Technical analysis, an art or a science?
The past two years have been great times for investing. Whether it’s through the stock market, real estate, commodities, cryptocurrencies or NFTs, the markets have seen record annualized returns. There are several reasons why the markets have been soaring lately. Indeed, low interest rates and government support have allowed the economy to ignite. This new market has given rise to new types of investors: the influencer investors. Indeed, more and more people are being exposed to this type of investor on social networks. They refer to technical analysis as the ultimate solution to obtain quick profits. Thus, many may be tempted to speculate on worthless stocks in the hope of obtaining a spectacular return on investment by relying on technical analysis.
But does technical analysis really work? This is a question that many people ask themselves. In fact, technical analysis works when you are rigorous, have a plan, and manage your emotions. Easier said than done!
The following text explains the main aspects of technical analysis, as well as the main indicators used by active traders.
What is technical analysis?
Technical analysis is the study of stock market charts. It is therefore the opposite of fundamental analysis, which considers the financial health of the company and its growth prospects. Fundamental analysis is also very qualitative. That is to say that financial reports are not sufficient to convey certain unwritten information, such as determining the quality of the management team.
On the other hand, technical analysis, the subject under study, is purely quantitative. Indeed, it is based on mathematical and graphical models to predict the direction of a stock price and its target price. Consequently, this type of analysis does not take into consideration the activities of the companies nor the intrinsic value of a share. Thus, technical analysis has its own set of concepts and relies on an entirely different set of criteria than fundamental analysis.
What is its purpose?
The purpose of technical analysis is to predict trends and signs of trend reversals. So, if the technical analyst (trader) manages to take a position at the right time, it is very possible that he will make a short-term gain. In order to perform this type of analysis, the trader uses technical indicators, chart formations and trend lines. These tools allow the trader to select the most relevant stocks for short-term gains.
More specifically, these indicators are used to determine price zones such as resistance and support, to interpret the movement of stocks based on its history and volume, and to determine a target price for buying and selling.
However, there are several problems when using these indicators. Indeed, the interpretation is very subjective and the signals can be contradictory from one analyst to another. That is to say that everyone can see what they want to see! Indeed, technical analysis is not an exact science but rather an art form. Moreover, the market represents the collective psychology of millions of investors. The stock market therefore tends to react very quickly to any news, positive or negative, on the price of the companies concerned. The trader therefore uses the movement of the crowd to his advantage and determines his probability of success before taking a short-term position.
But what about the long term? In fact, technical analysis is not a long-term strategy. Traders use this type of analysis to take advantage of price fluctuations, but if an investor wants to buy a stock for financial and fundamental reasons, the final return will be the same if he wants to buy the stock tomorrow morning rather than today at 1pm. However, it can be useful for the investor to know basic indicators such as the RSI and the moving average in order to understand where the stock stands in its historical price. In other words, technical analysis is a complement to fundamental analysis.
Which platform should I use?
Many trading platforms allow you to view stock charts. In fact, most financial institutions have this option, but there is one that I think stands out from the rest. TradingView is a very complete technical analysis platform that allows you to add several indicators at once. It is easy to use and free. But how do you use it?
First of all, it is important to select, from the start, the time frame used. Indeed, it allows you to generate a graph with the desired candles. For example, if a time frame of 1 day is selected on the platform, then each candle in the graph represents a period of 1 day. The following figure represents Apple for the past year. The “D” in the red square in the upper left corner represents the time frame used: Daily.
Figure 1: Apple (AAPL) price trend over the past year.
In addition, it is important to understand how to read the candlestick chart. Candlesticks are the basis of technical analysis. Candlestick charts show the opening price, the closing price, and the high and low price for the session. Finally, the color of the candlestick chart indicates whether the stock was up or down during the day. The following figure summarizes the concept.
Figure 2: Japanese candlestick.
Then, the TradingView platform also allows you to add trend lines with the left module and indicators with the top one. Hours of fun!
What are the main indicators?
An indicator is a mathematical formula that uses the price or volume of a security over a period of time to highlight and exploit market situations. There are dozens of technical indicators, but only a few are necessary. In addition, it is important to note that it is the synergy between technical indicators that allows the trader to make a decision. Thus, he must use several indicators at the same time to interpret a change in trend, to confirm situations and to predict price fluctuations.
Moving averages are the main trend indicators. They reflect the dynamics of the market and mainly its speed. They also allow identifying the current trend and to determine support/resistance levels. These indicators perform well in a directional market, but do not perform well in a volatile or sideways moving market. For example, the following figure uses the 200-day moving average, in red, to determine support levels, which have been relatively respected since the Covid-19 crash last March.
Figure 3: Apple (AAPL) price trend since March 2020. Moving average strategy.
The 200-day moving average is the most widely used trend indicator, as is the 50-day moving average. These relatively long-term moving averages smooth out the daily fluctuations, thus eliminating the daily noise. In addition, it is possible to use the exponential moving average if recent movements are more important to consider. Indeed, exponential moving averages are more reactive by giving weight to recent stock price events with exponentially decreasing precedence.
