What is technical analysis and how does it work?
April 28, 2022
6 minutes to read
In technical analysis, you assess a share using data points (especially traded volumes and prices) to map patterns.
While fundamental analysis seeks to determine the intrinsic value of a share, technical analysis aims to provide an insight into the future price movements of a share.
With technical analysis, you are trying to predict performance by studying patterns based on performance in the (recent) past. Trends in these patterns may also indicate that a correction or a buying opportunity is imminent.
Just like weather forecasts, technical analysis does not allow you to make 100% accurate predictions for the future. Instead, technical analysis can help anticipate how a price trend is likely to turn out.
Technical analysis can be applied not only to shares, but to all traded products (indices, futures, currency pairs , etc.) whose price is affected by supply and demand.
Analyses can be based on intraday (every 1 minute, 5 minutes, 10 minutes, 15 minutes, 30 minutes or hour), daily, weekly or monthly data. That’s why investors use technical analysis mainly for short-term trading, that is buying shares and selling them again quickly.
When (not) to use technical analysis?
Technical analysis only works if the price of a share is influenced by sufficient supply and demand. If there are many other forces involved, technical analysis is less useful. In the following situations, technical analysis is less useful:
- Not easily saleable (low liquidity) Frequently-traded stocks are preferred to stocks where supply and demand are limited. If there are only a few buyers and sellers, there is a risk that the price of the share may fluctuate widely because there are major differences between the bid and offer prices. Frequently-traded shares with a small spread are therefore better suited for technical analysis.
- Artificial price changes Paying a dividend and splitting shares can have a major impact on the price graph. Although in principle this does not make a difference to the intrinsic value of a share, events like these can have a major impact on the price chart and make technical analysis difficult.
- Unusual news A takeover, a fire at the company, the resignation of the CEO, an attack etc. whenever the price of a share is influenced by powerful external factors, it takes time for the graph to get back to normal again.
How to get started with technical analysis?
The principles of technical analysis are universally applicable using the same theoretical background. Technical principles such as support and resistance can be applied to any graph. However, technical analysis is far from simple. It requires a lot of focused study and time.
Many start with a top-down analysis. This starts with a broad market analysis, then you zoom in on sectors and finally perform an analysis of individual shares.
- Market analysis of major indices such as the Stoxx Europe 600, S&P 500, Nasdaq and Nikkei 225. and NYSE Composite.
- Sector analysis to identify the strongest and weakest sectors in the market as a whole.
- Analysis of individual shares to identify the shares with the most potential.
Technical analysis of a share: the basics
• The various indicators
- Trend indicators The first step is to identify the overall trend. You can draw this by plotting lines. A trend is rising as long as the price remains above the rising trend line or a given moving average. Congestion areas (the price barely changes within the lower narrow trading band) and the previous lows below the current price generally mark the support levels. A breakthrough downwards through this kind of support can be considered bearish and can negatively affect the overall trend. Congestion areas (the price barely changes within the upper narrow trading band) and previous highs above the current price indicate resistance levels. A breakthrough above this resistance can be considered bullish and can positively affect the overall trend. There are several trend indicators. One of the most commonly used is the Moving Average Convergence/Divergence (MACD). If the short-term averages are above the long-term averages, this is an indication of positive momentum. The MACD also indicates when the trend direction is changing.
- Trading indicators One of the most commonly used trading indicators is the RSI (Relative strength index). It is usually used to help investors identify momentum, market conditions and warning signs. RSI is expressed as a number between 0 and 100. An RSI of around 70 is often considered to be overbought (sell), while an RSI near 30 is often considered oversold (buy).
- Activity indicators This group of indicators provides information about the extent to which traded volumes determine the price trend. The On Balance Volume (OBV) is an example of this. This indicator shows the combined total of the buy and sell volumes. A sequence of peaks and troughs indicates a strong trend. A flat OBV indicates a lack of any trend. The last step is to combine the indicators used. This gives you an insight into the strength of the trend, the stage of the trend, the risk-return ratio at the time of purchase and a potential entry or exit level.
Candlestick charting is the most commonly used method for displaying movements on a chart. A candlestick is formed by the price movement over a given time period for each time frame (1 minute, 5 minutes, an hour, a day , etc.).
The highest point of a candlestick (the "wick") indicates the highest price at which the share was traded during that time period, and the lowest point (the bottom "shadow") indicates the lowest price during that time. The bar of a candlestick (the thick part) indicates the opening and closing prices for that time period. If the candlestick is green, this tells you that the closing price (top of the candlestick) was higher than the opening price (bottom of the candlestick). If a candlestick is red, the opening price was higher than the closing price.
The colours used may vary from one platform to another. Whatever colours you use, they offer an easy way to tell at a glance whether the closing price at the end of a certain period of time was higher or lower. Technical analysis using a candlestick chart is often easier than using a standard bar chart, as you get more visual cues and patterns.
• The patterns
When you take a closer look at the price lines, you will sometimes see typical patterns occurring. These can give investors a signal to act. There are many of these patterns: flags, wedges, diamonds, etc. Some patterns point to the reversal of a trend, others to the trend continuing. Here are the most well-known:
- Head and shoulders pattern A head and shoulders pattern signals the end of a rising trend. The pattern consists of three tops: two shoulders (S) with a higher top in the middle, the head (H). The tops are sitting on top of a support line, also referred to as the neckline. Once the pattern is complete, the price drops below the neckline.
- Reverse head and shoulders pattern Every pattern also exists in an inverted version. Reverse head and shoulders patterns signal the end of a falling trend.
- Double top or M A double top may indicate the end of a rising trend.
- Double bottom or W This can appear at the end of a falling trend.
- Ascending, descending and ordinary triangles Unlike the above patterns, triangles usually indicate the continuation of a given trend. An ascending triangle indicates an upward breakout, a descending triangle a downward breakout and an ordinary triangle usually breaks out in the same direction as the previous trend.
- Rectangle A rectangle is also a so-called continuation pattern. This pattern may indicate that the price will continue to move sideways between a ceiling and a floor.
Want to get started?
Tools for performing a technical analysis can be found at keytradebank.be. Log in to keytradebank.be, locate the share, and then select the technical analysis tab.