How Technical Analysis Works
Technical analysis is a key trading technique to identify trading setups based on price action and stock chart patterns.
What is Technical Analysis?
Technical analysis is a financial market technique that traders use to forecast the future direction of stocks or Forex through the study of past performances. Technical analysis does not care about the fundamental of a company, nor does it care about their competitors. Instead, it plots the daily stock prices of a company on a stock chart and predict how the stock will move in the near future. On a stock chart, you will start to see certain patterns on how the stock moves on a daily basis. For example, if a stock is trading in the $5-$10 range for a long period of time, we will want to buy the stock when it approaches $5 and sell when the stock is near $10. History repeats itself and this is exactly how technical analysis was form. There are traders who make millions every year using technical analysis and it is widely use by Wall Street traders and retail traders around the world.
How Technical Analysis Works
Technical analysis uses technical indicators to predict stock prices. Technical Indicators are indicators that are derived from price actions such as the open, close, high, low and volume of a stock. For example, if a stock is going higher with huge volume, that indicates that there are a lot of traders are buying the stock and the stock may go even higher. There are many different technical indicators that traders developed over the years and the following are some popular technical indicators.
Popular Technical Indicators
1. Moving average
2. Exponential Moving Average
3. Moving Average Convergence/Divergence (MACD)
4. Stochastic Indicator
5. Candlestick Patterns
6. Relative Strength Index (RSI)
7. On Balance Volume (OBV)
8. Average True Range (ATR)
9. Bollinger Bands
10. Money Flow Index (MFI)
11. Percentage Price Oscillator (PPO)
12. Adx Crossover (+DI Crossover -DI) / Directional Movement Index (DMI)
13. Accumulation Distribution Line (ADL)
14. Force Index
15. There are many more
Don't let this list scare you because you don't have to use all the technical indicators. You will just have to pick a few and stick with them. My personal preference are Candlestick patterns, stochastic, volume and MACD. So how do you decide which ones to use? Well, you will have to paper trade with some of these technical indicators and see which ones work the best for you.
What are the best technical indicators
People kept asking me what are the best technical indicators to use, my answer to them is it really depends on themselves. Remember, two people trade with the same trading strategy or using the same technical indicator may get different results. Technical indicator helps to predict the stock price, but it doesn't guarantee that the stock will go up or down. Therefore, you need to use stop loss in case the stock goes against you. Different trader use different stop losses for their trades, some risk 0.5%, some risk 5%, therefore their outcome will be completely different.
How to use technical analysis?
Let's look at a real stock chart and see how you can use technical indicator to predict the stock price. I will use my favorite technical indicators, Macd, Stochastic and Candlestick Patterns.
The stock RUE is on a down trend as shown in the candlestick chart below. There are a few signals that indicates the stock is turning around and going higher when the stock hit $24. First, the stochastic indicator was oversold and drop below 20 and then it crossover 20 on 8/8. This is the first bullish signal for the stock. Then on 8/15, the stock made a nice breakout above the trend line, this is another signal to go long on this stock. If you buy the stock base on the Stochastic Indicator, then you would buy the stock on 8/16 and if you buy the stock on 8/15, you would still have a nice gain on this stock.
If you are new to technical analysis or want to learn more about stock trading, read swing trading strategies.