Section 1 - Technical Analysis
In this Section:
- Liquidity and Volume
- Chart Types – line, bar, and candlesticks
- Understanding Trends
There are two main methods used by the best traders for analyzing a company and a stock – fundamental analysis and technical analysis. Let's look at both of these in a bit more detail:
Fundamental Analysis
This method determines the underlying value of a security by analyzing the company's financial statements. It is similar to the kind of analysis that you would undertake for value investing, and it relies on the overall health of the company. This information can be found in the financial documents of the business, and after conducting your own research, you should be able to assess the potential value of the stock (more on this is Section 4). Context is important in these situations so be sure to consider external factors such as interest rates, GDP, employment rates, and any industry changes that might affect the company's performance.
Technical Analysis
This is a more technical method that relies solely on the historical trend data and price movements of the stock. By analyzing chart patterns and price trends you can make an educated assessment of future price movement. The chart patterns will give you a graphical representation of the supply and demand for a stock and we will discuss how to read and understand these shortly.
Remember that both of these forms of analysis are only prediction tools and cannot accurately tell you how the stock will move or what the price will become. Forecasting and prediction tools cannot tell you the future. But they can help you to understand your current position better, analyze possible outcomes, and make informed decisions based on the data.
Whether you prefer fundamental or technical analysis will depend on the kind of trader that you are, your preferred methods of research, and the skills that you have at your disposal. By the end of this course, you will be able to read charts, understand trends, and analyze market movements. You will gain confidence in your ability to make informed decisions based on the information you have at your disposal. The psychology of trading is almost as important as the execution of trading, and by learning technical and fundamental analysis you are setting yourself up for success.
Liquidity and Volume
Before we get into charts and technical analysis, you first need to understand liquidity and it’s importance to the health of financial markets. Liquidity refers to how easy or difficult it is to convert an asset to cash without it impacting its market value. The most liquid asset of all is cash. Consequently, if there is not enough cash available to make transactions, markets cannot function efficiently.
The more liquid an asset is, the easier it is to turn that asset back into cash without it affecting the market price. Less liquid assets take more time to sell and may have a higher cost. For example, tangible assets like real estate or art, are relatively illiquid and it may take weeks or even months to sell. This may be fine if the seller is willing to wait, but it could present a problem if the seller needs cash immediately. As a result, they may have to sell the asset at a significant discount to attract a buyer.
The stock market, on the other hand, has higher market liquidity. If the exchange has a high volume of stocks to trade, and it’s not being dominated by selling, the bid (the highest price a buyer is willing to pay) and the ask (the lowest price the seller is willing to accept) will be fairly close together. When the spread (the price difference between the bid and ask) tightens, the market is considered more liquid. Therefore, because of the tight spread, investors will not have to give up any unrealized gains to sell their asset.
Pro Tip: Stocks that trade over the counter (OTC), like penny stocks, are often quite illiquid. These securities tend to be less known, have lower trading volume and lower market value.
Volume
In general, stocks are among the most liquid assets, but some trade more regularly than others. More activity generally means that there is a greater interest from investors and traders. You’ll be able to identify these liquid stocks based on their daily trading volume, which can be in the millions or hundreds of millions of shares.
When the term volume is used in the context of trading, it refers to the number of shares or contracts being bought and sold on the exchange. For stocks, volume is measured in the amount of shares being traded on the exchange. For futures and options, volume is based on how many contracts have exchanged hands. This data can usually be found at the bottom of the chart.
When a stock has high volume it means that there is a large number of buyers and sellers in the market, which makes it easy to buy and sell the stock without it affecting the market price. On the other hand, low volume of stock can be harder to buy and sell since there are fewer market participants, and therefore less liquidity.
Volume is a very effective tool in technical analysis, and being able to understand it is crucial to your success as a trader. Understanding volume can also help you understand price movements better, and you will get a unique perspective on market psychology. Volume will tell you the level of conviction behind certain trades and can help you to avoid being caught in a false breakout.
For example, if you see increasing volume on a downward price movement, you know that this demonstrates conviction amongst sellers. If, on the other hand, you see increasing volume on rising price movement, this demonstrates conviction amongst buyers. It can also be a sign that the market is gathering momentum to the upside.
Understanding market sentiment and when a stock or commodity might reverse direction is critically important to your success as a trader. When positions are established and market sentiment changes, the risk of loss increases for those who were following the previous trend. Being able to spot the trend reversal allows you to make moves that other traders might not be able to see and protect your losses.
Chart Types
Now that you have a basic understanding of volume, let’s take a look at the different chart types and how you can use these charts to quickly interpret changes in volume. The goal of reading any type of chart is to gather as much information as possible in the fastest possible time. Depending on what the subject of the chart is, you will have a graphic representation of an individual stock, a group of stocks, the stock market, or even the whole industry! Graphs can be used to represent anything, but for our purposes, we will be looking at the charts for individual stocks to see what we can learn from them.
