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Module 6: Basics of Technical Analysis

Module 6: Basics of Technical Analysis
Module 6: Basics of Technical Analysis
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Module 6: Basics of Technical Analysis

Module 6: Basics of Technical Analysis

6.1 What is Technical Analysis?

Technical analysis offers a framework for traders to study the price action of an asset. In the context of index investing, this means looking at the price charts of the index you are looking to trade, analysing them with the help of tools and indicators.

The idea behind technical analysis is that all market information – and thus trading conditions – is reflected in the price, so all that’s needed is to study the price action and volume of an asset. 

Technical analysis focuses on discerning rhythm, flow, and trends in price direction, using historical prices and trading volume. By identifying patterns in price action, a trader can determine the possibility of future price directions. 

One often-cited criticism of technical analysis is that it can be highly subjective; two traders may look at the same chart but come to different conclusions. The disparity is mainly attributable to how a trader makes use of such tools, as well as the tendency for differences in individual interpretations. However, with practice and experience, a trader should be able to increase the accuracy of their interpretations. Learning how successful traders perform and interpret technical analysis can also help accelerate this process. 

Traders who rely on technical analysis to guide their trading decisions are known as technical traders. 

Check out a more in-depth article on all the basics of technical analysis.

6.2 Candlestick Charts

Technical analysis is performed on a price chart, and the most commonly used type of chart is a Candlestick Chart. 

Candlestick charts display the High, Low, Open and Close prices of each trading period in a way that is easy to understand. 

By studying the characteristics of individual candlesticks, as well as candlestick patterns, traders can discern important information such as trend reversals, possible incoming price trends, as well as an overview of what happened during the trading period.

Additionally, candlestick charts work well with several other technical analysis tools, such as trendlines, support and resistance levels, and moving averages. 

Revisit Module 4: Essentials of Chart Reading for a recap on candlestick charts and patterns.

6.3 Trendlines

Charting trendlines can help us visualise price trends of the index. In the example above, notice how there are three trendlines shown: from left to right – a downtrend, then a sideways trend or range, followed by an uptrend. 

Remember that technical analysis is about determining the possibility of price trends based on past movement. Hence, you can use trendlines plotted on a trend that has already happened to forecast the likely high or low point of a similar trend that is forming.

Trendlines are plotted freely; you can choose the start and end point of a trendline, and draw it up, down or sideways, in accordance with the tops and bottoms of the candlesticks that the trendline is describing. 

In general, the longer the time period in between, the more accurate the trendline tends are likely to be. 

6.4 Support and resistance 

Besides charting uptrends, downtrends or sideways trends, trendlines are also useful for visualising levels of support and resistance. 

We understand that asset prices, including stocks, exhibit fluctuations, sometimes oscillating between upward and downward movements. However, there are periods during which the price remains constrained, reaching only a specific level without surpassing it.

In the example above, the long, red line at the top of the chart shows the price ceiling, which is the highest price where the asset appears to reach. This is commonly referred toas a level of resistance. 

Conversely, the short, red line in the bottom right shows the price floor which is the lowest price that the asset falls to, but no further. This is commonly referred to as a level of support. 

Depending whether the market is bullish or bearish, levels of support and resistance can be broken through and switch places. 

During a bullish trend when the market is going up, the price of the asset can break through the ceiling to chart new highs. If the price remains above this level, the resistance level becomes a new support level. 

During a bearish trend when the market is going down, the price of the asset can break through the floor to chart new lows. Provided the price fails to rebound, the support level becomes a new resistance level. 

Charting levels of resistance and support can be helpful in several ways, including minimising risks when trading.

6.5 Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a widely used technical indicator used to discern when the market is oversold or overbought. 

The RSI is presented as a scale from 0 (oversold) to 100 (overbought), making it an easy-to-use tool for traders who want to buy low and sell high. Common levels to pay attention to are 30 and 70.

Typically, you are able to set an RSI alert for when an index’s value hits a certain threshold. However, the RSI alone should not be the sole indicator that you base your trading decisions upon, as it has been known to be inaccurate, especially during times of volatility. 

Instead, RSI alerts should be the signal to start investigating a potential trading opportunity. 

