Technical analysis may seem intimidating for beginners but it needn’t be. Once you get the idea of what it aims to accomplish and get introduced to the basics, you’ll be well on your way to start applying it.
In this technical analysis introduction, I will demystify the concept of technical analysis as a way to predict future stock price movements and give you a general idea of how it is applied.
More specifically this introduction to technical analysis will help you understand:
- what technical analysis aims to accomplish
- what the support and resistance levels are
- what trendlines are supposed to help you with
- what moving averages are about
Now, let’s start from the foundation, shall we?
What is Technical Analysis About ?
Technical analysis is simply a tool that traders use to identify trading opportunities.
More precisely, it helps traders decide when to enter a trade and when to exit it by studying the past behavior of a stock’s price and its trading volume; because these two factors are the underpinnings of predicting a change in the direction of the price and, therefore, a trading opportunity.
At this point, it must be quite clear that technical analysis is based on the assumption that past data can help you predict future price movements. Although the past is far from a definite indicator of the future, history tends to repeat itself when it comes to market activity. Until it doesn’t, of course, and we will talk about that in a bit.
Now, let’s take a look at the two pillars of technical analysis…
Support and Resistance Basics
You probably must have heard of support and resistance levels in technical analysis. They are the two price levels on which a… “dramatic”, shall we say, direction of price movement can be expected.
In a downtrend (a downward movement of the price), an identified support level acts as a “floor” at which an increase of demand for the stock is likely to start an uptrend (an upward movement of the price).
By the same logic, a resistance level acts as the “ceiling” during an uptrend at which a concentration of supply can bring the rising stock price to an abrupt end and cause a downtrend.
In other words, technical analysts use past data (stock price charts, specifically) to identify a price point at which they could enter a trade (support) and one at which they should exit it (resistance).
Of course, there is no guarantee that the price of a stock won’t break through an identified support or resistance level. Thus, you’ve got to bear in mind that there is always the risk of unprecedented price behavior that will cause some loss.
To understand how support and resistance levels are used though, it’s important that we take a look at trendlines…
Trendlines
Trendlines are basically lines that analysts draw over price charts to define the general direction of stock prices. This is how traders usually identify a trend.
The idea is that you connect “peaks” and “bottoms” of a price movement to form a line that will dictate the direction of the stock. Traders draw trendlines and enter or exit trades as the price approaches the line that has been determined by past price points.
To draw a trendline you must have at least two price points, of course, and a specific time-frame.
As you can understand, your confidence that the price will not break through the trendlines is very dependent on the number of times the stock price has touched them but was unable to break through them in the past. So choosing to use a long time-frame and many price points is key here.
Moving Averages
Many technical analysts use moving averages as the most important indicators of support and resistance levels. A moving average is a tool that basically combines many price points over a specific period and then divides the result by the number of those price points.
A moving average is usually used within a time-frame of 10, 30, 50, 200, 365 days. But, of course, based on the holding period that as a trader you are most comfortable with, it can range from minutes to hours as well.
The idea is that by using a moving average, you apply a filter to the noise of the price movement to create a clear picture of the price’s trend.
Wrapping It All Up
There are many more tools that you can use to apply technical analysis on a specific stock or market, of course.
But the general concept is the same. You must identify price movement patterns, define your time-frame according to the period you’re planning on holding a stock, and plan when you should enter and exit a trade.
After getting more familiar with the concept of support and resistance and comfortable drawing trendlines over charts, the rest is all about understanding market psychology and sticking to a strategy.
This is important because many traders don’t fail because they are bad technical analysts. They do so because they don’t understand how other traders usually behave and because they also get overwhelmed by the noise of the crowd.
Well, I hope this technical analysis introduction helped you understand the idea behind it and probably prepared you for diving deeper into it.
Thank you for reading and let me know in the comments if you have any questions. Also, make sure that you share this article with others if it helped you!
Take care for now and talk to you in the next post!
Disclaimer: This information should not be viewed as financial advice. You should consult a financial advisor or do your own due diligence before you invest. The owner of this website and author of this article are not to be held liable for any undesired result by anyone who uses this information that is provided here in any way.
