Technical analysis. What is it? How does it work?

30 August 2023 by National Bank Direct Brokerage
A screen showing the different components of technical analysis.

Self-directed investors use different tools and strategies to help them make investment decisions. One approach is technical analysis. It is a method of evaluating and predicting stock movements by looking at data that focuses on the price and trading volume changes in a security over fixed periods of time.

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What is technical analysis?

Technical analysis is a way of predicting stock movement based on historical market data. It is used to evaluate investments and identify trading opportunities. It often incorporates insights from market psychology, behavioral economics, and quantitative analysis to carefully examine past performance to help predict future market behavior.

The two most important indicators in technical analysis are price movement and volume. As a trading discipline, it can be applied to any security with historical trading data, such as stocks, futures, commodities, fixed-income and currencies. The focus of technical analysis is price patterns and trends rather than external drivers such as news events or intrinsic factors such as company fundamentals.

Though some experts view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security, the core underlying principle is that the market price and the stock's chart trends reflect all the available and necessary information that could impact the market.

What is the difference between fundamental and technical analysis?

Technical analysis is often compared to fundamental analysis, another methodology. Fundamental analysis evaluates stocks based on industry and business fundamentals such as growth trends and a company's prospects using financial metrics like price-to-sales (P/S) and price-to-earnings (P/E) ratios.

While technical analysis focuses on charts and price patterns, fundamental analysis looks at earnings, dividends, and financial statements, as well as other indicators. Fundamental analysts see a connection between price movements and all things related to the economy — earnings, the actions of competitors, and important news events.

Fundamental analysis is largely concerned with the intrinsic value of a stock. It focuses on critical economic and financial indicators. This is distinct from technical analysis, which examines chart statistics like shifts in price or trading volume.

In some instances, technical analysts aren't particularly concerned about the company's purpose and are simply focused on analyzing a stock's price action. And while technical analysis lends itself to a faster investing pace, fundamental analysis has a longer decision timeline because of the extra due diligence required.

How can I use technical analysis?

Self-directed investors can apply technical analysis to any stock or ETF price chart that tracks price changes over different time frames. These range from shifts within a single day that can run from minutes to hours, called intraday trading, to extended periods that last days, months or years.

Technical analysis can be used the following ways:

  • Determine if a security is bullish or bearish.
  • Establish short and long-term trading opportunities
  • Fix an entry or exit point on a security and then use support or resistance levels to set a sell or buy limit order
  • Can be used for short selling
  • Help validate or confirm a buy or sell decision made using fundamental analysis

How does technical analysis work?

Technical analysis functions by examining security price fluctuations and volumes over time. It's important to remember that no single indicator provides a complete and accurate picture. Typically, a technical investor will combine several indicators before evaluating a purchase or sale. Below is a list of the indicators most used by technical investors.

What is chart analysis?

Chart analysis helps determine the prevailing trend of a security. It uses different types of charts to convey different kinds of information. Charts help traders make informed decisions and visually represent asset price, and volume changes over different periods of time. There are many types to select from such as a Candlestick chart or a Bar charts (high/low/close/open). Most direct brokerage firms will provide several different views to present the data.

Volume goes hand in hand with chart analysis because it is a valuable source of information for validating bullish or bearish signals. Therefore, it is important to always take volume into account at all times when analyzing charts, as it often represents the strength of a technical move. The higher volume, the higher the probability that the price change will continue to fluctuate.

What is a candlestick chart?

Candlestick charts are a standard method to show price movement on a chart. Each candlestick indicates price changes within a fixed period. In a day chart, each candlestick entry will show price fluctuations for the day, while a four-hour chart will graph changes in value over multiple four-hour periods.

Example of a candlestick chart

Example of a Candlestick chart

Each candlestick entry shows the asset's high value and the low value within that period. If the candlestick's body is green, the price trend is going up. The opening value of the asset is indicated at the bottom of the candlestick body, and the closing price for that slice of time is displayed at the top.

A red candlestick body indicates a descending valuation with the opening price at the higher or top value and the closing price at the bottom of the candlestick. The wick, or thin lines, extending out from the center of the body of a green or red candlestick, indicate the high and low price extremes for the asset during that same timeframe.

What is trend analysis?

