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Document 13: Technical Analysis for Stock Trading
Technical analysis is a trading discipline employed to evaluate investments and identify trading
opportunities by analyzing statistical trends gathered from trading activity, such as price movement
and volume. Unlike fundamental analysis, which focuses on a company's intrinsic value, technical
analysis focuses on the patterns and signals derived from market data.
1. Core Principles of Technical Analysis
Technical analysis is based on three key assumptions:
The Market Discounts Everything: All known fundamental factors (earnings, news,
economic data) are already reflected in the stock's price. Therefore, studying price action is
sufficient.
Price Moves in Trends: Stock prices tend to move in identifiable trends (up, down, or
sideways) that persist for periods of time.
History Tends to Repeat Itself: Investor psychology tends to be consistent, leading to
recurring price patterns.
2. Chart Types
Technical analysts primarily use charts to visualize price data:
Line Chart: Connects closing prices over a period, providing a simple view of price trends.
Bar Chart: Shows the open, high, low, and close prices for each period (e.g., day, week).
Candlestick Chart: Similar to bar charts but visually more intuitive. Each "candlestick"
represents a period's open, high, low, and close. The "body" of the candle shows the range
between open and close, and the "wicks" (or shadows) show the high and low. Green/white
candles indicate a close higher than the open (bullish), while red/black candles indicate a
close lower than the open (bearish).
3. Key Technical Indicators and Concepts
Technical analysts use a variety of tools and indicators to identify trends, momentum, volatility, and
potential reversal points:
Support and Resistance Levels:
Support: A price level where a downtrend is expected to pause due to a concentration of
demand. Buyers tend to step in at this level.
Resistance: A price level where an uptrend is expected to pause due to a concentration
of supply. Sellers tend to step in at this level.
Significance: These levels often act as psychological barriers and can indicate potential
turning points.
Trendlines: Lines drawn on a chart to connect a series of highs or lows, indicating the
direction and strength of a trend.
Uptrend Line: Connects a series of higher lows.
Downtrend Line: Connects a series of lower highs.
Moving Averages (MAs): Calculated by averaging a stock's price over a specific period (e.g.,
50-day MA, 200-day MA).
Simple Moving Average (SMA): A basic average.
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Exponential Moving Average (EMA): Gives more weight to recent prices.
Usage: Used to identify trends (price above MA is bullish), support/resistance, and
potential buy/sell signals (e.g., a "golden cross" when a shorter MA crosses above a
longer MA).
Volume: The number of shares traded over a period.
Significance: High volume accompanying a price move indicates conviction behind that
move. Low volume suggests less conviction.
Relative Strength Index (RSI): A momentum oscillator that measures the speed and change
of price movements.
Range: Typically ranges from 0 to 100.
Interpretation: Readings above 70 often indicate an "overbought" condition (potential for
a pullback), while readings below 30 suggest an "oversold" condition (potential for a
bounce).
Moving Average Convergence Divergence (MACD): A trend-following momentum indicator
that shows the relationship between two moving averages of a security's price.
Components: MACD line, signal line, and histogram.
Usage: Used to identify trend reversals, momentum, and potential buy/sell signals (e.g.,
when the MACD line crosses above the signal line).
Bollinger Bands: A volatility indicator consisting of a middle band (simple moving average)
and two outer bands (standard deviations above and below the middle band).
Usage: Prices tend to remain within the bands. When bands contract, it indicates low
volatility; when they expand, it indicates high volatility. Prices touching or breaking the
bands can signal overbought/oversold conditions.
4. Chart Patterns
Technical analysts look for recurring patterns in price charts that suggest future price movements:
Reversal Patterns: Indicate a potential change in trend (e.g., Head and Shoulders, Double
Top/Bottom).
Continuation Patterns: Suggest that the existing trend will continue after a brief pause (e.g.,
Flags, Pennants, Triangles).
Limitations of Technical Analysis
Self-Fulfilling Prophecy: Some patterns may work because many traders are looking at
them and acting on them, rather than reflecting true underlying value.
Lagging Indicator: Many indicators are derived from past price data and may not always
predict future movements accurately.
Subjectivity: Interpreting charts and patterns can be subjective, leading to different
conclusions among analysts.
Not a Guarantee: Technical analysis is a tool for probability, not a guarantee of future price
movements.
Technical analysis is often used by short-term traders but can also complement fundamental
analysis for long-term investors seeking optimal entry and exit points.
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