Introduction to Technical Analysis

  • Kanan Arora
  • May 11, 2021
  • Financial Analytics
Introduction to Technical Analysis title banner

About Technical Analysis 

 

  • Technical analysis is a trading discipline that analyses statistical patterns obtained from trading behavior, such as price change and volume, to determine trades and locate trading opportunities. 

  • It helps develop a point of view on a particular stock by defining the entry, exit, and other trade parameters.

  • Technical analysis is only concerned with the actions of the market participants. It helps visualize stock charts by focusing on patterns visible on them, and these patterns help determine trading opportunities.

  • Technical analysis does not focus on the reason behind the movement of a stock. A technical analyst is more interested in knowing “how” the price reacted to a market participant’s action than “why” the action took place.

 

 

Fundamental vs.Technical Analysis:

 

  1. Primary Research: Technical analysis examines price movements that are attributed to the psychology of the market participants. On the other hand, fundamental analysis looks into the company’s financial data, whose stock is being researched.

  2. Trades: Technical analysis is used for identifying short-term trades most of the time. Short term may refer to a period of less than a day- intraday or even a few weeks- swing. Fundamental analysis, on the other hand, is mainly used for long-term investment opportunities.

  3. Objective: Technical analysis is essential for trading, and the aim is to find the right time to enter/exit based on the trends. On the other hand, Fundamental Analysis is more concerned with investment, and the goal here is to find the intrinsic value of the stock.

  4. Returns: Since the trades in Technical Analysis are of short duration, it is unreasonable to expect as many returns as in investments that essentially use fundamental analysis and require a more extended period. It is essential to be consistent in one’s approach while using technical analysis, and a trader should expect small regular gains.

 

 

Basic assumptions of Technical Analysis:

 

  1. Price moves in a trend: Market price movements are not purely random but move in identifiable patterns and trends that tend to repeat over time.

  2. Markets discount everything: All known and unknown info in the public domain is reflected in the latest stock price.

  3. History repeats itself: In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements remarkably similar every time the price moves in a specific direction. Hence trend is our best friend in technical analysis.

 

 

Technical Analysis Charts:

 

Traders use charts to analyze the movement of a stock. Charts can be of different types, including line charts, bar charts, and candlestick charts. Most of the time, candlestick charts are used by traders. They are considered the most useful since they depict open, high, low, and close in a specified time frame, making it easier for an analyst to visualize the price movement. 

 

It is imperative to have a predetermined time frame before using the charts. Different time frames may have different candlestick patterns visible at a point in time, and the analysis done for a 5-min chart will not be suitable to take trades on a daily time frame.

 

Candlestick Charts

 

Now, a candlestick or a Japanese candlestick are made up of rectangular bodies that depict the Open (O), High (H), Low(L), and Close(C) of the movement of a stock in a particular time frame. 

 

Candlestick charts use OHLC data for their construction and traders can access this data from various sources, including yahoo finance and NSE’s official website.

 

  1. Open (O): Open is the opening price or the price at which a particular stock/ index is first traded in a specific time frame. For example, for a 1-day candlestick, open would be the price level at which the stock is first traded at 9:15 AM (Indian markets opening time ).

 

  1. High (H): High refers to the highest price reached by the stock/ index in a particular time frame. For example, for a 1-day candlestick, high would be the highest price at which the stock is traded on a specific trading day.

 

  1. Low (L):  Low refers to the lowest price reached by the stock/ index in a particular time frame. For example, for a 1-day candlestick, low would be the lowest price at which the stock is traded on a specific trading day.

 

  1. Close (C): Close is the closing price or the price at which a particular stock/ index is last traded in a specific time frame. For example, for a 1-day candlestick, close would be the price level at which the stock is last traded before 3:30 PM (Indian markets closing time).

 

Anatomy of a candlestick:

 

A candlestick comprises of three components:

 

  1. Real Body: This component connects the opening price and closing price of a stock’s price movement in a particular time frame.

  2. Upper Shadow: This component connects the high point and closing price of a stock’s price movement in a particular time frame.

  3. Lower Shadow: This component connects the low point and opening price of a stock’s price movement in a particular time frame.

 

Let us look at a few examples to understand the anatomy of candlesticks:

 

Note: All the examples in this blog have been taken from the Trading View website. These are real-life examples taken from the past movement of NIFTY BANK, the banking index of NIFTY that comprises of all the major banks in India, including HDFC Bank, Kotak Mahindra Bank ICICI Bank, Axis Bank, State bank of India, Indusind Bank, etc. All the charts being used are 1-day charts. 


