Technical Analysis Actually Works and How to Use It
Traders primarily rely on technical analysis rather than stock reports and financial statements to make their trading decisions. Technical analysis involves visually identifying patterns in performance graphs, similar to how musicians visualize a song through notes. In this article, we'll explore the mechanics and effectiveness of technical analysis.
However, before delving into the intricacies of technical analysis patterns, it's essential to understand what traders look for. Technical traders monitor price movements to detect trends and momentum. A brief spike or decline in prices alone isn't enough to warrant a trade. It's better to observe the stock for an extended period or conduct a look-back analysis to identify patterns.
Rather than relying on a single price movement, traders analyze moving averages. Two types of moving averages exist: simple and exponential. Simple moving averages use a standard average equation, while exponential moving averages place more weight on recent prices.
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Understanding Resistance and Support Levels
In technical analysis, there is a concept called the "level of resistance," which can be likened to an imaginary glass ceiling that a stock price cannot seem to surpass. During a bull market, resistance levels tend to increase, while in a bear market, they tend to decrease. While this isn't always a hard and fast rule, it's an essential principle to keep in mind when entering into trading.
Sir Isaac Newton's third law, which states that "For every action, there is an equal and opposite reaction," may not have been explicitly about trading, but it does highlight one of the fundamental principles of technical analysis that we'll discuss further below. If there's a resistance barrier that functions as a ceiling, there must also be a support barrier that prevents the stock from falling too low.
Resistance and support levels are easily recognizable in technical analysis. By examining any performance graph over a period of time, you can observe peaks and valleys. The highs represent the resistance level, and the lows represent support. Entering into trades in this territory without technical evidence makes it a high-risk venture.
However, it's worth noting that glass ceilings can be broken, and floors often have trap doors. If technical analysis were that simple, everyone would do it, and no one would profit. Thus, it's important to understand resistance and support levels as concepts, not constants. Successful traders are those who can predict when resistance levels will be broken. To do so, you'll need to know more.
Using Bollinger Bands as Trade Indicators
Traders don't necessarily need a finance degree to succeed in trading, nor are there any licensing or SEC guidelines to adhere to. However, having a good understanding of key terminology is essential. In addition to moving averages and levels of resistance, it's also crucial to grasp the concepts of "Bollinger Bands" and "Standard Deviation," both of which are fundamental elements of technical analysis.
A Bollinger Band is the area between two lines on a pricing graph. The first line is drawn across the peaks of the graph, while the second line is drawn across the valleys or lows. These bands are used to determine the probable range within which a security is likely to trade, typically two standard deviations from the moving average. The visual representation of this is shown below:
Bollinger Bands can help traders determine whether a stock is overbought or oversold. When the price hits or surpasses the upper level of the Bollinger Band, it may be a signal to sell, while touches of the lower level could indicate a good time to buy. While this approach isn't foolproof, using this knowledge can increase the odds of successful trading.
Understanding the basics of Bollinger Bands is an essential first step in comprehending technical indicators. For more advanced training on technical indicators, you can explore Tickeron's article database on the subject. Here, you can find various techniques for using moving averages, analyzing cash flows, and even applying Fibonacci numbers and the Golden Mean to your trading strategies.
Reading and Analyzing Chart Patterns
Now that you've grasped the fundamentals, it's time to delve into the essence of technical analysis. While chart patterns may appear to be simply lines on a graph to the average person, traders perceive them as indicators of investor behavior, corporate growth, and potential success or failure. Your primary objective going forward should be to learn how to interpret chart patterns.
Chart patterns can be thought of as shapes, including but not limited to cups and handles, triple bottoms, flags, pennants, and head and shoulders. These shapes are easily recognizable and we will devote the next few sections to explaining their meanings in detail. Additionally, we'll discuss trading models and how to identify the one that best suits your needs.
Behavioral Psychology of the Cup and Handle
The "Cup and Handle" is a popular chart pattern that often appears during bullish markets. Following a peak in price, investors tend to sell off some of their holdings, leading to a price decline. Once the price hits a certain level, investors buy back in, causing the price to rise once again. When graphed, this pattern resembles a cup shape with a handle. Here is an example:
After the price peaks, the handle formation occurs. Investors may take some profits but are likely to reinvest quickly in an attempt to capture a breakout over the upper resistance level. This can cause the price to surge even higher as more investors join in, afraid of missing out on potential gains. Additionally, those who have short bets may become anxious at this point, further fueling the uptrend momentum.
