Home » Technical analysis in the stock market and the use of technical indicators.

Technical analysis in the stock market and the use of technical indicators.

Technical analysis in stock markets and the use of technical indicators.

Photo courtesy Chris Liverani on Unsplash.

There are many technical analysis indicators that assist in stock trading. Prices move in trends that depend on a number of economic, political, and monetary factors.  Technical analysis helps in identifying the trend at an early stage where a person can enter a trade and maintain his trading position, till there is an indication that the trend has reversed.

Human nature has remained the same over the decades and reacts to the same situations in similar ways. By studying the previous market conditions it is possible to identify situations that indicate market top and bottom. Technical analysis helps in the identification of such situations. Though no two situations are similar technical analysis with its tools can help people in identifying such points and help in predicting price movements.

Technical Indicators-

Technical indicators form the foundation of technical analysis and are the tools that help a trader to determine the probable price of a stock in the future. This is due to the repeatable patterns that can be identified on the stock chart and provide the entry and exit signals. The traders want to take advantage of the short-term price movements to make profits. Studying the technical indicators carefully would help in improving the chances of success.

The technical analysis indicators that a trader can use for stock trading are-

Support and Resistance-

Support can be described as buying in stock in sufficient volumes to halt a downtrend in prices and resistance is selling in volume to stop price from going higher. Support represents a concentration of demand, and resistance a concentration of supply.

When one looks at a chart for potential support it is the previous low and resistance is the area of the previous high. These are the places where a trader can expect a reversal and can be used in affiliation with other indicators. The other potential formation of support resistance zones takes place at round numbers(psychological points where traders base their decisions), trend lines, moving averages, and the retracement points like ratios. The importance of a support or resistance area depends on the speed of the previous price move, the amount of stock that has changed hand in an area (the greater the activity, greater is the significance of the area), and the time period that has passed since the zone was last approached.

Moving Average-

Stock prices move in trends, but there are some fluctuations in the prices due to the volatility which can be a haphazard representation on the chart. The moving averages try to tone down the fluctuations and provide an easy-to-read trend line based on the average of the stock price over a period of time. There are three types of moving averages used in technical analysis and they are- simple, weighted, and exponential.

The most common time frame used for the moving average is – 30 days, 50 days, 90 days, and the 120-day average. As an example, for calculating the 30 days moving average of a stock you have to add the closing price of the stock for the past 30 days and divide the total by 30. Every day the oldest price moves out and a new one is added, so it is called the moving average.

Changes in price trend are recognized not by the change in direction of the moving average but by the price crossing its moving average. When the price moves above its moving average a bullish signal is generated and when the price moves below its moving average a bearish signal is generated.

Moving averages of different time frames can be used in association with each other to provide accurate buy and sell signals in stock trading. Let’s take two moving averages of different time frames like a 30 day and a 90 day. The place where these two moving averages cross paths is the moving average crossover.

A bullish crossover is when the short-term moving average crosses above the long-term moving average and it can be a buy signal that can lead to gains ahead. Likewise, when the short-term moving average crosses below the long-term moving average it is a bearish crossover and signifies a price decline ahead.

The exponential moving average is more sensitive to the changes in the price trend. In the simple moving averages, the same level of importance is given to the oldest as well as the newest closing price of the day. In the exponential moving averages, more importance is given to the most recent price as it gives a trader a more accurate picture of where the price is headed. It gives more accurate buy and sell signals than the simple moving average.

Moving Average Convergence Divergence (MACD)-

The moving average convergence divergence (MACD) indicates the relationship between two moving averages of stock and is a momentum indicator. It is calculated by subtracting the 26-period exponential moving averages from the 12-period exponential moving averages, creating the MACD line. A nine-day EMA of the MACD which is called the signal line is plotted on the MACD line. The two lines create an oscillator that can show if the stock is overbought or oversold.

When the MACD line crosses above the signal line, it’s a bullish crossover and indicates that the price is likely to move up. Similarly, when the MACD line crosses below the signal line, it’s a bearish crossover and indicates that the price is likely to fall. MACD helps the investors to understand if there is a bullish or bearish trend in the stock price, indicating weakening or strengthening.

Bollinger Bands-

We have already discussed that the moving averages act as important points in the support and resistance areas. The theory of support and resistance can be taken further by constructing two parallel lines to the moving average acting as an envelope. There are three lines that compose the Bollinger band; a simple moving average line (middle band) and the upper and the lower band. The upper and lower bands are 2 standard deviations away from a simple moving average.

The Bollinger bands provide support and resistances points and expand and narrow depending on the price volatility. When the Bollinger bands narrow, the following widening is followed by a sharp price move. When the price breaks through the upper or lower band it is a sign of strong momentum and the trend is expected to continue.

