When it comes to Technical Analysis, people often get overwhelmed!
There are so many different indicators and tools out there, that they are left scratching their heads…
Don’t worry, its not as difficult is it sounds.
It may seem confusing at first, but once you understand how and why we use these technical tools, everything will make a lot more sense!
What is Technical Analysis?
Since markets are largely driven by the laws of supply and demand, certain predictable patterns tend to form. The goal of technical analysis is to exploit these patterns, by using the price action history to try and make predictions about where the price might go in the future.
TA is most confusing when viewed as a whole, but if you broke down each factor you are paying attention to one by one, it is much more easy to digest.
While the factors can be quite different from one another, they ultimately make us come to one of two conclusions…
- It makes it more likely for a stock to go up (Elevating Factor)
- It can make it more likely for a stock to go down (Deprecating Factor)
When we break down each factor in this way, we can effectively stack them on top of one another, helping us with our decision making process.
Before we can use elevating and deprecating factors effectively though, we must first understand the basics of reading charts!
A candlestick can be thought of as the most basic unit of any stock chart.
It gives us a simplified and distorted version of the truth that’s much easier to understand than breaking down exactly what the price is doing at any given moment.
The candlestick consists of a few different components…
We have the thick part in the middle (known as the body), and the thin lines at the end (called the wicks).
The body tells us the opening and closing prices for each candlestick…..but how can we tell which is which?
A green body means that the price action was bullish, so the close needs to be higher than the open. A red body on the other hand indicates that the price action was bearish, so the close needs to be lower than the open.
The wicks tell us the absolute highs and lows that were reached for a given candlestick.
Let’s put all of this together!
The price always starts at the open and then gets pushed up/down by the market, reaching the highs and lows at the wicks. Finally, the candle closes either above the open forming a green candlestick, or below it resulting in a red one.
We mentioned previously that a candlestick serves as a simplified version of price action for a certain period of time…..that time period however can vary.
Any time you see a chart, the first question that should be asked is what is the timeframe on it?
The timeframe of a chart is a combination of two things:
- The total period of time that is encapsulated from the beginning of the chart to the end
- The period of time that each candlestick represents.
For example, a “5 day: 1 hour” timeframe indicates that the period of time represented on the entire chart is 5 days, while each individual candlestick represents 1 hour.
Generally speaking, less time per candlestick means more data about the price action, since each one gives us a unique set of opens, highs, lows, and closes.
Folks often get overwhelmed when they start looking at all the different time frames they can use…
The trick is that you have to use the time frame that roughly matches the length of the position you are interested in taking.
For example, if your interested in taking a position for a week or two, it doesn’t make sense to be using a 3 year chart! That being said, it can be helpful to look at some charts with longer time frames to get a general idea for the longer term price action trend, perhaps 90 or 180 day for our example.
Support and Resistance
We have yet to discuss how we can interpret the movement on the chart and what it tells us about a stock…
Setting support and resistance levels is one of the most powerful ways to get a read on the price action!
The premise behind it is fairly straightforward…..the more a certain price level has historically shown to have an effect on the price direction, the more likely it is for it to happen in the future.
If it changes it from bearish to bullish we call this support, if it’s from bullish to bearish we call it resistance.
Support acts as a shield, protecting the stock from going further to the downside, and the more times it shows the ability to do so, the stronger it becomes.
Resistance is also a type of price shield, but from upside potential. The more times a stock reverses to the downside at a certain price point the stronger of a resistance level it becomes.
This is not some sort of magic, as a price level is tested, either as a support or resistance, the more the market notices it and uses it as part of their decision make process…
You could say that its a self fulfilling prophecy of sorts.
Of course support and resistance levels are not bullet proof, so its useful to think of them from the framework of an elevating or deprecating factor.
From this perspective, support is elevating because it makes it more likely that the stock will go up. However, if a stock breaks below support then this is a deprecating factor because it weakens the strength of that initial factor.
A strong resistance level is a deprecating factor, because it makes it more likely that a stock will go down. If the stock breaks above resistance, then it turns into an elevating factor because the resistance was weakened!
Now, if you actually go out and try to set support/resistance levels for yourself, you will quickly realize that there are usually multiple levels that make sense.
So what do we do in such a situation?
We have to look at the levels that are relevant to our positions!
Risk vs. Reward
While the support and resistance levels themselves are useful for us when the price is near them, they also have an indirect function in other circumstances…
We can look at the current stock price and compare that to the most relevant support and resistance levels for our position.
The closer the stock is to the support level the better the risk-to-reward ratio is!
Obviously, if the stock ends up breaking support/resistance, then this has an effect on the relevancy of the level in question, and thus affects the risk vs. reward calculation.
If you are interested in trading stocks, its important to always have an eye on the trading volume as it has important ramifications for a position…
You see, in order to be able to buy into and out of a stock, you need to have someone on the other side of the transaction. If there is low liquidity than it is likely that the order will not get filled quickly…
What does this mean?
It means that the price you are trying to get in at is not the price that you will likely get. Furthermore, depending on the number of shares one is looking to purchase and how low the volume is, the act of trying to buy or sell these shares will itself move the stock price!
In other words, you will get filled at a higher price then what you wanted when you buy a stock, and a lower price when you sell it.
Volume can also be used as a technical factor for gauging price movement…
A high level of volume that goes in tandem with bullish/bearish price action is an indication that there is momentum building. It is therefore an elevating factor if the volume is accompanied by upward price movement, and a deprecating factor if it is accompanied by downward movement.
If you want add additional layers to your technicals, then you may want to include indicators to the trading setup as well.
The thing with elevating and deprecating factors is that you can always stack more of them to help increase the odds of success.
There is a flip side to this though…
The more technical factors used at one time, the more elements that have to be juggled at one time making life more difficult. In addition, since more criteria have to be met, it makes it harder to find stocks that fit all of them at any one time.
A middle ground that can be used is having a requirement that a set number of indicators need to be elevating at any one time in order to take a position, but not all of them.
A few that we recommend:
- Simple Moving Average (SMA)- Helps determine whether there is short and long term price strength.
- Relative Strength Index (RSI)- Shows when a stock is being overbought and oversold.
- MACD- Helps to clearly determine the level of price strength.
Its important to remember that technical analysis is more of an art then a science, so everyone has their own style…
Its best to experiment with different indicators to see what works best for you.
Putting it All Together
The key to fitting all the pieces to together is to just keep working at it!
It’s like a puzzle, the more pieces you fit, the easier the rest will fall into place as well!
Its also important to keep in mind that there are other important aspects of trading stocks, such as risk management, fundamental analysis, and trading psychology that should not be ignored.
Technical Analysis is just one piece of a larger puzzle…