Technical analysis is a key component of the stock market on a number of scales.
Traders can use it to pick good stocks to trade and to predict and forecast future stock prices. It can also be used to identify entry and exit points which enables good returns.
In this blog post, you are going to learn why technical analysis is important, particularly to day traders.
But before we go further, it is important to first understand what technical analysis is, its underlying assumptions, and how it is used by day traders.
What is the meaning of technical analysis?
Technical analysis is a way of using patterns in price charts to help make trading decisions.
Also known as chartism, technical analysis differs from fundamental analysis, which seeks to unearth the intrinsic or true value of a stock by looking at the finances and economics of companies and industries.
Technical analysis mostly involves the study of price charts, and that’s why those who engage in it are called chartists.
These individuals also tend to keep a close eye on trading volume and whether upward/downward price trends are being sustained.
While there are some complex mathematical concepts tied to technical analysis, it is simply a way of determining if a stock or the market, in general, is rising or falling.
Once you identify these trends, you are in a better position to make more informed decisions.
Assumptions of technical analysis
There are three assumptions of technical analysis – the market discounts everything, price moves in trends, history tends to repeat themselves.
- The market discounts everything
Technical analysis assumes that, at any given time, the price of a stock reflects everything that could or has affected the company including fundamental factors.
Chartists believe that the stock has priced the fundamentals of a company, along with market psychology and broader economic factors, thus removing the need to actually consider these factors separately.
Therefore, the only thing that technical analysts consider is the price movement that gets affected by demand and supply forces represented on charts.
- Price moves in trends
Another assumption of technical analysis is that price follows a given trend instead of moving unevenly. The trend can be either bullish or bearish, following unique patterns that tend to repeat over time.
Technical analysis shows which stock will trend in the pattern. Once a trend is established, the stock price is assumed to be moving in a certain pattern until a new trend is created.
- History tends to repeat itself
Lastly, technical analysis assumes that trends are repetitive, and both human history and human behavior repeats itself.
Since the stock price pattern is repetitive, chartists observe the past stock price to forecast future price trends with the help of chart patterns.
Technical indicators and patterns
Technical analysts use a variety of indicators. Here are some of the common patterns that emerge and the tools used to analyze them.
- Trading volumes
The volume of trading plays a crucial role in technical analysis.
Heavy trading volume suggests bullishness, where many traders are interested in the stock. Low volumes suggest bearishness because there are fewer buyers and minimal trading activity.
Simply put, volume validates the trend. In stock charts, volume is detonated by the bars at the bottom of a chart.
- Support and resistance levels
When trading stocks or other financial instruments, support and resistance levels are the foundation of almost all technical analysis charting patterns
Support and resistance levels simply refer to where supply and demand forces meet. They are the prices that are difficult for a stock or an index to break.
The support level is a price at which you can expect buyers to be more than sellers. The resistance level, on the other hand, is a price at which you can expect sellers to be more than buyers.
While these levels can be extremely obvious on some charts, they can also be hard to spot especially if you are a relatively new trader.
- Moving averages
In the simplest term, moving averages are the values of a stock over different time frames.
This technical indicator combines price points of a given stock, over a specified time frame, and divides by the number of prices points to give you a single trend line.
Technical analysts use moving averages to smoothen the daily fluctuation in stock prices by creating a continually updated average price.
You can calculate moving averages for any time frame, from minutes, hours, weeks, to years. But the common moving average time frames are 20, 50, 100, and 200 days, which approximate one month, 10 weeks, 20 weeks, and 40 weeks, respectively.
Chartists typically use the 20-day moving average for a shorter trading horizon. The 50-day moving average is used for the mid-term, while 200 DMA is ideal for a longer duration.
Now, let’s see why technical analysis matters so much to day traders
The stock market is full of day traders who are looking to predict how stock prices will move in the future because they know there are riches to be made if they get it right.
And if you ask us, you can’t be a day trader without applying technical analysis.
Day traders use technical indicators and patterns out of necessity. There is absolutely no way you can make decent returns on fast time frames by just relying on fundamental analysis tools.
As a trader, you have to use tools that display market data and price action to help us form analysis that will determine profitability.
When analyzing the stock charts, you can create price charts that help determine the next move. By relying on technical analysis, you can identify the following factors:
- Value and ability of a stock compared to the broader market.
- Instability in the stock prices in the present and past.
- History of trading and volume levels.
- Stock value and price fluctuations prior to and after key events.
Technical analysis can also help to understand the psychology of other traders regarding the market and offers a clear picture of what they are up to.
It also makes it easy for traders to predict important stock market trends i.e. uptrend, downtrend, and sideways/ranging market.
Additionally, technical analysis provides early signals before a trend reversal so that traders can base their decisions on those signals.
Moreover, it clearly defines the stop loss and target for the position taken by traders in the stock market. This is important because it helps day traders to decide as per the individual risk appetite.
Drawbacks of using technical analysis to day trade stocks
The flip side of technical analysis is that it is not a valid scientific approach as most methods study prices while factoring in price-related data.
Therefore, it is important that you constantly review your day trading strategies to check their workability.
A majority of traders tend to oscillate between different trading strategies and as a result, fail to their technical analysis in a steady manner, and this eventually results in losses more often than profits.
Bottom Line
Technical analysis provides a set of indicators and tools for day traders.
The purpose of technical analysis is to help you make a more financially sound trading decision because the supply and demand of stocks all depend upon it.
By evaluating the history of stock prices, you get a future reading of what a particular stock would be priced at.
While there is no assurance that technical analysis will bring you profits, day traders who practice it and constantly learn from it can enjoy great success.