Technical analysis – the basics and beyond
Technical analysis is a method of analysis in finance that focuses on price trends and derived technical indicators from prices and volume. In addition, technical analysis focuses on chart patterns which is why it is also called chart analysis.
The main idea behind technical analysis is that we humans behave in patterns, and therefore act in predictable ways, which is also reflected in the stock market.
An analysis of price behavior can give an investor insight into the mindset of the market, which can serve as a basis for predicting the next price movements and making profitable trades.
In addition to fundamental analysis, which tends to focus on company fundamentals (balance sheets, competitive advantages, valuations, etc.), technical analysis is one of the most popular approaches to analyzing stocks.
Technical analysis is most often used by short-term traders (day traders, swing traders, forex traders…) or by long-term traders and investors as a signal for entering the position.
In this blog post, we will look at the basics of technical analysis and its core principles. Reading this blog post will provide you with enough information to decide if technical analysis is something you should include in your investment toolkit.
If the answer is “yes,” you’ll also find additional resources at the end.
The basics of technical analysis
The core principle of technical analysis is that all the important information regarding the stock is reflected in the price (and volume). Any new piece of information is almost immediately discounted in the price.
That means the price chart and indicators calculated from the price movements are the most important elements that an investor needs in order to make smart investment decisions. In other words, technical analysts believe that all the information you need to make a trading decision are already embedded in the price.
“The goal of a technical trader is to identify what the crowd is doing and take advantage of it without falling prey to the market’s emotions.” – Barbara Rockefeller
If we take a step further, observing price movements throughout history reveals that similar trends and patterns constantly repeat themselves. These repetitive patterns are based on the irrationality of the market, or the general moods of the crowd.
The stock market is driven by mass sentiments, which means that understanding the mass psychology behind price movements can give an investor an important edge. History doesn’t repeat itself in an exactly similar way, but in very similar patterns.
Technical analysis approaches investing in a very different way to fundamental analysis. Fundamental analysts dive deep into the performance of the company, examining financial statements, the competitive edge of the company, valuations…
They expect that if the fundamentals are good (and not yet recognized by the market) that will sooner or later be reflected in a higher price for the company’s shares.
Technical analysts, on the other hand, believe that emotions such as fear and greed have a much higher impact on price movements than fundamentals. That’s why the stock market can be the best predictor of fundamental (or even macroeconomic) trends.
In other words, the stock market is always looking ahead, trying to forecast the state of the economy. If stocks go up, the market is forecasting that demand will go up, and following that, financial performance goes up, most of the stock prices go up, etc. A rising tide lifts all boats. If the stock market goes down, it drags fundamentals with it.
So, if a fundamental analyst deals with financial statements, valuation formulas, benchmarking and similar tools, a technical analyst focuses on a stock chart, patterns on the chart, and technical indicators calculated from the price and volume movements. We’ll talk more about these very soon.
A good chartist also needs good charting software. One of the most popular solutions is Trading View, which comes as a web, mobile, and standalone app.
Does technical analysis really work?
This is a tough one to answer. Some people think technical analysis is complete charlatanism, while many other successful traders completely swear by it.
There is extensive scientific research on technical analysis, and no clear conclusion as to whether it works or not. The main argument against technical analysis is that we tend to see patterns where there are none.
In the end, you will have to find the answer for yourself on whether technical analysis can give you an investing edge or not. Nevertheless, below is our perspective on the usefulness of technical analysis.
Technical analysis can be good for:
- Trading – Many successful day traders use the advanced principles of technical analysis, such as:
- Forging investing tactics – Position size, entry point, take profit, stop loss
- Risk management – Position size, stop loss
- Price micro-optimization – Choosing the entry point, namely choosing good timing to get the best results no matter if you are a short-, mid-, or long-term investor.
- Holistic approach – Combining technical analysis with other analytical disciplines, such as fundamental analysis, macro investing, etc.
Technical analysis is not good:
- as the main tool for selecting stock (e.g., value investing, growth investing etc.)
- for mid- or long-term forecasting
If your goal is to become a (day) trader, mastering the advanced principles of technical analysis is a must. Technical analysis is the most frequent tool day traders use. If your goal is to become a successful mid- or long-term investor, technical analysis can be one of the weapons in your arsenal, especially for making tactical decisions.
