Technical analysis is a dynamic process by which a trader is equipped with tools to logically reason and pick the most profitable trades while weeding out poor performing ones. It seeks to analyse the historical price and volume changes in a stock to identify patterns and establish relationships. Once these patterns are identified, a trader is able to forecast the stock price levels or the direction of the stock chart and make bets accordingly.
Technical analysis utilises hundreds of technical indicators to compare, screen and then apply an appropriate trading strategy. Stock charts are the key tool used in technical analysis. They may be weekly, daily, or intraday charts of price and volume movements which help identify opportunities.
For the analyst to figure out some semblance of patterns in stock charts, moving averages are frequently used to smooth out price data. Moving averages help in creating a trend following indicator which does not predict the price direction but defines the current direction of a stock, filtering out the noise factor. Simple Moving Averages are the most popular kind of moving average used to help identify the stock price direction, support and resistance levels.
Moving average convergence and divergence (MACD)
The MACD or Moving Average Convergence and Divergence indicator is perhaps the simplest and most effective momentum indicator available in technical analysis. It uses two moving averages and subtracts the longer period moving average from the shorter period moving average to create a momentum oscillator. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders look for signals and triggers from cross overs above or below the MACD.
Relative Strength Index (RSI)
The RSI or Relative Strength Index compares the magnitude of recent gains to recent losses in order to compute overbought or oversold levels for a stock chart. RSI ranges from 0 to 100. Generally, an RSI of around 20 or 30 is considered to be oversold, signalling to the trader that it is time to buy a stock. RSI of around 70 or 80 is considered to be overbought, signalling to the trader that it is time to sell the stock.
Head and Shoulders
This is a common stock chart pattern which is also considered to be one of the most reliable by most analysts. It is a pattern whose formation looks like consisting of a left shoulder, a head and a right shoulder above a neckline drawn underneath. When prices break through the neckline and keep falling, they are expected to bounce back again to touch the neckline before continuing the declining trend.
Above are few of the many technical chart patterns used by analysts in combination with other technical indicators to generate, buy or sell signals in order to make profitable trade decisions.