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What is Technical Analysis? • Technical analysis is the study of past market action to try to gauge what the market might do in the future. At its most basic, it is the study of price. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes an entirely different approach; it doesn't care about the "value" of a company. Technical analysis is only interested in the price movements in the market.
Technical analysis philosophy There are three basic tenets that technical analysis is built from:
• Market action discounts everything • Prices move in trends • History repeats itself
Market action discounts everything • All known information related to the security is reflected in the price of the stock. This includes fundamental factors. As soon as new information comes to light it is immediately included in the price.
Prices move in trends • In technical analysis prices of securities tend to move in observable trends with a tendency to stay in the trend. The trend is considered to be intact until the trend line is broken. After a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. This is where the old adage “the trend is your friendâ€? comes from, meaning you should trade in the same direction as the trend.
History repeats itself • Technical analysis is the study of what has happened to the price of a security in the past with the expectation that history tends to repeat itself. Many of the charts patterns in technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. The repetitive nature of price movements is attributed to market psychology.
What are charts? • A stock chart is simply a visual representation of a security’s price or index over a set period of time. Any security with price data over a period of time can be used to form a chart for analysis. • On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis with the most recent plot being the furthest right.
Types of charts • Line Charts • Bar Charts • Candlestick Charts
Line Charts • This type of chart is usually used to get a “big pictureâ€? view of price movements. The line chart is formed by connecting the closing prices over a specified time frame. Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored. Today, this type of chart is most commonly seen with mutual fund charts, since they only have closing prices and no intraday movement.
Bar chart • Perhaps the most popular charting method is the bar chart. This type of chart can show the opening, high, low, and closing price of a particular security on a particular day. This can give one a better idea of how the stock traded throughout the day, or its daily volatility. • The open, high, low and close are required to form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. One of the main differences between a line chart and an OHLC (Open, High, Low, and Close) chart is that the OHLC chart can show volatility.
Candlestick charts • The third common chart type is the Candlestick chart. Many traders like this type of chart because it is similar to an OHLC chart but it can present the information on one particular day’s trading in a quicker, easier to read format. • Candlestick charts are very similar to OHLC charts in that they provide the same information, just in a different format. The candlestick is constructed using a horizontal line to indicate the open and close and a vertical box is made connecting these two lines to form the “body” of the candlestick. A single vertical line is drawn in the middle above the box to show the high and a single vertical line in the middle is drawn below the box to show the low, these are called the “wicks” or “shadows.” The next difference is the color of the body or whether it is filled or not. In traditional candlesticks, if the close is higher than the open then the body is left hollow (white or green) to indicate an up day in that day’s price action. If the close is lower than the open then the body is closed (black or red) to indicate a down day.
Basic concepts of trend • Trend is the direction that prices are moving in, based on where they have been in the past. Trends are made up of peaks and troughs. It is the direction of those peaks and troughs that constitute a market’s trend. Whether those peaks and troughs are moving up, down, or sideways indicate the direction of the trend.
Three directions of trend • An uptrend • A downtrend • A sideways trend
An uptrend An uptrend is made up of ascending peaks and troughs. Higher highs and higher lows.
A downtrend A downtrend is made up of descending peaks and troughs. Lower highs and lower lows.
A sideways trend A sideways trend (Consolidation) is when prices move sideways in a horizontal range.
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