Depicting candlestick depicting price movement on 30th April 2021

Candlestick depicting price movement on 30th April 2021


This is the candlestick depicting the price movement of NIFTY BANK on 29th April 2021. The index opened at 33112.40,, made a high of 33455.25, made a low of 32663.40, and closed at 32781.80. Since the opening price is higher than the closing price, the index suffered a loss and formed a bearish candle. Bearish candles are usually red or black in color.


Displaying Candlestick depicting price movement on 1st February 2021.

Candlestick depicting price movement on 1st February 2021


This is the candlestick depicting the price movement of NIFTY BANK on 1st February 2021. The index opened at 30976.35, made a high of 33305.30, made a low of 30906.45, and closed at 33089.05. Since the opening price is lower than the closing price, the index gained and formed a bullish candle. Bullish candles are usually blue or green or white in color.

 

Trends on charts:

 

In stock markets, a 'trend' is the direction in which the market moves. 

 

  1. Bullish: A bullish trend is an upward trend in stock prices or the overall rise in indices. A bullish trend is the characteristic of a bull market, and it portrays investors’ confidence in a market. In a bullish market, demand overpowers supply.


    Highlighting Bullish Trend in BANKNIFTY on a daily time-frame

Bullish Trend in BANKNIFTY on a daily time-frame


  1. Bearish: A bearish trend is a downward trend in stock prices or the overall fall in indices. A bearish trend is the characteristic of a bear market and it portrays the fear of investors in a market. In a bearish market, supply overpowers demand. 


    Showing Bearish Trend in BANKNIFTY on a daily time-frame.

Bearish Trend in BANKNIFTY on a daily time-frame


  1. Sideways: A horizontal price movement characterizes a sideways trend. It portrays the uncertainty in the markets and is usually preceded and followed by a bearish/ bullish trend. In a sideways market, the forces of supply and demand are almost equal.


    Outlining Sideways Trend in BANKNIFTY on a daily time-frame

Sideways Trend in BANKNIFTY on a daily time-frame


Candlestick patterns

 

Candlestick charts are used to recognize candlestick patterns which are then used to execute trades. There are two types of candlestick patterns:

 

  1. Single candlestick patterns: 

 

Such patterns are formed by just one candlestick. In general, the longer the candle, the more powerful is the purchasing or selling action. The size of the candlestick and the relative size of the real body, upper shadow, and lower shadow determines the type of candlestick pattern. 

 

For example, a candlestick with no shadows indicates a strong buying/ selling interest, and in such a case, usually, the next candle also moves in the same direction. Thus, providing a reliable setup. This type of pattern is called a Marubozu, which means “bald” in Japanese. 

 

Other types of single candlestick patterns include the Spinning Top, the Doji, the Paper Umbrella, the Hammer, the Hanging Man, and the Shooting Star.

 

 

  1. Multiple candlestick patterns: 

 

As suggested by the name, multiple candlestick patterns require 2 or 3 candlesticks to form a pattern. Such patterns require more patience than single candlestick patterns but are usually more reliable as well. 

 

The most famous of these is the engulfing pattern, a two candlestick pattern used to figure out trend reversals. It consists of two candlesticks that overlap each other horizontally. The outer candlestick is bigger and consequently more significant than the inner one, and it engulfs or envelopes the inner candle. 

 

A bullish candlestick that does so at the end of a bearish trend indicates a trend reversal to a bullish one and vice-versa. Other multiple candlestick patterns include the Harami pattern, the Morning Star, the Evening Star, etc.

 

 

Conclusion

 

To conclude, almost all of the market participants use technical analysis nowadays. Therefore, it has become an essential topic of study for anyone who wishes to enter the financial markets.

 

(Must check: What is credit rating?)

 

In this blog, we understood the key features of technical analysis, contrasted it with fundamental analysis, and understood the tools that help us in technical analysis. As established, the primary tool used in technical analysis is candlestick charts. Even though a trader can use other charts, most of the traders use candlestick charts.

 

These charts are then used to determine patterns- both by using them separately and in combinations. These patterns form the basics of price action trading, an integral part of trading in financial markets using technical analysis.

 

Candlestick charts can also derive technical indicators that form another critical part of trading in financial markets using technical analysis. We will discuss these aspects in more detail in the following blogs.

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