The second widely used trend indicator is the Moving Average Convergence Divergence (MACD). It gives buy or sell signals when its signal line crosses the MACD line. Indeed, if the MACD line crosses the signal line upwards, it is a buy signal. Otherwise, if the MACD line crosses the signal line downwards, it is a sell signal. The following figure shows the strategy.
Figure 4: MACD indicator strategy.
Therefore, the application of the indicator on AMD would have resulted in two consecutive winning trades. Indeed, Figure 5 shows the buy signals announced by the MACD before the price surge.
Figure 5: Price trend of Advanced Micro Devices (AMD) since April 2021. MACD strategy.
The RSI (Relative Strength Index) indicator is the most widely used indicator among oscillators and in technical analysis. It identifies areas of tension between buyers and sellers that may lead to a correction/reversal. Traders use these indicators for their overbought/oversold areas. For example, the following figure shows the different overbought and oversold areas of the RSI located at the bottom of the screen. The two overbought zones are above the purple zone (line 70) and the oversold zone is at the bottom of it (line 30). The strategy is to buy when the stock is oversold and sell when it is overbought. The goal is therefore to do the opposite of the short-term market sentiment. The application of the RSI on AMD stock allows us to see that prices have followed an opposite direction in the short term as a result of excessive buying or selling pressure from investors.
Figure 6: Price performance of Advanced Micro Devices (AMD) since April 2021. RSI strategy.
Momentum is a classic in technical analysis. It is obtained by subtracting the closing price of today’s session from that of a previous session. Therefore, the Mom indicator is a moving difference between two closing prices spaced by a fixed time interval (called frequency). This indicator does not tell the investor when to buy or sell. Rather, it shows whether the current trend, despite its apparent strength, is running out of steam. Its interpretation is based on the visual divergence observed between the momentum trend and the price trend of the stock under study. When they are moving in opposite directions, a change in the current price trend can be expected. The following figure clearly shows three divergences that anticipate a change in the direction of the stock price.
Figure 7 : Apple (AAPL) price trend since March 2021. Momentum Strategy.
In April, the Mom Index is trending down, while Apple’s stock price is still trending up. However, the stock price falls in early May. Then, in October, while the stock price is trending down, momentum is already pointing upward in anticipation of a major rally that will continue into early 2022. Finally, the same thing happens again in March 2022.
Volume is very important in trading. Volume means the number of trades executed over the given period. It is an indicator that is not based on price, like the momentum indicator. It therefore represents the emotional involvement of traders, i.e. the force that sets prices in motion. Indeed, high volume indicates high interest in an instrument at its current price and vice versa. Thus, the volume indicator is not used alone, but in combination with other technical indicators, since it does not give buy signals, but rather market sentiment. For example, one would expect high buying volume at a support level and high selling volume at a resistance level.
Its interpretation is simple. The more bands the histogram shows, the more the stock is traded during the selected period. Green bands represent growth in volume, while red bands represent a decline from the previous period.
A strong uptrend is usually accompanied by high volume on the upside and lower volume on the downside. Oppositely, a strong downtrend is accompanied by high volume on declines and lower volume on corrections.
Figure 8 : Price performance of Meta Platforms, inc. (FB) since March 2020. Volume strategy.
Figure 8 shows the exceptional volume recorded on February 3, when Meta (formerly known as Facebook) reported its quarterly results. Indeed, its worse-than-expected results caused the stock to drop 26% in a single trading day!
Volatility-based indicators are valuable technical analysis tools that consider the changes in market prices over a given period of time. The faster prices change, the higher the volatility. The slower the price change, the lower the volatility. This usually indicates whether a market is overbought or oversold, like the RSI indicator seen earlier.
The most popular and easiest indicator to use is the Bollinger Bands (BB) Method. The Bollinger Bands consist of a band of three lines that are drawn in relation to the prices of securities. It is the synergy between the three bands that will give the trader indications such as buy or sell signals.
The average band: simple moving average (usually 20 days).
The upper band: 20-day simple moving average + (standard deviation x 2).
The lower band: 20-day simple moving average – (standard deviation x 2).
Thus, Bollinger Bands are essentially a way to measure and display volatility (or standard deviation). As volatility increases, the bands widen. Similarly, as volatility decreases, the gap between the bands narrows. In this sense, prices are almost always within the band. Therefore, when prices rise near the upper band, many traders consider that value to be overbought. Thus, like the RSI strategy, this type of event would be a selling opportunity. Oppositely, when prices fall near the lower band, that stock may be considered oversold and a buying opportunity may present itself.
Figure 9: Apple’s price evolution (AAPL) since March 2021. Bollinger bands strategy.
Figure 9 shows the stock price of Apple in a 1-day period. The Bollinger Bands allow us to statistically visualize the overbought and oversold situations when the candles touch the upper or lower bands. We can even see the strong oversold movement of the stock in late February 2022. This episode had a strong short-term rebound and was a buying opportunity.
Resistances & supports
When you start to take an interest in the stock market chart, one of the first things you need to learn is to understand the support and resistance lines. These lines, traceable by the trader, are price levels from which the price movement should stop and take the opposite direction. Thus, these are the levels that constitute the floor and ceiling of future price movements.
