1. Background
Introduction to the concept of technical analysis and how it differs from Fundamental analysis. We also discuss the kind of return expectation one needs to set while trading based on Technical Analysis ..
1.1 – Overview
The previous module on the Basics of the stock market set us on a great starting point. Taking cues from the previous module, we know that developing a well-researched point of view is critical for success in the stock market. A good point of view should have a directional view and should also include information such as:
- Price at which one should buy or sell stocks
- Expected Risk
- Expected reward
- Expected holding period
Technical Analysis (also abbreviated as TA) is a popular technique that allows you to do just that. It helps you develop a point of view on a particular stock or index and helps you define the trade in terms of entry price, exit price, and risk.
Like all stock market research techniques, Technical Analysis also comes with a few associated conditions and assumptions, some of which can be highly complex. However, technology makes it easy to understand and execute trades based on TA. We will discover these conditions as we proceed along with this module.
1.2 – Technical Analysis, what is it?
Consider this analogy.
Imagine you are vacationing in a foreign country where everything, including the language, culture, weather, and food, is new to you. On day 1, you do the regular touristy activities, and by evening you are starving and craving food. You want to end your day by having a great dinner. You ask around for a good restaurant, and you are told about a vibrant food street close by. You decide to give it a try.
To your surprise, the food street has 100s of vendors selling different varieties of food. Everything looks different and interesting. You are clueless as to what to eat for dinner. To add to your dilemma, you cannot ask around as you do not know the local language. So given all this, how will you decide on what to eat?
Well, you have two options to figure out what to eat.
Option 1: You visit a vendor and figure out what they are cooking. Check on the ingredients used, figure out the cooking style, taste a bit, and determine if you like the food. You repeat this exercise across a few vendors, after which you would most likely eat at a place that satisfies you the most.
The advantage of this technique is that you know exactly what you are eating since you have researched it independently. However, on the flip side, the methodology you adopted is not scalable. There could be about 100-odd vendors, and with limited time at your disposal, you can probably cover about 4 or 5 vendors. Hence there is a high probability of missing out on the best-tasting food on the street!
Option 2: You stand in a corner and observe all the vendors. You try and find a vendor who is attracting the maximum crowd. Once you find such a vendor, you make a simple assumption -‘The vendor is attracting so many customers, which means they must be making the best food!’ Based on that assumption and the crowd’s preference, you decide to go to that particular vendor for dinner. The chances are that you could be eating the best-tasting food available on the street.
The advantage of this method is its scalability. You need to spot the vendor with the maximum number of customers and bet that it is good based on the crowd’s preference. However, on the flip side, the crowd need not always be right.
In the world of stock markets, option 1 is very similar to Fundamental Analysis, where you research a few companies thoroughly. We will explore the Fundamental Analysis in greater detail in the next module.
Option 2 is similar to Technical Analysis, where one scans for opportunities based on the current trend, aka the market’s preference.
Technical Analysis is a research technique to identify trading opportunities in the market based on market participants’ actions. The actions of market participants can be visualized in stock charts. Over time, patterns form in these charts, and each pattern conveys a certain message. The job of a technical analyst is to identify these patterns and develop a point of view.
Like any research technique, technical analysis stands on a bunch of assumptions. As a technical analysis practitioner, you must trade the markets, keeping these assumptions in perspective. Of course, we will understand these assumptions in detail as we proceed along.
Also, at this point, it makes sense to throw some light on a matter concerning FA and TA. Often, people argue that a particular research technique is a better approach to the market. However, there is no such thing as the best research approach. Every research method has its own merits and demerits. It would be futile to compare TA and FA to figure out a better approach.
Both techniques are different and not comparable. A prudent trader would educate on both techniques to identify great trading or investing opportunities.
1.3 – Setting expectations
Market participants often approach technical analysis as a quick and easy way to profit. On the contrary, technical analysis is anything but quick and easy. If done right, consistently generating profits is possible, but to get to that stage, one must put in the required effort to learn the technique.
A trading catastrophe is bound to happen if you approach TA as a quick and easy way to make money in markets. When a trading debacle happens, more often than not, the blame is on technical analysis and not on the trader’s inability to efficiently apply Technical Analysis. Hence before you start delving deeper into technical analysis, it is important to set expectations on what can and cannot be achieved with technical analysis.
- Trades – TA is best used to identify short-term trades. Do not use TA to identify long-term investment opportunities. Long-term investment opportunities are best identified using fundamental analysis. Also, If you are a fundamental analyst, use TA to calibrate the entry and exit points.
- Return per trade – TA-based trades are usually short-term in nature. Do not expect huge returns within a short duration of time. The right way to use TA is to identify frequent short-term trading opportunities that can give you small but consistent profits.
