Technical analysis (TA) is an analysis or technique which helps you to identify trade opportunities, price direction using a chart on which patterns are formed by volume and price movement.
Technical Analysis is based on the fact that “History repeats itself”. In the context of technical analysis, it means that the price repeats itself.
Technical analysis is used for short term trades that can last anywhere between a few minutes or seconds to a few weeks. Never use technical analysis for long term trades, use Fundamental analysis for it. However, you can use technical analysis to determine entry and exit points in a long-term trade.
In this blog we will learn the following:
- Technical analysis vs Fundamental Analysis
- Candlestick chart
- Single candlestick pattern
- The Dow theory
Technical Analysis (TA) VS Fundamental Analysis (FA)
Both the method of analysis has their own merits and demerits.
|S.No||Technical analysis (TA)||Financial analysis (FA)|
|1.||It is used for short term trades.||It is mostly used for long term trades.|
|2.||Concepts of TA can be applied to any asset type like equity, commodity, currency, etc.||FA analysis is different for different asset types like equity, commodities, etc.|
|3.||Technical analysts did not care whether the stock is undervalued or overvalued.||Fundamental analysts do care whether the stock is over or undervalued.|
|4.||Here, we analyze charts that are based on the movement of prices and volume.||In it we analyze profit and loss statements, balance sheet, cash flow statement.|
To learn more about Fundamental Analysis, you can read my blog on Fundamental Analysis.
The timeframe is defined as the time period for which you want to study a chart such as a chart like monthly, weekly, daily chart or 1hour, 30min, 2min, etc chart.
You have to decide the timeframe depending on the trader you want to be. For example a long-term investor focuses on a monthly or weekly chart, an intraday trader can choose a 3hour, 30min, or 1min chart depending on the number of trades he/she wants to do in a day.
Candlesticks were originated from Japan, we would not be going into its history much as it is not much use to us. If you want to read its history, You can read here.
Candlesticks can be classified as bearish or bullish candle represented by red and blue/green color respectively.
A candlestick has three components: the central real body, upper shadow, and lower shadow.
In the bullish candle, the central body connects the opening and closing price, upper shadow connects the high point to close and lower shadow connects the low point to open whereas, in a bearish candle, it is vice versa i.e. upper shadow connects the high point to open and lower shadow connects the low point to close.
The length of the candle signifies the intensity of trading. Longer the candle means more intense is buying and selling activity whereas shorter candle means less buying and selling.
It is advisable to not trade on days when the candle is too short (below 0.75% range) or too long (above 10% range). Now, you would wonder “what is range?” here. The range is simply the measure of the difference between open and close of the day divided by the average of open and low.
Single Candlestick Patterns
Now, we would talk about some patterns formed by a single candlestick.
1. Bullish Marubozu
It is defined as a candlestick with no upper and lower shadow however very tiny lower and upper shadow is acceptable.
This implies that open is equal to low and high is equal to close. This means there is so much interest in buying the stock in the market that traders are buying at every price point during the day.
It is expected that stock will be bullish over the next few trading days and you should look for buying opportunities. You should buy it by applying stop-loss at the low of the Marubozu in case the market moves in the opposite direction.
2. Bearish Marubozu
It is the opposite of bullish marubozu with open = high and close = low. This means there is so much selling in the market of that stock and you must look for selling opportunities as the stock will be bearish for a few trading days.
3. The Spinning top
It is defined as a candlestick with a small rear body and almost equal upper and lower shadow.
The rear body indicates that open and close price are close to each other. The upper shadow indicates that the bulls try to take the market higher but were not successful at it, if they have done so then candle would have been a long and green. Similarly, the lower shadow indicates that the bears tried to take the market lower but they were not successful at it. If they have done so then it would have been a long red candle.
The spinning top does not tell anything to the trader, it only tells that there is an indecision in the market.
4. The Doji
It is similar to the above spinning top except for the fact that it does not have a rear body however a very tiny body is acceptable. Here, also the bulls and market are not able to influence the market and there is an indecision in the market.
5. The Paper umbrella
It is a type of candlestick pattern with a long lower shadow and a small body, there should be ideally no upper shadow but a very tiny upper shadow is acceptable.
Here, the color of the body does not matter. The size of the lower shadow should be equal to or greater than twice the length of the real body.
Paper umbrella consists of two trend patterns:
If the paper umbrella appears at the bottom end of a downtrend, it is called a hammer. Here, the trader should look for buying opportunities as the hammer indicates that the sentiment of the market can change to an uptrend. The trader should buy the stock by applying a stop-loss at the low of the hammer.
2. The Hanging man
Hanging Man is formed when the paper umbrella appears at the top end of an uptrend. Here, the trader should look for selling opportunities as the hanging man indicates that the sentiment of the market can change to a downtrend.
6. The Shooting star:
The shooting star looks like an inverted paper umbrella with a long upper shadow and a small body. Ideally, the shooting star should not have a lower shadow, but a very tiny one is acceptable.
The shooting star is a bearish pattern as the prior trend is bullish. The longer the upper shadow, the more bearish will be the pattern. After the shooting star appears, the trader should look for selling opportunities as it is expected that there will be a bearish pattern.
The Dow Theory
In this section we would talk about some patterns in Dow Theory. Before candlesticks were introduced, traders use Dow’s theory to look for short-term trading opportunities.
But, modern-day traders have not forgotten it and use it along with candlesticks to make their decision more accurate. For example, if you found a candlestick pattern along with Dow’s pattern in a trade you will become more confident in doing the trade.
Some of the patterns that comes under Dow’s Theory are:
1. Double bottom formation
It is formed when a stock price after hitting a low price level, rebounds, and the price increases for at least two weeks, and after that, it falls to the same low price level again and forms a double bottom. The formation of a double bottom is considered bullish and you should look for buying opportunities.
2. Double top formation
It is the opposite of double bottom formation. Double Top is formed when a stock hits a high price level and then it falls for at least two weeks and after that it rises to the same high price level. The formation of a double top is considered bearish and one should look for selling opportunities.
3. Triple top formation
It is similar to the double top formation. However, here the price reaches the top-level thrice. But here the sensation of bearishness is more powerful and you should look for selling opportunities here.
4. Triple bottom formation
It is similar to double bottom formation but the only difference here is that the price reaches the bottom level thrice. You should look for buying opportunities here.
5. Range formation
Range formation means when the stock hits the same lower and upper price level multiple times. This happens when there is nothing excited or bad about a company such as no new exciting product, their growth rate may have become stagnant, etc.
The range formation can be very irritating for long term investors. However, the short term traders can take advantage of it by selling at a low price level and selling at a high price level over and over again.
This range can continue for a long time until some breakout point occurs such as a big announcement. But the stock can go in either direction depending on the outcome and effects of announcement.
6. Flag Formation
A flag is formed when the price of the stock moves in a declining manner between two parallel lines for 5 to 10 trading days.
Before the flag formation there is a steep increase in price and if you were not able to take advantage of it. No worry because after the flag formation there is another steep increase in price and you should look for buying opportunities here.
After reading this blog I am sure you must have understood the concepts explained above. But this is not all in Technical analysis, there is much more.
I will definitely cover all the other topics of technical analysis in future blogs as it is not possible to add all topics in one blog. I will link all the other blogs of technical analysis that I will write in the future here.
Ans. Yes, Technical Analysis is useful for short term trades such as Intraday trading. But never use technical analysis for long term investing however you can use it to identify the best entry and exit points. But for long term trades, entry and exit points don’t matter much.
I am a student currently pursuing B-tech in electrical engineering from Delhi Technological university.