Traders using the Bollinger band in technical analysis use it such that when the price of the stock approaches the upper band it acts as a sell signal and when the price nears the lower band it acts as a buy signal.

Relative Strength Index (RSI)-

The Relative Strength Index is a momentum indicator that measures the strength of the price change to assess whether it is an overbought or oversold condition in stock. The RSI is used by traders to identify opportunities to enter or exit a stock in conjunction with other technical indicators.

The RSI moves between 0 and 100. When the RSI moves up and passes the 30 reference level it is a bullish sign and when it slides down below the 70 reference level it is a bearish sign. When the RSI moves above 70 it is considered overbought and when it is moving below 30 it is considered oversold.

Stochastic Oscillator-

The stochastic oscillator is a momentum indicator that compares the closing price of a stock to its price over a certain period of time. It is used for generating overbought and oversold signals and moves between 0 and 100. The readings over 80 are considered to be overbought and those under 20 are considered to be oversold.

The stochastic oscillator consists of two lines; one is the value of the oscillator in each session and the other its 3 days simple moving average. The intersection of these two lines indicates that there may be a reversal in the offing.

Both the Stochastic oscillator and the relative strength index (RSI) are price momentum oscillators and are used in technical analysis. The RSI measures the speed of price movement and is more useful in trending markets while the stochastic oscillator works best in trading ranges and is more useful in a sideways market.

On-Balance Volume-

The on-balance volume (OBV) is a momentum indicator that measures the positive and negative volume flow. When there is an increase or decrease in volume without significant change in stock price, in due course the price springs upwards or downwards. The idea is that a sharp increase in trading volumes will ultimately lead to a sharp increase or decrease in price. The use of this indicator is to find stocks that have had a sharp increase in volume but the price has remained the same.

The on-balance volume tracks whether the volume is flowing in or out of a security. When the on-balance volume shows that the volume is high and flowing in security it means that the institutional investors are buying the security and the retail investors would follow them driving the price upwards. When the on-balance volume shows that the volume is high and flowing out of the security it indicates that the institutional investors are selling and the retail investors will also start selling leading to a sharp drop in prices.

Fibonacci Retracement-

Fibonacci retracement helps in determining support and resistance levels. The Fibonacci ratios provide the price level to which the market trend could retrace before moving in the original direction.

A chart can be divided by the Fibonacci ratios. O% is the start and 100% is the complete reversal to the original price. Common ratios are 61.8%, 50%, 38.2% and 23.6% and horizontal lines can be drawn at these price levels. Fibonacci retracement levels are static prices and unlike the moving averages don’t change.

When a stock is in an uptrend and breaks through the Fibonacci retracement level the next level is the resistance and the price where it has broken on the way up becomes the support. In the same way, when the stock is falling through a Fibonacci retracement the level from where it has fallen becomes resistance and the next level becomes the support.

Head and Shoulder pattern-

The head and shoulder pattern is easy to identify and has three peaks with the middle peak being the highest. It signifies a trend reversal from the bullish to a bearish trend. It consists of a left shoulder where the price rises and form a peak followed by a decline. This is followed by a head where the price rise higher to form a peak and then the price falls and the final is the right shoulder where the price rises to form the right peak and then the price falls again.

A neckline is formed by connecting the low after the left shoulder and the low after the right shoulder. The target profit is the price difference between the head and the low point of either of the shoulders. The difference is subtracted from the neckline breakout level to provide a target price while going down.

Double Tops and bottoms-

The double tops and the double bottoms indicate a changing trend. A double top has an ‘M’ shape and is a bearish reversal. In the case of the double top, a stock tests a price level which in both cases is the resistance. The bottom formed between the two tops is a support level and when this is broken a sell signal is generated and the price can decrease by an equal distance as measured from the first top to the bottom.

A double bottom on the other hand has a ‘W’ shape and signals a bullish price movement.  It occurs when the stock falls to a price level and finds support there in both cases. The top formed between the two bottoms is a resistance level. When this resistance level is broken a buy signal is generated. The stock can gain in price equal to the distance from the first bottom to the top resistance level.

Indicators are useful in technical analysis, indicate the trend, and provide signals when the price is about to reverse. There are many indicators that assist in stock trading and no indicator is 100% accurate. If you like an indicator it is better to do thorough research and test it before doing live trade. It is good to use a few indicators in conjunction to confirm price trends and form an entry and exit strategy.

Also, read- What is scalp trading and the pros and cons.

Leave a Reply

Your email address will not be published. Required fields are marked *