- Holding Period – Trades based on technical analysis can last between a few minutes to a few weeks, usually not beyond that. We will explore this aspect when we discuss the topic of timeframes.
- Risk – Often, traders initiate a trade for a certain reason; however, in case of an adverse movement in the stock, the trade starts to lose money. Usually, in such situations, traders hold on to their loss-making trade with the hope they can recover the loss. Remember, TA-based trades are short-term; if the trade goes bad, do remember to cut the losses and move on to identify the next opportunity.
Key takeaways from this chapter
- Technical Analysis is a popular method to develop a point of view on markets. Besides, TA also helps in identifying entry and exit points.
- Technical Analysis visualizes the actions of market participants in the form of stock charts.
- Patterns are formed within the charts, and these patterns help a trader identify trading opportunities.
- TA works best when we keep a few core assumptions in perspective.
- TA is used best to identify short terms trades.
2. Introducing Technical Analysis
This chapter explores the many characteristics of Technical Analysis including its adaptability to different asset classes, time frames etc. We also understand the need to summarize the Open, high, lo ..
2.1– Overview
In the previous chapter, we briefly understood technical analysis and the main difference between technical and fundamental analysis. In this chapter, we will dig a bit deeper and explore the assumptions technical analysis is based upon.
2.2 – Application on asset types
One of the greatest advantages of technical analysis is that you can apply TA on any asset class as long as the asset type has historical time series data. Time series data in technical analysis is the price information, namely – open high, low, close, volume, etc.
Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car, you can drive any car, whether a Mahindra XUV or a Maruti Swift. Likewise, you only need to learn technical analysis once. Once you do so, you can apply TA on any asset class – equities, commodities, foreign exchange, fixed income, etc.
The fact that TA can be applied to multiple assets is probably one of the biggest advantages of TA compared to the other stock market research techniques. For example, one has to study the profit and loss, balance sheet, and cash flow statements when it comes to the fundamental analysis of equity. However, the fundamental analysis of commodities is completely different.
When dealing with an agricultural commodity like Coffee or Pepper, the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. However, the fundamentals of metal commodities are different, so it is for energy commodities. So every time you choose a commodity, the fundamentals change.
On the other hand, the concept of technical analysis will remain the same irrespective of the asset you are studying. For example, an indicator such as ‘Moving average convergence divergence (MACD) or ‘Relative strength index (RSI) is used the same way on equity, commodity, or currency.
2.3 – Assumption in Technical Analysis
Unlike fundamental analysts, technical analysts don’t worry about the company’s valuation. The only thing that matters is the stock’s historical trading data (price and volume) and the insights the past data provides about the future movement in stock price.
Technical Analysis is based on a few key assumptions. You need to know these assumptions to ensure you use technical analysis effectively.
1) Markets discount everything – This assumption tells us that all known and unknown information in the public domain is reflected in the latest stock price. For example, an insider could buy the company’s stock in large quantities in anticipation of a good quarterly earnings announcement. While the insider does this secretively, the price reacts, revealing to the technical analyst that something is about to happen in the stock price.
2) The ‘how’ is more important than the ‘why’ – This is an extension of the first assumption. Going with the same example discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long as the technical analyst knows how the price reacted to the insider’s action.
3) Price moves in trend – All major moves in the market are an outcome of a trend. The concept of trend is the foundation of technical analysis. For example, the recent upward movement in the NIFTY 50 Index to 18500 from 14750 did not happen overnight. This move happened in a phased manner in over 11 months. Another way to look at it is that once the trend is established, the price moves in the direction of the trend.
4) History tends to repeat itself – In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in remarkably similar ways every time the price moves in a certain direction. For example, in an uptrend, market participants get greedy and want to buy irrespective of the high price. Likewise, market participants want to sell in a downtrend irrespective of the low and unattractive prices. This human reaction has been the same towards stock prices over time, ensuring that history repeats itself.
2.4 – The Trade Summary
The Indian stock market is open from 9:15 AM to 03:30 PM. During the 6 hours 15-minute market session, millions of trades occur. Think about an individual stock – every minute, a trade gets executed on the exchange. As market participants do we need to keep track of all the different price points at which a trade is executed?
To illustrate this further, let us consider this imaginary stock in which many trades exist. Look at the picture below. Each point refers to a trade being executed at a particular time. If one manages to plot a graph that includes every second from 9:15 AM to 3:30 PM, the graph will be cluttered with many points. I’ve tried to represent this in the chart below –
The market opened at 9:15 AM and closed at 3:30 PM, during which there were many trades. It will be practically impossible to track all these different price points. One needs a summary of the trading action and not the details on all the different price points.
We can summarise the price action by tracking the Open, high, low, and close.