Within the financial industry there is a common saying: the trend is your friend. This saying relates to the concept of momentum and that a security will want to continue moving in the same direction (upward or downward) and you shouldn’t fight it. Keeping that in mind, before making an investment decision on a stock, it is essential to define the stock's trend. By doing so, we can ensure that we invest in the direction of the trend. A moving trend has a higher probability of continuing.

Upward trend line:

A positively sloping line drawn by connecting two or more ascending troughs on the price curve. This line indicates that demand (buyers) is or has been stronger than supply (sellers). As long as the stock price remains above the trend line, the trend is valid. A break of the price across the trend line indicates weak demand, and may therefore correspond to a bearish signal.

Downward trend line:

Negatively sloping line drawn by connecting two or more descending vertices on the price curve. This line indicates that supply (sellers) is stronger than demand (buyers). As long as the stock price remains below the trend line, the trend is valid. A price break through the trend line indicates an increase in demand, and may therefore correspond to a bullish signal.

Trend analysis

Graph demonstrating trend analysis.

What are support and resistance levels?

Support and resistance levels show the point at which an asset price rebounds upwards or downwards. As a stock's price trends downwards, it will hit a low point at which the price becomes attractive to potential buyers. At this point, demand increases and prices start going up. Over time this rebound point can be plotted as a straight line called the support level.

A resistance level is the exact opposite of a support level. As an asset increases in value, it will reach a point where demand outstrips supply. However, as the price increases, traders may determine that they are too high, have met a perceived target price or are overvalued. The consequence is a decrease in demand and a reduction in the value of the asset. Plotted over time, this line or zone is the resistance level.

Many investors can also use those price levels in order to set purchase or sales prices for their securities. Other investors will monitor support and resistance levels to see when they are crossed, used with other indicators and volume it could be a sign that the price of the security will continue to increase or decrease.

Technical analysts use support or resistance lines as predictors of price thresholds. But these indicators are open to a great deal of interpretation because a security might not rebound up or down at those same levels in the future.

What are moving averages?

The moving average is a type of statistical average used to determine the average value of a security over a fixed period of time. It is calculated by adding up the closing value at each time frame and dividing the total by the number of time frames. For example, the moving average over five days would involve adding up the total at each day's close and dividing by five.

Moving averages are used as trend indicators and help traders establish support and resistance zones for a stock. When a share price crosses a moving average, it is considered a buy or sell signal because it indicates a shift in the directional momentum of the security.

The most frequently used moving averages are the 20, 50- and 200-days moving averages which are suitable for longer-term investors.

Moving average

Graph demonstrating moving averages.

What are classic patterns?

Classic patterns are a term used to refer to a group of patterns that typically have a longer-term horizon which can be bullish or bearish and have distinct price swings such that the price swings form distinctive patterns.

The patterns will consist of some combination of trendlines, support and resistance levels. Unlike other types of technical analysis, classic patterns are the only ones that provide the investor with a target price. There are numerous patterns that exist and that are followed looked for by technical analysts. One of the most well-known is the bullish head and shoulder pattern.

What is a head and shoulder pattern?

The head and shoulder pattern is an easy-to-spot pattern in technical analysis. It is an initial peak followed by an upward trend that peaks to a second higher level called the head. It then takes a short downward trajectory peaking again below the head level, before continuing in a price descent. Visually, it appears as three peaks on a graph, with the middle one higher than the two peaks on either side.

Though formations are rarely perfect, the standard head and shoulders pattern describes a chart formation that predicts a bullish-to-bearish trend reversal. Despite its limitations, it is considered one of the most reliable trend reversal patterns for traders who use technical analysis.

What are oscillators?

Oscillators are another widely used group of technical analysis chart indicators that can aid a trader in determining if a security is in an overbought or oversold condition. They are usually range bound and will oscillate between them and they can draw attention to a possible change in the price direction of the security. Oscillators tend to work best when the security’s price has become range bound.

Two of the most well-known oscillators are the Relative Strength index and the Moving average convergence divergence analysis which will be elaborated below.

Relative strength index (RSI)

The relative strength index (RSI) is a stock momentum indicator.10 The RSI allows traders to assess a stock movement's strength and identify trends shifts. The index compares a security's strength on days prices go up to its strength when prices go down.

Operating on a scale ranging from 0 to 100, if an RSI drops below 30, the share is considered oversold; if it goes up above 70, it is considered overbought. A stock is oversold when technical analysts feel it is trading at a lower-than-expected price. A stock is overbought when it trades above its intrinsic value and is priced higher than expected.

