Technical analysis is a method of using historical and quantitative data to predict the future of stock prices. There are several ways of predicting stock prices in technical analysis. A key tool used in technical analysis are stock charts, that are leveraged to understand and monitor stock patterns. It also shows the price of a stock over a particular period of time. The article looks at three ways that technical analysis can help one make money.
A ‘breakout’ is an opportunity when a stock price moves beyond a particular level. Stock chart patterns play a very important role in this method of technical analysis. Market players use stock charts to figure out patterns that can be used to predict prices.
Traders use charts to figure out resistance and support points for stocks, for higher and lower price levels respectively . If the stock breaks the upper point of resistance, a trader should go long on the stock. If the support is broken at a lower level, the trader goes short on the stock.
When the resistance or support levels are broken, the stock typically turns more volatile and trend in the direction of the breakout. Once breakout levels are crossed, the old breakout levels typically become the new support levels.
Points to keep in mind:
A breakout level is not a fixed level but it is a zone. For example: Stock A, trading at $10, could have a breakout level at $12-$13. This means the share price of stock A will keep fluctuating between $10-$13 for some time until it breaks the barrier. If it crosses $13, it is likely to continue to $15. At that point in time, $15 is the new breakout level while $13 is the new support level.
Prices will start to consolidate and different price chart patterns like triangles, flags and head and shoulders will start to form. When these patterns form, they are more often than not, indications that the trader is on the right track.
It can become difficult to make an exit as the trader sees new breakouts forming. However, one must then calculate the average distance between support levels and breakout levels. If new breakout levels are not formed, it might be time to exit the stock.
Cycles are part and parcel of life, whether one is talking of natural cycles or the stock markets. Cycles repeat themselves with amazing regularity. If you have a good understanding of technical analysis, you can use it to identify cycle patterns using stock charts to make money for yourself. Cycles are obviously different to each kind of trader. A day trader can see 3-5 cycles a day while a long-term investor will see a cycle last a year. Value investors see cycles that last decades.
Cycles are generally broken down into four phases: Trough, upmove, crest and slide.
A trough is a phase when the stock has bottomed out. This is where value investors start accumulating the stock. They realize that the worst is over (for now) and that valuations are attractive. They realize that the rest of the market is fearful and now is the perfect time to pick up the stock for cheap. If the stock was a product, you have innovators operating in this space.
Upmove is when the early adopters start buying the stock. These traders/investors have recognized that market sentiment has changed and the stock is a good one at the moment.
At this point, the stock is trading at its 52-week high or thereabouts where the late majority piles in. Stock volumes increase substantially. By this time, the innovators, early adopters and early majority have cashed out of their positions. The crest can last for some time, and this where the bullish sentiment on a stock turns to a mixed sentiment. The stock moves sideways and the late majority continues to pile in.
This is where the stock has moved as far as it will go and begins to drop. Buyers who have held onto the stock for too long are forced to give up their positions but a large number of them won’t because the selling price is much lower than their buying price. However, at some point, it becomes untenable for them to continue to hold on to their position. At one stage, the stock price will bottom out making it attractive to innovators, and the whole cycle starts again.
A Fibonacci sequence is based on The Golden Ratio. It is a sequence of numbers where the sum of two numbers equals the third. Example: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233…and so on.
When you divide one number by the one to its right, the answer is 0.618 or 61.8%. Example: 55/89 or 144/233. The answer is always 61.8%.
In technical analysis, Fibonacci retracement levels are used to calculate the support and resistance levels of a stock. Each level is a percentage. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%. Even 50% is used even though it is not an official Fibonacci ratio.
The way these percentages are derived is simple. 21/34 = 61.8%, 21/55 = 38.2%, 21/89 = 23.6%. Try it with any number on the Fibonacci sequence and you’ll get the same result.
Fibonacci retracement levels indicate key levels where stocks might rise or fall. These levels predict the future price levels of the stock. For example if a stock rises by $10 and then falls by $3.82, it has fallen by 38.2% which is a Fibonacci number.
The bottom line
We can see how technical analysis can help you make better trading decisions. While a few of these tools require extensive knowledge and a good amount of expertise, you can leverage them to take advantage of market trends and its underlying volatility.