Let’s take a look at the three most popular styles of charts:
- Line Chart
- Bar Chart
- Candlestick Chart
Line Charts
The line chart is probably the simplest of all charts. It is constructed in a linear way and the time period moves along the x-axis. You will see in the example below that the horizontal axis of the graph is a series of lines of varying heights. The height of the line refers to only the closing price for the stock within a specific time period which can be days, weeks, or in this example below, months.
What makes the line chart simple to read is also what makes it effective. You can judge the trends of the stock price by seeing how the closing price on one day relates to the days around it, and you can visualize stock price movements over longer time horizons like months or years. The simplicity of the chart helps to eliminate the noise that can come with some types of trading charts, and you might find yourself reverting to the line chart when you need trend information in a hurry to analyze historical price movements.
Bar Charts
A bar chart is slightly more complex than a line chart but it provides additional information that can be useful for making trading decisions.
These indicators give you a better perspective into the price movement during that trading period. The longer the bar, the larger the fluctuation in price and can indicate an increase in trading volume for that time period.
Unlike a line chart, a bar chart does not connect the closing prices and this often results in large gaps appearing on the chart. These gaps are often the result of unexpected external factors such as an earnings report or a news article that creates an emotional response from traders. These gaps usually end up getting filled once the traders have adjusted to the news, but if these gaps are not filled it can be a sign that the trend will continue in that direction. This means that the news, good or bad, could be more than just a momentary adjustment, but rather a sign that there is a sustained change in sentiment.
Candlestick Charts
Just like individual bars, candlestick charts consist of individual candlesticks that also show you the open, high, low, and the closing price for that trading period. However, unlike individual bars, candlesticks have a body in the middle.
If the close is lower than the open, the body of the candlestick will appear red. If the close is higher than the open, the body will appear green. This increase in color contrast makes patterns more visible and charts easier to interpret. The thin line at the top and bottom of the candlestick (known as a shadow or wick) represents the highest and lowest price for that trading period, and is what gives it its “candlestick” appearance.
To understand candlestick charts and learn how to interpret them better, there are some more terms that you should become familiar with:
Now that you understand what a long candle means and how a doji or spinning top can represent indecision and a potential change in direction, let’s look at how that would be expressed in chart form:
You can clearly see from this chart the formation of a doji top representing the end of the bull run before sentiment changed quickly for Tesla stock. Imagine if you had been following this stock for the months leading up to that moment and were able to use your technical analysis to correctly predict when that turn would occur. That’s the kind of trade you can make once you master the fundamentals of technical analysis.
Pro-tip: Both a doji and a spinning top have more significance if they come at the end of a trend rather than in the middle of a choppy market. Remember this and consider the context of recent market movements before making your decision.
Candlestick Patterns
While a single candlestick can be a helpful indicator, it becomes much more reliable when considered in the context of a pattern. A series of candlesticks next to each other will tell you much more about what is happening in the sense of a growing trend or a choppy market. These candlestick patterns can be formed over several days or many weeks and they can indicate that an entire market is about to turn.
The engulfing pattern is a reliable, two-candle pattern that occurs at the end of a trend and consists of a red candle and a green candle. In the bullish engulfing pattern, the first candle (day 1) continues a downtrend, but the second candle (day 2) the trend reverses direction as it gaps away from the previous day’s close, completely engulfing the previous candle. This wipes out any losses from the previous day, and when combined, turns these two trading days into a bullish candle. The opposite is true for the bearish engulfing pattern and may take place at the end of an uptrend.
Pro-tip: The engulfing pattern is only measured by the length of the bodies of the candles, the length of the wick is irrelevant.
Trends
Now that you are familiar with the different kinds of charts and understand how to analyze each one, we are going to consider how to use these charts to identify and understand trends. Understanding trends and assessing the reliability of trend patterns is the cornerstone of good technical analysis.
A trend is formed when the demand for a stock either increases or decreases between buyers and sellers. Based on the general principles of supply and demand, as demand for an item increases, this puts pressure on the amount available and leads to an increase in the price. The same happens when there is a decrease in demand and the price will subsequently drop. If supply goes up and the market is flooded with a particular stock due to a sell-off or other event, the price will go down.
As demand and supply shift, the price will continue to fluctuate until it finds an equilibrium – also known as the consolidation price. Being able to handle the uncertainty of the price fluctuations and knowing when the consolidation price is reached is an important skill to learn as a trader.
In finance, a trend line is a bounding line for a security’s price movement. This line is formed when the price pivots at three separate areas and is then followed by either higher highs or lower lows. A sustained difference between supply and demand can cause a price trend in either direction. This is a helpful tool to determine how a stock is perceived by other traders and can give you insights into what moves they are making. I'm a firm believer in the saying " The trend is your friend! " and would advise you to write that down and remind yourself regularly.
Let’s look at how these trends form and how to read the chart correctly. In the example below, you will see the formation of a bullish trend. This trend indicates that the price will likely continue to increase. You can see that the stock dropped three times and pivoted each time, which creates a trend line between points 1, 2, and 3. Each point has a higher bottom price – 3,750, then 3,850, and then 4,050 - and so we say that the trend line is bullish.
Pro-tip: The key to good technical analysis is to not get caught up in the intraday price action but rather look at the price performance over an extended period.
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