In this article, we will introduce you to the essential concepts of technical analysis and explain how to use them in a concrete way.
First of all, it is important to understand that studying charts can be used with equities, stock indices, commodities or exchange rates. Indeed, in all cases, technical analysis is based on the following assumptions:
- Prices reflect all known information
- Prices change in phases
- History tends to repeat itself
According to these principles, by analyzing data from the past, it is possible to predict future movements in the price of a stock. For this reason, it is in your best interest to understand the different concepts of technical analysis in order to properly make sense of the charts at your disposal.
Above all, according to the Dow theory, the market evolves according to a primary trend, which is a rising or falling directional movement, and this can last one or more years. Moreover, this major trend is made up of secondary and tertiary trends that contradict or mimic the underlying trend. Detecting these trends within a chart can help you improve the timing of the decisions you make and better evaluate the future direction of share prices. In other words, the dominant direction in the price represents, in a way, the overall market sentiment towards the stock you are analyzing.
In practical terms, a rising trend is formed by rising lows, while a downward trend is made up of lower and lower peaks. To spot these phases in a chart, you need to identify 2 to 3 points (peaks or troughs) and then link them together to create a trend line. Check out the image below to see an example of a stock that is moving in a downward trend. As long as the price remains below the line, the stock still has bearish momentum and reflects a pessimistic attitude.
Source : Market-Q
You should know that it is also possible to detect a trend reversal in a chart. Indeed, in technical analysis, when the price of a stock closes on the other side of a trend line, it signals a reversal in the trend. Usually, the more contact points there are with the trend line, the more likely it is that the break should cause a strong correction. On the other hand, a break in the line could also mean the current trend is running out of steam and, in this case, the stock could begin a simple horizontal consolidation phase, called a “trading range.” In fact, in other articles, we have already discussed technical indicators (RSI, MACD) that allow you to gauge momentum and confirm trend reversals.
Another crucial element when analyzing a stock chart is the concept of support and resistance. Essentially, these are price levels where the share price tends to rebound upwards or downwards.
Support line: the level at which the price tends to rise due to high demand.
Resistance line: the level at which the price tends to fall back due to pressure from sellers.
See the image below for a practical example of the concept of support and resistance. As you can see, the share price seems to rebound on these 2 price levels. Following this logic, an investor could decide to buy as close as possible to the support line and then sell as close as possible to the resistance line.
Source : Market-Q
How solid these price levels are depends mainly on the number of times they have been reached and how long they have been in place. In other words, a support line that spans several months should be more robust than a support level that emerges over a period of a few hours. Similarly, a resistance level that has been tested time and time again will likely be more difficult to overcome than a resistance level that has just formed.
What happens when there is a break in a price level?
In fact, when the price of a stock crosses a resistance line, that price level now becomes a support line. Conversely, when a support level is crossed, this price now serves as a resistance level. Note that a real break in a price level is often accompanied by a significant increase in volume. You can therefore infer that it is possible to take a position after a significant level is broken through in order to take advantage of a strong push in the share price.
It is also interesting to note that these psychological price levels seem to permeate the “market memory” and remain valid over time. See the example below.
Source : Market-Q
In summary, the concepts of trends and price levels are tools that help you recognize the overall mood of the market and identify the best time to buy or sell. The data inside a chart can be used to anticipate the future direction of the price of a stock or even a stock index. In the end, while technical analysis does not allow you to predict the future with certainty, this type of analysis is a useful process that you can include when making decisions as a do-it-yourself investor.
Author biography: Alexandre Demers has been an active investor since 2013 and is the founder and president of Traders 360 Inc. He has also authored the e-book “Investir à contre-courant” (Investing against the grain) and hosts the “Finance 360” podcast available free on Spotify and iTunes. His goal is to make stock trading more democratic and educate the public at large about the possibilities of self-managed investments.
The above article was written by Traders 360, an independent external firm partnered with National Bank Direct Brokerage.