Open Price – When the markets open for trading, the first price a trade executes is called the opening price.
The High Price – This represents the highest price at which a trade occurred for the given day.
The Low Price – This represents the lowest price at which a trade occurred for the given day.
The Close Price – This is the most important price because it is the final price at which the market closes for the day. The close indicates the intraday strength and a reference price for the next day. If the close is higher than the open, it is considered a positive day; otherwise negative. Of course, we will deal with this in greater detail as we progress through the module.
The closing price also shows the market sentiment and serves as a reference point for the next day’s trading. For these reasons, closing is more important than the opening, high or low prices.
The main data points from the technical analysis perspective are open, high, low, and close prices. Each of these prices has to be plotted on the chart and analyzed.
Key takeaways from this chapter
- Its scope does not bind to technical Analysis. The TA concepts can be applied across asset classes as long as it has time-series data.
- TA is based on a few core assumptions.
- Markets discount everything
- The how is more important than the why
- Price moves in trends
- History tends to repeat itself.
- A good way to summarize the daily trading action is by marking the open, high, low, and close prices, usually abbreviated as OHLC
3. The Chart Types
We explore the different chart types used in technical analysis along with its merits and de merits. Specifically we discuss the candlestick chart and why traders prefer candlesticks over bar charts. ..
3.1– Overview
Having recognized that the Open (O), high (H), low (L), and close (C) serves as the best way to summarize the trading action for the given period, we need a charting technique that displays this information in the most comprehensible way. If not for a good charting technique, charts can get quite complex. Each trading day has four data points, ’ i.e. the OHLC. If we are looking at a 10-day chart, we need to visualize 40 data points (1-day x 4 data points per day). So you can imagine how complex it would be to visualize 6 months or a year’s data.
As you may have guessed, the regular charts that we are generally used to – like the column chart, pie chart, area chart etc. do not work for technical analysis. The only exception to this is the line chart.
The regular charts don’t work mainly because they display one data point at a given point in time. However, Technical Analysis requires four data points to be displayed at the same time.
Below are some of the chart types:
- Line chart
- Bar Chart
- Japanese Candlestick
This module’s focus will be on the Japanese Candlesticks; however, before we get to candlesticks, we will understand why we don’t use the line and bar chart.
3.2 – The Line and Bar chart
The line chart is the most basic chart type, and it uses only one data point to form the chart. When it comes to technical analysis, a line chart is formed by plotting a stock’s closing prices or an index. A dot is placed for each closing price, and a line then connects the various dots.
If we are looking at 60-day data, then the line chart is formed by connecting the closing prices’ dots for 60 days.
The line charts can be plotted for various time frames, namely monthly, weekly, hourly etc. So, if you wish to draw a weekly line chart, you can use weekly closing prices of securities and other time frames.
The advantage of the line chart is its simplicity. With one glance, the trader can identify the general trend of security. However, the disadvantage of the line chart is also its simplicity. Besides giving the analysts a view on the trend, the line chart does not provide any additional detail. Plus the line chart takes into consideration only the closing prices ignoring the open, high and low. For this reason, traders prefer not to use the line charts.
The bar chart, on the other hand, is a bit more versatile. A bar chart displays all four price variables: open, high, low, and close. A bar has three components.
- The central line – The top of the bar indicates the highest price the security has reached. The bottom end of the bar indicates the lowest price for the same period.
- The left mark/tick – indicates the open.
- The right mark/tick – indicates the close.
For example, assume the OHLC data for a stock as follows:
Open – 65
High – 70
Low – 60
Close – 68For the above data, the bar chart would look like this:
As you can see, in a single bar, we can plot four different price points. If you wish to view 5 days chart, we will have 5 vertical bars as you would imagine. So on and so forth.
Note that the left and right mark on the bar chart varies based on how the market has moved for the given day.
If the left mark, which represents the opening price, is lower than the right mark, it indicates that the close is higher than the open (close > open), hence a positive day for the markets. For example consider this: O = 46, H = 51, L = 45, C = 49. To indicate it is a bullish day, the bar is represented in blue colour.
Likewise, if the left mark is higher than the right mark, it indicates that the close is lower than the open (close <open), hence a negative day for markets. For example consider this: O = 74, H=76, L=70, C=71. To indicate it is a bearish day, the bar is represented in red colour.
The length of the central line indicates the range for the day. A range can be defined as the difference between the high and low. Longer the line, bigger the range, shorter the line, smaller is the range.
While the bar chart displays all the four data points, it still lacks a visual appeal. This is probably the biggest disadvantage of a bar chart. It becomes tough to spot potential patterns brewing when one is looking at a bar chart. The complexity increases when a trader has to analyze multiple charts during the day.
