the basic assumptions underlying technical analysis. There are assumptions in technical analysis trading:
- Price movements are not random. They do form a certain pattern and trends that are known to be repeated over a course of time.
- Markets are known to be effective in showing the value that represents factors which influence security’s price.
- History repeats itself. People are expected to apply the same methods in current situations as they did in past with those same situations. Hence, technical analysts can use how traders reacted in past in current situations to make the most out of it.
Technical analysis focuses on short periods, that is, from a few minutes to a period no longer than a month. Hence it is for people who frequently buy and sell in order to make profits rather than relying on long term investments. Therefore, if traders are into technical analysis then they should rely on quick results as for long term investments and profits, fundamental analysis is authentic.
In technical analysis, analysts look through charts and graphs of security prices to figure out the direction in which prices are moving, Following are the trends:
- Uptrends, highs and lows that become progressively higher.
- Downtrends, successive high and lows that are progressively lower.
- Horizontal trends, where successive highs and lows do not fluctuate much from previous highs and lows.
- Channel lines are the trend lines that are drawn to join successive highs with each other and likewise, successive lows with each other, making easier to spot trends.
- When trends last longer than a year, then they are called major trends when they last for at least a month but no longer than a year then are called intermediate trends, and trends when last for less than a month are near-term trends.
- Four charts are used by analysts while doing technical analysis-
- Line charts are used to place closing stock prices over a period of time.
- Bar and candlestick charts are used to show the high and low prices for thegiven trading period and gaps between the trading periods.
- Point and figure charts are used to show the price movements over a course of time.
There are some patterns that technical analysts have named based on their analysis:
- A pattern looking alike head and shoulders imply that a trend is likely to reverse itself
- A pattern like a cup and handle shows that an upward trend should continue after short downward correction for a while.
- A rounding pattern indicates a long term bottoming out of a downward trend before an upswing.
- Other patterns include double top, triangle, wedges and more.
Support is defined as the lowest price of a security that is reached before more buyers dive into the market and make the price rise higher. Resistance means the highest price a security reaches before owners start to sell their shares and make the price fall down. On a channel lines chart, the support line is indicated by the bottom line (floor price of the security) and the resistance line is indicated by top line (ceiling price). Support and resistance levels are often used to confirm a trend and to ascertain when a trend is likely to reverse itself.
Level of buying and selling can show the validity of a trend and help predict whether a trend is about to reverse itself. It is assumed that if the volume of trades if rising even with the increase in prices then the trend is valid. On the contrary, if the trading volume rises slightly or falls when price rises, the trend is said to reverse itself.
A moving average is a series of calculated averages evaluated over successive, equal periods of time. Moving averages make it easier to see overall trends by removing unrepresentative high and lows. Trend reversals are easy to spot by placing prices against moving averages, or short-term averages against long-term averages. Some of the averaging methods used are:
- The simple moving average (SMA) is calculated by adding together all the closing prices during the time period and thereby dividing that sum by the number of prices included.
- In a linear weighted average, each price is taken and multiplied by its position on the chart before adding the prices together and dividing by the number of prices. Therefore, over a five-day period, the first price would be multiplied by 1, the second by 2, the third by 3, the fourth by 4 and the fifth by 5.
Indicators are the calculations that support trend information or movements gathered from price movements and thus contribute as a factor in deciding whether to buy or sell securities. Indicators may have any values but those ranging in specific values such as from 0 to 100 are termed as oscillators.
Indicators can be leading or lagging. Leading indicators forecast price movements and are most reliable during horizontal trends to signal uptrends or downtrends. Whereas, lagging indicators affirm price movements and hence are most functional during uptrends and downtrends.