And please bear in mind that if you are a long-term investor and not a trader, you should not rely too much on technical analysis. As the saying goes: if you look too long at a stock chart, you will definitely start to see interesting patterns, even if there are none.
For the purpose of making tactical investment (not trading) decisions, knowing the basic elements of technical analysis is enough. These are:
- Trend lines, support and resistance
- volume and
- moving averages.
But if you want to be a day trader, knowing these is far from enough. Thus, we’ve listed the best additional resources on technical analysis at the end of this article.
To be honest, technical analysis can get really complicated, and it’s almost impossible to learn how to do it solely by reading. Sooner or later, you need to put some skin in the game (invest money), but you can definitely start small.
No matter whether you prefer technical or fundamental analysis, one thing is for sure: a successful investor always has a certain edge. Can fundamental analysis be your edge?
Understanding the charts
Charts and charting software are the main tools of a technical analyst. A chart most often represents price (vertical axis) in relation to time (horizontal axis), where different timeframes can be used.
We know of several different types of charts, based on the chart style, time frame and preferred design (line colors, etc.). So as not to make this article too long, we’ll look at just a few of the basics of chart drawing.
The most popular styles of charts are:
- Bar charts
- Line charts
And the most popular timelines to analyze are:
- Short-term trends: From 2 weeks to 3 months
- Mid-term trends: From 3 to 6 months
- Long-term trends: From 6 to 12 months or even longer
Here is an example of a chart drawing from trading view that can be highly customized (colors, timeframe, number of indicators, etc.):
Support, resistance and the main chart patterns
Now, what should you look for in the chart in technical analysis? The first few things to know when it comes to technical analysis are trendline, support, resistance, and the main chart patterns.
1. Trend line
Trend is your biggest friend in technical analysis. A trend line connects several price points (usually at least three points; either lows in an uptrend or highs in the downtrend) and then extends into the future to predict the future direction.
One of the main jobs of a technical trader is to assess the reversal point, namely the point at which the trend direction changes.
Stock prices move during trends, and these trends can be:
An uptrend line has a positive slope and serves as the support (as long as the prices are above the line), and a downtrend line has a negative slope, showing potential resistance.
Identifying the trend is important, as is following investing advice to never go against the trend (if you are not shorting). Trend lines can also serve as support and resistance lines.
“Trends remain in place until some major event comes along and stops them.” – Barbara Rockefeller
2. Support and resistance line / level
The support line, as the name implies, is the level at which the price is expected to bounce back and stop the downtrend.
It’s a price below the current price, at which there are expected to be more buyers than sellers, meaning that the price shouldn’t go below the support level. It’s the level at which a reversal of a trend is expected, and is usually correlated with recent lows and round numbers.
The resistance level is the opposite of the support level. This is the price level at which the stock price is expected to meet resistance and potentially change the trend, since at that price there are expected to be more sellers than buyers, which is usually correlated with recent highs and round numbers.
The increased stock price causes more selling interest, and the stock price can change the trend at the support or resistance level, or break it, following which new levels are set.
3. Chart and bar patterns
Chart patterns are defined as indicators that consist of geometric shapes and can be drawn on a chart. An example of such an indicator would be a triangle.
Patterns are often accompanied by at least two trend lines. Chart patterns are an important part of technical analysis.
We know the three main types of patterns:
- Reversal patterns
- Continuation patterns
- Bilateral patterns
There are more than 400 different chart patterns, and new ones are constantly being added to the list. In this link, and in the picture below a visual representation of the most popular ones:
In a similar way as chartists look for patterns in the chart, they also look patterns in candlesticks. In such patterns, each one can be an indicator of what will happen to the price in the future, either because a pattern needs to get completed or indicates some form of mass thinking.
The main technical indicators
Besides charts and bar patterns, technical indicators are the main focus of technical analysis. There are more than 100 technical indicators, divided into four main categories – trend, momentum, volatility, and volume indicators.
TradingView provides a comprehensive list of technical indicators and strategies with a to-the-point explanation of what they mean.
Please keep in mind that no indicators work all the time. Indicators are extremely unreliable and their main purpose it to help you separate the signal (trend changes) from the noise.
You usually must use the right combination of different indicators, according to the situation. Many times, indicators even give mixed signals, and that’s where advanced understanding and experience come into play.