Identifying the cup and handle pattern and pinpointing where the handle begins to form presents a promising trading opportunity. It does not require an in-depth analysis of the company's financials since the pattern is easily recognizable. Previous "cups" in the data can provide evidence of a clear growth pattern. Entering the market at point #4 in the pattern should yield a favorable return.
The Predictability of Triple Bottoms
The "triple bottom" chart pattern is a highly reliable trading pattern that typically appears during a bull market. It is characterized by three consecutive touch points on the Bollinger band, indicating a strong support level. This can be a positive sign of a healthy financial outlook for the company and/or a committed investor base that is selling and reinvesting in a timely fashion.
As a trader, identifying the bottom point of a stock's price is a crucial signal for determining when to enter a position. Typically, after the third bottom, there is a high probability of an uptrend and a breakout above the resistance level. To maximize returns, it is advisable to buy at the start of the uptrend and set a stop-loss just below or at the breakout price. This pattern presents a favorable opportunity for generating profit with relative ease.
Reading Flags and Pennants
Flags and pennants are formed when prices consolidate and move within a narrow range. During an uptrend or bull market, we call this pattern a flag, and during a downtrend, it's known as a pennant. These patterns serve as indicators that a stock price is likely to move in one direction or the other. Flags are generally considered a buy signal, while pennants are often seen as a signal to sell. Additionally, there are a variety of options strategies that traders can employ in these scenarios.
Head and Shoulders for Bears and Bulls
The chart pattern known as the "head and shoulders" can be observed in both bear and bull markets. In the following image, we depict this pattern in a bullish scenario. Initially, investors purchase during the first low point (shoulder) and subsequently sell when prices reach the neckline. When the price seems to be bottoming out at the head, buying activity resumes. This cycle repeats until prices reach the neckline once again.
Usually, in this pattern, the next downtrend will halt at the second shoulder, and the subsequent uptrend should mark the point where the price surpasses the neckline. However, in the bearish version of this scenario, the head and shoulders are positioned above the neckline, resulting in a downtrend after the second shoulder. As these patterns may appear similar, it is essential to exercise caution.
Select the Right Trading Model
It should be apparent that technical analysis is effective. However, to benefit from it, you must have a thorough comprehension of it and select a trading model that aligns with your personality and financial objectives. It's crucial to understand specific chart patterns and technical indicators required for each trading model, so avoid entering the market blindly. To assist you in this regard, Tickeron provides various recommendations in the "Educational Courses" section of our application.
Unlike investing, stock trading is a mathematical science and not influenced by emotional, sociological, or political triggers. Trading models are strategies for implementing technical analysis in a market that is impeded by emotional inefficiencies. When embarking on this journey, one must leave emotions at the door.
The "random walk hypothesis" is a trading model that believes no technical analysis can consistently beat the market over time. In contrast, the "divergence analysis" model, which is primarily based on technical analysis, incorporates fundamental analysis to track the convergence and divergence between indexes.
Intraday trading, which involves buying and selling positions within a single day, relies heavily on technical analysis. It is also the most exciting and lucrative form of stock trading. If this article has improved your understanding of how to use technical analysis, your chances of success in intraday trading will be significantly higher.
The main idea behind technical analysis is the ability to find recurring price patterns and trends and use them to predict the direction of future market trends. We started with the creation of AI-based Engines (Pattern Search Engine, Real-Time Patterns, Trend Prediction Engine) that allow us to effectively analyze market trends. We then have explored almost all existing methods (price patterns, trend indicators, oscillators, and many others) using neural networks and deep historical backtests. As a result, it was possible to form a pool of trading algorithms that together allow our AI Robots to effectively determine the key points of change in market trends.
Contributor
Sergey Savastiouk, Ph.D. has a degree in Applied Mathematics from Moscow University and has extensive experience as an entrepreneur, investor, manager, and mathematician. His professional expertise is in applied mathematics, mathematical modeling, system and pattern analysis, and software and hardware system integration. He has served as the CEO of several hi-tech start-up companies and nonprofit organizations, which has given him proven capabilities in business strategy for high-tech start-up companies, market assessment, company formation, team building, product development, marketing, and sales. He has published numerous articles in journals and magazines on related fields. As a retail investor, he spent 15 years developing his proprietary trading and quantitative algorithms (now Tickeron’s A.I.), which brought him significant returns in trading the stock market. His current work and goal in founding Tickeron is to bring professional, sophisticated stock market analysis capabilities to retail investors via an easy-to-use interface.
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