Hence, for this reason, the traders do not use bar charts. However, it is worth mentioning that there are traders who prefer to use bar charts. But if you are starting fresh, I would strongly recommend the use of Japanese Candlesticks. Candlesticks are the default option for the majority in the trading community.
3.3 – History of the Japanese Candlestick
Before we jump in, it is worth spending time to understand in brief the history of the Japanese Candlesticks. As the name suggests, the candlesticks originated from Japan. The earliest use of candlesticks dates back to the 18th century by a Japanese rice merchant named Homma Munehisa.
Though the candlesticks have been in existence for a long time in Japan, and are probably the oldest form of price analysis, the western world traders were clueless about it. It is believed that sometime around 1980’s a trader named Steve Nison accidentally discovered candlesticks, and he introduced the methodology to the rest of the world. He authored the first-ever book on candlesticks titled “Japanese Candlestick Charting Techniques” which is still a favourite amongst many traders.
Most of the candlesticks pattern still retains the Japanese names; thus giving an oriental feel to technical analysis.
3.4 – Candlestick Anatomy
While in a bar chart the open and the close prices are shown by a tick on the left and the right sides of the bar respectively, however in a candlestick the open and close prices are displayed by a rectangular body.
In a candlestick chart, candles can be classified as a bullish or bearish candle usually represented by blue/green/white and red/black candles. Needless to say, the colours can be customized to any colour of your choice; the technical analysis software allows you to do this. This module has opted for the blue and red combination to represent bullish and bearish candles, respectively.
Let us look at the bullish candle. The candlestick, like a bar chart, is made of 3 components.
- The Central real body – The real body, rectangular connects the opening and closing price.
- Upper shadow – Connects the high point to the close.
- Lower Shadow – Connects the low point to the open.
Have a look at the image below to understand how a bullish candlestick is formed:
This is best understood with an example. Let us assume the prices as follows.
Open = 62
High = 70
Low = 58
Close = 67Likewise, the bearish candle also has 3 components:
- The Central real body – The real body, rectangular which connects the opening and closing price. However, the opening is at the top end, and the closing is at the rectangle’s bottom end.
- Upper shadow – Connects the high point to the open.
- Lower Shadow – Connects the Low point to the close.
This is how a bearish candle would look like:
This is best understood with an example. Let us assume the prices as follows.
Open = 456
High = 470
Low = 420
Close = 435Here is a little exercise to help you understand the candlestick pattern better. Try and plot the candlesticks for the given data.
If you find any difficulty in doing this exercise, please ask your query in the comments at the end of this chapter.
Once you internalize the way candlesticks are plotted, reading the candlesticks to identify patterns becomes a lot easier.
This is how the candlestick chart looks like if you were to plot them on a time series. The blue candle indicates bullishness and red indicates bearishness.
Also note, a long-bodied candle depicts strong buying or selling activity. A short-bodied candle depicts less trading activity and hence less price movement.
To sum up, candlesticks are easier to interpret in comparison to the bar chart. Candlesticks help you quickly visualize the relationship between the open and close and the high and low price points.
3.5 – A note on time frames
A time frame is defined as the time duration during which one chooses to study a particular chart. Some of the popular time frames that technical analysts use are:
- Monthly Charts
- Weekly charts
- Daily or End of day charts
- Intraday charts – 30 Mins, 15 mins and 5 minutes
One can customize the time frame as per their requirement. For example, a high-frequency trader may want to use a 1-minute chart instead of any other time frame.
Here is a quick note on different types of time frames.
As you can see from the table above, the number of candles (data points) increases when the time frame reduces. Based on the type of trader you are, you need to take a stand on the time frame you need.
The data can either be information or noise. As a trader, you need to filter information from noise. For instance, a long term investor is better off looking at weekly or monthly charts as this would provide information. While on the other hand an intraday trader executing 1 or 2 trades per day is better off looking at the end of the day (EOD) or at best 15 mins charts. Likewise, for a high-frequency trader, 1-minute charts can convey a lot of information.
So based on your stance as a trader, you need to choose a time frame. This is extremely crucial for your trading success because a successful trader looks for information and discards the noise.
Key takeaways from this chapter
- Conventional chart type cannot be used for technical analysis as we need to plot 4 data points simultaneously.
- A line chart can be used to interpret trends, but no other information can be derived.
- Bar charts lack visual appeal, and one cannot identify patterns easily. For this reason, bar charts are not very popular.
- There are two types of candlesticks – Bullish candle and Bearish candle. The structure of the candlestick, however, remains the same.
- When close > open = It is a Bullish candle. When close < open = It is a Bearish candle.
- Time frames play a very crucial role in defining trading success. One has to choose this carefully.
- The number of candle increases as and when the frequency increases
- Traders should be in a position to discard noise from relevant information
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