Here is the list of the most popular indicators (price analysis tools) in technical analysis:
|Trend indicators||Simple Moving Average (SMA)|
Exponential Moving Average (EMA)
Moving Average Convergence Divergence (MACD)
Average Directional Index (ADX)
|Momentum indicators||Relative Strength Index (RSI)|
Commodity Channel Index (CCI)
Rate of Change (ROC)
|Volatility indicators||Bollinger Bands|
Average True Range (ATR)
|Volume indicators||On-balance Volume (OBV)|
Money Flow Index (MFI)
Now let’s look at a few main technical indicators worth knowing and thinking about when analyzing a stock:
1. Trading volume / On-balance volume (OBV)
Trading volume shows how many shares were traded in a certain period of time (for example in one trading day). Besides showing the liquidity of the stock, trading volume can be also used to measure buying and selling pressure on it.
One of the volume indicators is called On-Balance Volume (OBV) and tries to predict changes in the stock price based on the trading volume. OBV is calculated by adding volume on up days and subtracting volume on down days.
The main idea behind OBV is that when there is a bigger change in volume without a significant change in the stock’s price, there is a great possibility that the stock price will jump upwards or downwards. The actual value is not important, but rather the trend.
The OBV trend line should be compared to the stock price trend to look for any divergences.
- If the stock price continues to reach new higher peaks and the OBV doesn’t follow, the upward trend is in question.
- In the same way, if the price continues to reach new lows and the OBV doesn’t, the trend might be failing or stalling.
2. Accumulation / Distribution indicator (A/D)
The A/D line is a similar indicator to the OBV indicator, exploring the difference between a stock’s price and volume.
This indicator considers the closing price of a stock in a period, multiplied by volume. In each calculation the value is added or subtracted from the previous period.
- If the stock price is rising and the A/D line is falling, it might indicate that the stock doesn’t have enough support from buyers, meaning the stock price might soon decline.
- In the same way, if the stock price is falling and the A/D line is soaring, it might be an indicator that the downtrend is failing or stalling.
3. Moving averages (SMA, EMA)
Moving averages are used to determine the stock price trend. They are called “moving” since the number is constantly recalculated, taking the latest price into account; and “averages” because the data points in a given time period are divided by the number of time periods.
The most basic moving average is the Simple Moving Average (SMA). The SMA is calculated as the average price in a certain period. A similar moving average is called Exponential Moving Average (EMA), with the difference being that EMA puts more weight on more recent price data, which means it reacts quicker to price changes.
A different number of days can be used in the calculation. For the long-term trend, 200 or 100 days (slower moving average) can be considered, for the intermediate trends, 50 days, and 10 or 20 days (faster moving average) for the short-term trend.
There are a few ways that moving averages are used as buy/sell signals:
- Trend – In general, if the SMA/EMA are moving up, the stock price trend is also considered bullish, and if they are moving down, the trend is considered bearish.
- Price crossover – A price crossover happens when the stock price crosses below or above the selected moving average. If the stock price crosses above the SMA it can be considered as a buy signal, and a sell signal when below.
- Comparing two SMA – You can also compare a faster SMA to a slower SMA. When the faster SMA crosses above the slower SMA, it can be a buy signal and an indication that the trend is turning up, and when it crosses below, this crossing can be considered a sell signal.
- Support and Resistance – The MA can also present a resistance or support line for the stock price.
4. Moving Average Convergence Divergence (MACD)
MACD is an indicator which looks at the differences in moving averages, subtracting the longer-term MA from the shorter-term MA. The MACD line is most often calculated as 12-days EMA minus 26-days EMA. A signal line is then added to the graph, which is calculated as the 9-day EMA of the MACD line.
On the graph, most often a histogram is also added which shows the distance between the MACD and signal line. The histogram can be used as an indicator of how strong the momentum is. MACD is usually used in two ways:
- Signal line: When the MACD line crosses above the signal line, it can be considered as a buy signal, and as a sell signal when it crosses below the signal line.
- Zero line: You can use the zero line (the point when the two EMAs cross) to determine the trend. The MACD rising above the zero is considered bullish and diving below zero is considered bearish.
5. Average Directional Index (ADX)
ADX is calculated as a moving average of the expanding price range values, and it’s used to measure the strength of a trend. ADX values range from 0 to 100, and the higher the number, the stronger the trends. A declining ADX could be an indicator of a weakening trend and ADX rising of a strengthening trend.