Although the RSI can be useful to active investors trying to take advantage of short-term price fluctuations, it is less reliable in trending markets than in trading ranges. Most traders understand that the signal given by the RSI in strong upward or downward trends can often be false.

Relative strength index (RSI)

Graph demonstrating the relative strength index (RSI).

Moving Average Convergence Divergence (MACD) analysis

The Moving Average Convergence Divergence (MACD) is an indicator that is used to identify and confirm trend reversals in a stock's movement. A MACD compares a 26-period exponential moving average price with a 12-period exponential average of the same price. If the MACD line moves above the signal line, it indicates a bullish trend; an investor using this indicator would buy the security. If the MACD line drops below the signal line, this indicates a negative trend, in which case an investor might sell.

Differences between the MACD line and the signal line also indicate divergences. A divergence occurs when the share price and the MACD line no longer follow the same trend. For example, a share price could continue to rise to new highs while the indicator shows that those highs are getting progressively lower.

Active traders often use the MACD indicator because it allows them to see changes in the momentum of a trend easily. Nevertheless, traders should also confirm momentum or trend changes using other technical indicators too, such as RSI and candlestick charts.

MACD indicator

Graph demonstrating the MACD indicator.

Discover how to optimize your trading strategies with Technical Insight

Best practices for technical analysis

Like all investment strategies, technical analysis may be relatively quick and efficient, but it has limitations. No technical indicator allows you to predict the future with certainty, and it is important to remember not to make a trading decision based on the analysis of only one indicator.

Though technical analysis is useful to traders focusing on the short term, fundamental analysis tends to be better for long-term investing. As a general rule, the degree of confidence in the direction of a security goes up when many different signals point in the same direction.

Ultimately, using a combination of both fundamental analysis and technical analysis is the best way to reach an informed determination of the value of a particular security.

Predicting the future is an inexact science at best. Even if you do your homework no single investment strategy is foolproof. But independent investors with more precise knowledge and better tools will be able to make more informed investment decisions.

At the same time, it is important to remember that investing involves a level of risk. Markets can be volatile, and things can change unexpectedly. National Bank Direct Brokerage can help you grow your wealth as an independent investor.

Discover technical insights. Find out more about technical analysis on the NBDB website.

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Key Takeaways

  • Technical analysis relies on historical data about a security's price and trading volume changes to evaluate the quality of the asset
  • Analytical time frames can run from hours to years.
  • Technical analysis is best suited to short-term investment strategies and is often used by day traders.
  • Correlating multiple technical indicators is essential when deciding to buy or sell a security.
  • Technical analysis is often used alongside fundamental analysis to make investment decisions.

Welcome to our video on the Trading Central Technical Insight tool which is available on the National Bank Direct Brokerage transactional platform. Technical Insight allows investors of all skill levels to optimize their trading strategies through actionable technical analysis on individual stocks and ETFs.  

You can simply type in your symbol, or you can use their powerful customizable search tool to find trade ideas. Our video today will concentrate on finding trade ideas by using their search criteria via the filtering tool and how you can use it to quickly identify potential investment ideas.  

The Technical Insight tool can be accessed via the market's heading and then select Trading Central from the drop-down menu. Technical Insight gives you the screening power to sift through pretty much every publicly traded security. Now before we delve into the screening tool if we scroll down the page a bit we can see my recently viewed stocks that are saved here.  

Below that section, Technical Insight also provides you with a list of stocks and ETFs viewed by all of their clients. For example, if you want to know what most investors are looking at this will allow you to view their most viewed bullish symbols, their most popular ones, what's trending now and finally at the bottom we have most viewed bearish events that you can consult as well.

Now let's take a look at their screening tool that you can access by clicking on the briefcase icon shown here, for stocks and ETFs. Once the page loads, we are now directly in their search tool. Let’s jump right into an example to show you how Technical Insight can help you find promising opportunities.

The first step is to choose the market you're interested in, the default setting is Canada but the drop down menu lets you choose a specific exchange whether Canadian or U.S. You could for example choose the Nasdaq if you wanted  to concentrate on technology stocks but for today I'll stick to the Toronto stock exchange.

You can then choose one of the preset lists shown here, some of these lists are theme inspired like 5g or ESG. One can choose a long-term uptrend if you're bullish or a specific sector and even volume leaders. To the right if you're interested in a specific industry you can choose from one of the 55 on their list and finally we have the opportunity type which can be bullish, bearish and other or leave it all.  