Support is the price level below the market price, at which buyer interest should be able to resist seller pressure and prevent the price from falling further. Conversely, resistance is the price level above the market price, at which selling pressure should be strong enough to overcome buying interest and prevent the price from moving higher. In addition, a resistance line can become a support line and vice versa. Indeed, if the buying pressure is great enough to push the price above the resistance line, then this breakout phenomenon will change the identity of the resistance line, which will now be the support line of the last price.
It is possible to observe this phenomenon very easily on the AMD stock in the following figure. The precision is quite spectacular!
Figure 10: Advanced Micro Devices (AMD) stock price trend since October 2020.
Indicators often present clear signals, but some signals must be interpreted directly by active traders. Divergences are more difficult to discern and require more experience for traders. Divergences occur when a technical indicator does not mark the same high/low as the asset price. We have seen this with the momentum indicator, but the principle is the same for the RSI and MACD. For example, Figure 11 shows a bearish divergence using the RSI.
Figure 11: Advanced Micro Devices (AMD) price trend since November 2020. Bearish Divergence Strategy.
Bearish divergence is the formation of two consecutive peaks in the price, with the most recent peak higher than its previous peak, while at the same time the RSI makes two peaks, the most recent of which is lower than the previous peak. This can be interpreted as a trend reversal signal, as AMD stock reacted to this signal. In contrast to the bearish divergence, the bullish divergence can also be used to determine a trend reversal, towards the upside.
In addition, another indicator is often useful in determining theoretical support and resistance zones. Fibonacci’s retracements are based on the principle that a trend is never linear and that there are always corrections in an uptrend and rebounds in a downtrend. Thus, Fibonacci retracements make it possible to determine retracement zones of the previous movement, i.e., levels on which rebounds or corrections can be stopped.
Figure 12: NVIDIA Corporation (NVDA) Price Performance since January 2021. Fibonacci retracement strategy.
Other indicators, which are purely qualitative, help us understand market sentiment. Indeed, chartist figures and candlestick patterns allow us to detect the trend, i.e. optimistic (bullish) or pessimistic (bearish). There are dozens of these indicators, but only a few will be presented.
In terms of bullish chartist patterns, the cup with handle is a continuation pattern after consolidation, which appears at the end of an uptrend. It is easily identified by its “U” shape and the slightly decreasing handle. With this strategy, the trader will place a buy order when there is a breakout of the upper trend line of the handle.
Figure 13: Cup with handle.
On the other hand, in terms of Bearish Chartist patterns, the head and shoulders pattern is a very well-known trend reversal pattern. This pattern has three peaks, with the centre peak, “the head”, being higher than the others. To take advantage of this pattern, the trader positions the neckline that allows him to place his buy or sell orders. This line, which is a resistance or support line, is shown in Figure 13. Thus, the active trader places his order when it is broken and when the formation is complete.
Figure 14: Head and Shoulders.
In addition, it is also possible to draw trend lines in order to construct symmetrical, ascending and descending triangles to understand the movement of stock prices. They are widely used in active trading to predict the exit of a consolidation movement. These triangles are represented by two trend lines that converge towards each other in a given direction. These are continuation patterns like the cup with handle pattern. Again, the active trader must wait for a strong breakout of the triangle (high volume is required) before taking a position in the asset. Finally, the trader’s target price is the difference between the high and low points at the beginning of the triangle carried forward to the price breakout point. The following figure shows the three types of triangles.
Figure 15: Chartist triangle pattern.
Similarly, it is also possible to analyze candles directly to determine candlestick patterns. The hammers are the best known. Hammers are called this when it is in the lowest point of a downtrend, while they are called a “hangman” when it is in an uptrend. This pattern is therefore a sign of a trend reversal. Indeed, the long stem of the hammer candle represents the pressure of buyers or sellers, a sign of a trend reversal.
Figure 16: Hammer and Hangman.
Finally, chartist patterns are candlestick patterns that help the active trader make a decision about whether to buy or sell a security at a given time. These methods are directly related to the psychology of investors. They are therefore purely subjective and do not allow one to take a position without confirmation from other indicators. It is therefore important to combine the indicators in order to properly interpret the price direction.
The final word
In conclusion, there are dozens of different technical indicators and the active trader may find himself confused by all these methods. In fact, each trader has his own strategy that fits his investment style. In this sense, it is important for amateurs to determine which combinations of technical indicators work for them. For example, using the synergy of up to four or five indicators allows you to trade on a clear chart where only relevant information is present. However, it is also important to remember that this kind of practice is very difficult psychologically and only a small percentage of successful traders make a living from it. But everything is possible with practice and perseverance. Indeed, practice allows you to build a reliable work and analysis methodology. In fact, on TradingView, the trading platform mentioned earlier, it is possible to paper trade to practice executing transactions with fictitious money, but with the real market prices.
Finally, the stock market is a roller coaster of emotions where it is very difficult to keep your cool. So, if there is one thing to remember from the article, it is to respect your game plan when trading. That is, determine your entry price, stop loss and target price before making the trade.
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