Technical analysis of stocks is the method of evaluating stocks and securities based on statistical data of market activity. It relies on historical trends on price changes and volume than on intrinsic value of the security. In a way, technical analysis of stock helps in forecasting the future price movement of the stock based on past price movements.
Unlike fundamental analysis of stocks, technical analysis doesn’t consider value, growth, income and management’s effectiveness. It relies purely on numbers and charts. Technical analysis uses a wide variety of charts that show price over time. This usually helps to estimate what the future price of a stock may be after studying the past trends as they rely on the principle that ‘history repeats itself’.
Assumptions on which technical analysis work
There are 3 assumptions on which technical analysis of stocks is done. These are:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
Types of charts used in stock technical analysis
The various types of charts being used in technical analysis are:
OHLC (Open high low close charts) – These charts are bar charts in which the high and low price movement of a stock is charted vertically and open and close are charted horizontally. This chart is used to graph outliners and ranges.
Candlestick charts – This chart is similar to open high low close charts but open and close are filled. Often Black or Red candles represent a close lower than the open. And White, Green or Blue candles represent a close higher than the open.
Line charts – These are the simplest of charts which are charted on close price of a stock over a period of time. Analysts believe that the closing price is the most important price of a security.
Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being shown on a chart and the information that it provides. Let’s take a look at how are trends noticed in charts. We are only covering the topics on analyzing the stock trends in this article. We would have a separate article discussing technical analysis of stock trends to go deep into this topic.
- Head and shoulders
- Cup and handle
- Double tops and bottoms
- Triangles
- Flag and pennant
- Wedge
- Gaps
- Triple tops and bottoms
- Rounding bottom
These are the most popularly used trends and chart patterns which would help you understand price movement of stock.
Price-based indicators
Price based indicators are very important and are derived from these charts and historical prices. These indicators are generally shown below or above the main price chart.
Accumulation/distribution index—based on the close within the day’s range
Advance decline line — a popular indicator of market breadth
Average Directional Index — a widely used indicator of trend strength
Commodity Channel Index – identifies cyclical trends
MACD – moving average convergence/divergence
Parabolic SAR – Wilder’s trailing stop based on prices tending to stay within a parabolic curve during a strong trend
Relative Strength Index (RSI) – oscillator showing price strength
Rahul Mohindar Oscillator – a trend identifying indicator
Stochastic oscillator, close position within recent trading range
Trix – an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson
Similar to price based indicators there are a few volume based indicators as well:
Money Flow – the amount of stock traded on days the price went up
On-balance volume – the momentum of buying and selling stocks
PAC charts – two-dimensional method for charting volume by price level
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