Formulating trading strategies and picking right stocks using technical analysis can help an investor make the right decision
In the last two series of this column, we understood how fundamental analysis, both quantitative and qualitative, helps investors pick stocks for long-term investment. Fundamental analysis typically answers the question: What to buy. On the other hand, technical analysis provides an answer to the question: When to buy. Technical analysts or technicians analyse market activity, prices, volume and other statistics and then select stocks on the basis of gathered data. Those who follow this method look at different indicators and make inferences about future stock prices.
Technical analysis or chart analysis is the study of market action, using price charts to forecast future price direction. The cornerstone of technical philosophy is the belief that all factors that influence market price — fundamental information, political events, natural disasters and psychological factors — are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down. Here are some tools that are used by technical analysts to predict stock price movements.
Simple Moving Average (SMA): Moving averages are one of the main indicators in technical analysis, and is available for different time periods ie, 20 days, 50 days and 200 days. Here, the daily average is taken for a given number of days. This tool is used by analysts to make buying or selling decisions. It is commonly used to smooth price data and technical indicators. The longer the period of the moving average, the better the results, but more lag is introduced between SMA and the source. Price crossing SMA is often used to activate trading signals. When prices cross above the SMA, an analyst may want to go long or cover short and when they cross below the moving average, he/she may want to go short or exit long. SMAs are often used to get trend direction. If the SMA is moving up, the trend is up. If it is moving down, the trend is down.
Moving Average Convergence Divergence (MACD): This tool is used to spot moving averages that show a new trend, whether it is bullish or bearish. Though this medium is somewhat the same as SMA, it is different in terms of calculations. It is not used to find overbought or oversold conditions. MACD is plotted on a chart with zero as the equilibrium. The amount of divergence between the main line and the trigger line is also plotted on this chart. During a period when there is a strong trend, the two MACD lines will diverge. During sideways consolidation, they will come closer and is called convergence. This might often lead to crisscrossing one another few times. MACD crossing above zero is considered bullish while below zero is termed bearish. Second, when MACD turns up from below zero, it is considered bullish. When it turns down from above zero it is considered bearish.
Relative Strength Index (RSI): The relative strength index is a momentum indicator that measures the magnitude of latest price changes to assess over-purchased or over-sold conditions in the price of a share or other asset. The index ranges from zero to 100 and is considered over-purchased when above 70 and over-sold when below 30. These traditional levels can also be adjusted if needed to better fit security. This index also often forms chart patterns that may not show on the underlying price chart such as double tops and bottoms and trend lines. In addition, while looking at the chart, one should look for support or resistance on the RSI. The divergence between the RSI and price is often a helpful reversal indicator. The RSI needs a certain amount of lead-up time in order to operate successfully. It helps in detecting movements which might not be as readily noticeable on the bar chart. The most commonly used is the 14-day RSI but other duration RSIs can also be used. Also, it shows when it was last in the overbought or oversold region and the movement can be used along with other indicators like Bollinger Bands and Candle Stick to determine price movements.
Technical analysis, however, is not a long-term strategy where actions are taken frequently by monitoring the ups and downs of the stock market constantly and speed is important to technical analysts. Support and resistance are common concepts in the world of technical analysis. Traders usually buy and sell stocks at these levels because they indicate how well a stock might (or might not) perform. Support and resistance are certain pre-determined levels of the price of a security at which it is thought that the price will tend to stop and reverse. These levels are denoted by multiple touches of price without a breakthrough of the level.
Just like any other stock-picking strategy, the technical analysis relies on different techniques compared to fundamental analysis. But regardless of the style used, mastering technical analysis takes time, experience and practical understanding.
(The writer is Assistant Professor, Amity University)