Technical analysis is a method of assessing securities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Technical analysts believe that past trading activity and price changes of the security can be valuable indicators of the security's future price movements.
Technical analysts believe that by identifying patterns in price charts, they can predict future price movements and make profitable trades. However, technical analysis is not a perfect science, and there is no guarantee that it will be successful, but it can still be very useful.
Why technical analysis is crucial for stock trading
Among the benefits of using stock market technical analysis are:
- Timely entry and exit points. Technical analysis helps traders identify potential entry and exit points for traders by analyzing price charts, patterns, and indicators. It assists in capitalizing on price movements and trends on time, improving the chances of profitable trades.
- Visual representation of price trends. Charts provide a visual presentation of historical price movements, making it easier to identify trends, patterns, and potential support/resistance levels.
- Objective decision-making. Technical analysis of stocks relies on quantitative data and objective criteria, such as price patterns and indicators. It reduces emotional biases that might influence decisions and leads to more rational and disciplined trading.
- Flexibility across timeframes. Technical analysis can be applied to various timeframes, allowing traders to adapt their strategies to different trading styles. Whether a trader is focused on day trading, swing trading, or long-term investing, technical analysis can be adjusted accordingly.
- Risk management. Technical analysis trading can aid in risk management by identifying potential support levels where prices might reverse, reducing the risk of significant losses.
- Short-term trading opportunities. Technical analysis is particularly useful for short-term traders who seek to profit from quick price movements. By identifying short-term trends and patterns, traders can capitalize on intraday volatility.
- Global applicability. Technical analysis can be applied to various financial markets and instruments, including stocks, commodities, currencies, and indices. This versatility allows traders to use similar analysis techniques across different assets.
What trading indicators to pay attention to
Technical analysis provides investors with a lot of different trading indicators that can be useful. Among the most common:
- Moving averages. A simple moving average (SMA) is calculated by taking the average of the closing prices over a certain number of periods. An exponential moving average (EMA) gives more weight to recent prices, which makes it more responsive to changes in trend.
- Bollinger bands. Bollinger bands are a volatility indicator that identifies overbought and oversold conditions. The bands are created by plotting a standard deviation from a moving average. When the price is close to the upper band, it is considered overbought. When the price is close to the lower band, it is considered oversold.
- Relative strength index (RSI). A momentum indicator measuring the speed and magnitude of price changes. The RSI is calculated by taking the average of the gains and losses over a certain number of periods. An RSI of 70 or above is considered overbought, while an RSI of 30 or below is considered oversold.
- Stochastic oscillator. The stochastic oscillator is another momentum indicator that measures the speed and magnitude of price changes. It is calculated by taking the closing price and dividing it by the highest price over a certain number of periods. A stochastic oscillator of 80 or above stands for overbought, while a stochastic oscillator of 20 or below stands for oversold.
- MACD. The MACD is a trend-following indicator that uses moving averages to identify changes in momentum. The MACD is calculated by taking the difference between two moving averages.
One should remember that it is important to choose indicators that are appropriate for your trading style and risk tolerance. And more importantly: no single indicator is foolproof, and false signals can occur. Combining indicators that complement each other and align with your trading strategy can increase the probability of successful trades. Always consider the broader market context, news, and company fundamentals when making trading decisions.