- In general, a strong trend is considered to be present when the ADX is above 25, and there’s no strong trend when the ADX is below 20.
6. Aroon Indicator
The Aroon Indicator is a trend indicator with two lines. The “Aroon Up” line measures the strength of an uptrend (the number of days since the highest stock price) and “Aroon Down” measures the strength of a downtrend (the number of days since the lowest stock price).
The lines are presented on a scale from 0 to 100 (50 being the centerline), where values towards 0 indicate a weak trend and values towards 100 a strong one.
- The uptrend is considered strong as long as the Aroon Up is close to the maximum levels, and the downtrend when the Aroon Down has high values.
- If the Aroon Up is above the Arron Down it’s considered to indicate a bullish trend, and if the Aroon Down is above the Aroon Up, it’s a bearish trend is indicated.
- A crossover between the lines can indicate a change in the trend.
7. Relative Strength Index (RSI)
RSI measures the speed and the magnitude of changes in price movements and shows if the stock is overbought or oversold.
- If the RSI is between 0 and 30 it’s considered oversold, which means it could lead to a stock price increase.
- If the score is between 70 and 100, a stock is considered overbought, and a correction in price is expected.
8. Stochastic oscillator
The stochastic oscillator is used as an indicator of an overbought or undersold stock. The indicator compares the closing price of a stock to the highest and lowest price points in a given time period and tries to predict the reversal points.
The indicator is usually used for broader trading ranges and shows the momentum of the price.
The indicator can range between 0 (the lowest point of the trading range) and 100 (the highest point of the trading range). It usually consists of two lines;
- one representing the actual value of the indicator (%K: fast stochastic line – reacts more quickly to market changes) and
- the second the 3-day SMA (%D: slow stochastic line).
- If the indicator is between 0 and 20 (the oversold region) it’s a signal that a stock is oversold; and when it’s between 80 and 100 (the overbought region) it’s a signal of an overbought stock. If the indicator is below 20 and goes back above this value, it can be a buy signal, and if it’s above the 80 and then goes below it can be a sell signal.
- When the fast stochastic line moves above the slow stochastic line it can be a buy signal; and when the fast stochastic line crosses under the slow stochastic line, it can be a sell signal.
9. ATR and Bollinger Bands
Besides ATR – Average True Range (shows how much an asset moves, on average, during a given time frame and whether there are price gaps), Bollinger Bands are one of the most popular indicators of volatility.
As the name suggests, a Bollinger Band is actually a band composed of three lines: the upper and the lower band, and the moving average. The bands are calculated as the standard deviation level above and below the simple moving average, measuring volatility.
The upper and the lower band are most often 2 standard deviations from the 20-day simple moving average. When we have a band plotted, bands can at some points come closer together (a squeeze) or go wider.
- A squeeze can indicate a consolidation period before a break-out happens. The consequence can be a sharp move in the stock price in either direction.
- When bands move unusually widely apart, the volatility has increased, and it might indicate that any existing trend is ending.
10. Fibonacci levels
The name of this indicator comes from the Fibonacci sequence. The retracement levels (horizontal lines) are indicators of where the support and resistance levels might occur (changes in the trend).
Frequently used retracement levels based on the Fibonacci sequence are 23.6%, 38.2%, 50.0%, 61.8% and 78.6%.
The basis lines are set at the significant swing high and swing low in a given period. Based on these two lines, other horizontal lines are plotted at the Fibonacci sequence percentages. These lines could present support or resistance lines.
Additional resources on technical analysis
To finish, let’s add a few resources worth mentioning when it comes to technical analysis:
The best books on technical analysis
- Charting and Technical Analysis by Fred McAllen
- Trading: Technical Analysis Masterclass: Master the financial markets by Rolf Schlotmann
- Technical Analysis of the Financial Markets by John Murphy
- Technical Analysis for Dummies by Barbara Rockefeller
- Getting Started in Technical Analysis by Jack Schwager
- Technical Analysis Explained by Martin Pring
- “Technical Analysis from A to Z” by Steven B Achelis
- Japanese Candlestick Charting Techniques by Steve Nison
- Encyclopedia of Chart Patterns by Thomas Bulkowski
- Technical Analysis: The Complete Resource for Financial Market Technicians by Charles D. Kirkpatrick
You can also check out our resource of the 100 best investing books.