What is technical analysis and how do you get started?
New to technical analysis? Start here with these seven tips.
So you've started trading and want to take things to the next level – this is where technical analysis can help.
Technical analysis uses historical prices and trade volumes to try and predict future price trends. The idea is that by gauging whether a stock's price might move up or down over different time frames, you can find the best moments to capture profit.
Typically, this is done using price charts and adding indicators such as price trendlines.
Not everyone believes technical analysis works – in fact it's a hotly debated topic among investors. Still, it works often enough that it has stayed a popular tool by both day traders and long-term investors for centuries.
If you're interested in finding out more, here are a few tips to get started.
1. It's human nature
Behind all the numbers, there are people making both rational and irrational trading decisions. So how can you predict what people are going to do next?
The basis of technical analysis is that stock prices tend to move in patterns that are either cyclical or based on trends. While you can't know what investors are going to do next, we do know most of the time people respond to certain events in the same way.
For example, if a stock price rallies sharply over several days or weeks, we can expect that some people will want to cash in their profits. This is why we often see prices dip sharply after a boom, such as after a major IPO.
And when prices crash, we know that some investors will be waiting to scoop up the low prices (as we saw in March and April) resulting in a response rally – and the cycle starts again. Technical analysis can help to predict these typical behaviours by identifying price peaks or troughs.
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2. Start with a price chart
Technical analysis always begins with a price chart. There are many different types of charts used by analysts, but their goal is always to map out price trends.
One of the most common charts you'll come across is the candlestick chart, named after the red and green coloured vertical bars.
The bars show the stock's opening and closing prices for the period you're viewing – often a single day. Green means the price went up and red means the price went down. The short lines called the "wicks" that appear at the top and bottom of the rectangle show the highest and lowest price ranges for that period.
Candlestick charts are useful because they show how volatile a stock's price has been over time.
From here you can start to look at other indicators and map out price trends.
3. Look at trading volumes
Trade volume is the number of buy or sell trades that are made for a stock or commodity over a given time. This typically sits at the bottom of a price chart as light grey columns or lines.
Volume is used alongside prices to determine whether a prolonged trend or a reversal is about to occur. As a general rule, higher volumes of trading are more likely to result in a prolonged price trend, either upwards or downwards.
When volume rises with prices, you might expect a long bull run. If prices are falling while volumes are going up, it indicates a prolonged correction.
However, if prices hit a new peak as volume drops, it could be a sign that the stock is losing its zeal and a sharp reversal is about to occur.
4. Understand support and resistance
Just like any other product, the demand for stocks fluctuates depending on prices. For example, when a stock's price is low, it becomes more attractive and demand for the stock goes up. When a stock price becomes too expensive, buyers will start to drop off and some people will see an opportunity to sell.
Technical analysis tries to predict these demand patterns using "support" and "resistance" trendlines on a chart. A support line indicates the lower price range where buying typically starts to pick up. A resistance line shows the higher price range where traders are expected to start selling.
Such trendlines are made by connecting prices – you just need to figure out which prices you want to connect that will help to inform you. Typically, traders connect low price points or high price points together. If the support or resistance lines stand the test of time, the more reliable it is deemed to be in the future.
There are a few ways to construct your support and resistance lines, and the most well-known method is through "moving averages".
5. Identify uptrends and downtrends
The key question you're trying to answer in technical analysis is whether a stock's price is trending upwards, downwards or sideways. To work this out, traders use resistance points to map out trendlines.
At a basic level, a downward sloping line indicates there are more sellers than buyers and the correction might be a prolonged one. Some traders will take this as a sign to sell before prices dip further.
An upward sloping line means the opposite – and you might want to consider holding onto your stock for a longer period.
These lines are also used to determine the points where prices start to meet resistance and could reverse. If prices fall below this trend level, you might expect a panic sell to occur as it indicates a "black swan" event has occurred.
For example, the image below shows a trendline for the S&P/ASX200 index over several decades.
This trendline indicates that by around the start of 2020, prices should reverse at around the 5,550 mark. Of course, the ASX200 did fall below this point in March this year and panic selling occurred as a result.
This trendline will have subsequently lost its validity and numerous new trendlines will have been made to accommodate the new market conditions.
6. Moving averages
The moving average indicates the average price of a stock over a period of time – often weeks or months. This gives you a better idea of how the stock has been performing over longer time frames and it's commonly used to find support and resistance lines.
On a price chart, you'll often see the symbol MA followed by a number, e.g. MA200. This means the moving average shown on the chart is over a 200-day period.
There are two main ways to look at an average stock price. You can look at the simple moving average (SMA) or the exponential moving average (EMA). Both SMA and EMA average the stock's price over a specific period of time , but EMA weighs recent prices as more important than those further in the past.
These averages are used to create support and resistance lines (see point 4). For example, if a stock's price can't close the day above the moving average line, it indicates a resistance point – this is the level where more people are starting to sell than buy.
If a stock's price can't close below the moving average, we find a support point – the level where more people are beginning to buy than to sell.
Once you map out your support and resistance lines, trend indicators also start to appear. When stock prices fall outside of these lines, it could be a sign that a new trend is starting, such as a bull market or a correction.
7. Relative Strength Index (RSI)
Relative Strength Index is a popular indicator to work out whether a stock or other asset is overbought or oversold. It's typically shown as a line graph and might sit just below the price chart.
RSI is measured over a 14-day period on a scale of 0 - 100, with 0 being the most undersold value and 100 the most overbought. It's calculated using the asset's average gains and losses – usually over a 14-day period.
As a general rule, the 70 mark is where a stock or asset is considered to be overbought, while 30 is the level where it's thought to be undersold.
Of course, to get the most accurate results, technical analysts use all of these indicators and many, many more.
These are some of the basics, but technical analysis is a long journey that for many people never truly ends. There's still plenty more to learn and experience – enjoy the journey!