6.6 Moving Average

A moving average in technical analysis is used to filter out noise in price data by creating a constantly updated average price. It is a lagging indicator that relies on past prices to identify the trend direction of an index, or to find levels of support or resistance. 

Moving averages can be calculated any length of time, but the most widely used moving averages are the 50-day and the 200-day moving averages, as they are considered important trading signals. 

In the example above, the blue line is the 50-day moving average. As you can see, it’s helpful in charting price trends, showing clearly periods of rising and falling trends. 

Traders can use a pair of moving averages – one with a shorter lag (50-day) and one with a longer lag (200-day) to identify trend reversals. When the shorter moving average crosses above the longer-term one, a bullish trend is indicated. When it crosses below, a bearish trend is indicated. 

There are two types of moving averages – a simple moving average (SMA) and an exponential moving average (EMA). The first is a simple arithmetic average of prices over a timespan, whereas in the second, greater weight is placed on more recent prices than older ones over the time period.

6.7 Fundamental Analysis vs Technical Analysis 

Fundamental analysis focuses on evaluating macroeconomic data and global events to assess an index valuation and price movements for informed trading decisions.

Conversely, technical analysis uses charting tools and indicators to analyse price charts, aiming to identify the market conditions and potential trading opportunities.

Given that both have vastly distinct approaches and theories, which one should you use?

Well, fundamental analysis and technical analysis each have their own strengths and weaknesses, and can complement each other. 

For instance, let’s say that the U.S. election is drawing near, an event expected to push the US Dollar higher. A trader might take note of this political event and start looking for potential trading opportunities. 

Next, a trader may turn to technical analysis, trying to find indications that would confirm the prevailing bullish thesis. If the technical indicators fail to show convincing signals, or display conflicting ones, there may be a deeper story that could cause the intended trade to go against the trader. 

In this case, the trader should reconsider their trading thesis, or make arrangements to hedge against uncertainty and risk.

As a beginner index trader, it is a good idea to become familiar with both fundamental analysis and technical analysis. This will give you a broader suite of foundational skills from which to draw with as you deepen your knowledge and grow as a trader. 

CTA: Check out a more in-depth article on all technical indicators.

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Module recap

  • Technical analysis is a framework for traders to study the price action of an index. Charting tools and technical indicators are commonly involved, and a trader who makes trading decisions mainly via technical analysis is known as a technical trader.
  • Using historical price and trading volume data, technical analysis allows a trader to discern the possibility of future price trends and events.
  • Technical analysis is often criticised for being too subjective; this is thought to arise from differences in how charting tools are employed, as well as differences in individual interpretations.
  • Technical analysis is most commonly done on a candlestick chart, where traders can study individual candlestick characteristics and candlestick patterns to identify potential price reversals and incoming price trends. 
  • Trendlines can be plotted on a price chart to better visualise price trends – uptrends, downtrends and sideways trends. This can help minimise risk.
  • Trendlines are also used to demarcate levels of support and resistance. Support levels represent a price floor, whereas resistance levels represent a price ceiling.
  • Depending on the state of the market, support and resistance levels may be broken. When price rises above resistance levels during a bullish trend, the level turns into a new support level. When price falls below support levels during bearish trend, the level turns into a new resistance level.
  • The Relative Strength index is widely used to signal when the market is overbought or oversold. It is displayed as a number from 0 (oversold) to 100 (overbought). Typically, traders pay attention to levels 30 and 70 on the RSI.
  • A moving average filters out noise on the price chart by creating a constantly updated average price. It is a lagging indicator that relies on past prices to identify the trend direction of an index, or to find levels of support or resistance.
  • A pair of moving averages can also be used to discern price trends. For instance, when a 50-day moving average (shorter lag) crosses above a 200-day moving average (longer lag), a bullish trend is indicated. When it crosses under instead, a bearish trend is indicated. 
  • A simple moving average is a simple arithmetic average of prices over a timespan. An exponential moving average accords more weight to recent prices over older ones in the time range. 
  • While fundamental analysis and technical analysis are two very distinct approaches to trading analysis, traders can benefit from both methods. Learning both will provide a trader with a richer foundation to draw upon.
Module 6: Basics of Technical Analysis