Now that we have a general sense of the screener let me draw your attention to the powerful filters, with a few quick selections you can  narrow down the results to best match your needs.  

Your first step is to narrow down the universe of your search, you might select only ETFs or if you plan on using options instead of buying  the stock you would choose stocks with options or leave it blank to include all stocks. You can use the market capitalization section to refine your search and choose from large, medium or small cap stocks or simply leave the default option to all.

Below we have the TC Quantamental Rating which is an automated stock ranking tool that analyzes stocks from a fundamental and technical perspective looking at the company's earnings, P\E ratio, momentum and price and then ranks the securities from a scale of one to ten.  

Ten being the most bullish and one the most bearish, basically it allows you to combine fundamental and technical analysis together. Let's set it to six to filter out the bearish and the weak bullish stocks.

Moving on to the next section which is price and volume many people will enter a price range to filter out penny stocks or stocks whose share price is very high. Below you'll see a volume filter where you can set a minimum volume to focus on stocks that have enough trading liquidity to avoid price swings when entering a position or when closing it out.

We've now reached the technical event filter; this is where you will truly appreciate what Technical Insight can do for you. We can start by specifying the preferred chart period, daily or weekly or leave it blank to include both. Now we can move towards more specific technical analysis events let's start with classic patterns which typically have a longer-term horizon and provide you with a price target which is helpful in trying to determine an exit price.  

Since classic patterns provide you with a target price you can also specify a possible price move as well let's say 15%. Now going back to the classic patterns category, we can either choose the entire category or you can select one or more of the 28 classic patterns shown here.  

Let's choose the ascending continuation triangle and a little further down the head and shoulders bottom and right away the tool has filtered out matches for you to consider.  

Before going further, I wanted to mention that Technical Insight has an education center that you can consult that explains all these technical events I'll come back to it a little bit later.

Now here we have the name and symbol of the company as well as the industry it's in.  

To the right we have the technical event and the day that it happened and finally the closing price and below that the price target.

Now for those of you are a little more visual we can click on the rectangle shown here and we can view them in chart format, the chart shows you if this pattern is intermediate or long term as well as maybe give you a better idea of how the formation looks like.

Now let's head back to the other screen, moving further down the list we have the candlesticks and bar patterns these technical event opportunities are useful for suggesting possible short-term price movements. They are also useful for supporting or refuting the possible price movements suggested by classic patterns.  

Just like in our previous example we can select the entirety of the category, or we can specify specific pattern from their available list. Let's choose the hammer pattern as our example and see the matches that we have.  

As you can see Technical Insight quickly scans the universe of stocks and charts and identifies those that meet your selected criteria based on the previous evening's close. 

Our next section is on indicators which shows the average value of a securities price over a period of time.

What that means is that moving averages can help identify the price trend of the security either going up or down or staying neutral.  Finally, we have oscillators which are chart indicators that can assist the trader in determining overbought or oversold conditions.  

Most traders will use multiple oscillators to confirm the price direction, here we have a list of 11 and let's select the relative strength index commonly referred to as the RSI which gives us a few candidates.  Now if we view them in the chart version you can see that an RSI under 30 is considered oversold but the selected stocks have now crossed back  over that barrier which is a bullish signal.  

As previously mentioned for those of you who are new to technical analysis Trading Central has an education section just for you in the upper right hand corner shown as a book icon. Here we have a complete list of the technical events shown with a definition as well as how to interpret them.  

How about we look at the hammer which falls under short term and bullish and is the fourth one on the list. Here we have the implication, the description, trading considerations as well as other criteria that you can read up on.

There is also a find events button you can click on which brings you back to the filter page with a list of securities with the hammer technical event. Finally once you've made your choices Technical Insight lets you save your search criteria by clicking on the subscribe button shown here.

You need to name your search criteria let's call ours hammer and click on  ok, it's now been added to our alerts section with your saved search parameters and every day this list will be updated but better still if you add your email address you will be advised via email of new additions.

This concludes our first video on how to find trading ideas with our Technical Insight tool please join us for the second video on how to look up individual  securities and set up alerts in our watch list

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Abbreviations for different finance terms on a blue backdrop.

Finance is a funny language.

Our webinars can help you understand it.