Seasoned investors optimize their investment decisions based on varied approaches. One such universally acclaimed approach is technical analysis.
It is widely used by investors to identify short-term and long-term trends and to know when to time their action. It further helps to identify support and resistance levels to help make sound investment decisions.
The approach is focused on ascertaining whether or not a current trend will continue and, if not, when it will reverse.
Technical analysis focuses only on the price of the shares and not on the operations of the company. It considers that the current or past price action in the market is the most reliable indicator of future price action.
Let us get a deeper understanding of what is technical analysis and what are the tools of technical analysis.
What is Technical Analysis?
Technical analysis is the interpretation of the price action of a company’s underlying stock.
Sounds complicated? Let us simplify this for you.
Technical analysis is a method used by traders and investors to forecast future price movements of stocks by analysing past trading activity. It utilises various chart patterns and statistical indicators to identify price support and resistance levels, range and trends.
Understand it this way.
The price of a share moves up and down on a regular basis. But, if you look at the stock price movement over time, you may notice some trends and patterns emerging. Technical analysis is nothing but the study of these chart patterns and trends in stock prices.
It is the study of historical market data, including price and volume. Some of the important factors that help technical analysts in predicting future market behaviour are market psychology, quantitative analysis and behavioural economics.
Tools of Technical Analysis
Technical analysts make use of a combination of tools and indicators to identify potential entry and exit points for trades. These tools and technical indicators are as follows:
Charts act as the canvas where the story of a stock is painted. The common types of charts are candlestick, bar and line charts.
Price and volume charts are the most widely used technical analysis tools. A price chart depicts the sequence of prices plotted over a specific timeframe. A volume chart depicts the number of shares of a company traded in the market over a specific timeframe.
Charts are generally used along with trendlines.
· Momentum Indicators
Momentum indicators measure the momentum of a stock including overbought and oversold conditions. They are statistical figures that are calculated based on the price and volume data of stock. They help to generate effective entry and exit signals for the traders.
While most of the technical indicators majorly focus on determining likely market direction (up or down), momentum indicators primarily focus on determining market strength. This helps traders determine whether the current price movement represents range-bound trading or an actual significant trend.
Some of the widely used momentum indicators are Stochastic Oscillator, Relative Strength Index (RSI), Commodity Channel Index (CCI), Average Directional Movement Index (ADX) and Moving Average Convergence-Divergence (MACD) indicator.
Momentum indicators act as supporting tools for charts and moving averages.
· Moving Averages
Moving averages are used to remove sharp and frequent fluctuations in a stock chart. Sharp movement in stock prices within a short period of time can often make it challenging to predict the trend in the stock chart. Moving averages help eliminate this impact and make a trend more prominent.
Some of the commonly used moving average tools are Exponential Moving Average (EMA), Linear Weighted Average (LWA) and Simple Moving Average (SMA).