While fundamental analysts study financial statements and earnings, technical analysts study stock charts. By studying technical analysis, you can identify market trends and price patterns. You can learn about the many different types of technical indicators and employ them to predict future stock prices. These indicators are used to assess which stock is trending and the probability of its direction. Examples of technical indicators include MACD, moving average, and stochastic oscillator.

There are many advantages in using technical analysis. One of the best things about technical analysis is that it is easy to use. The only thing that you need to do is to examine stocks charts, after which you can make your decision on whether you should buy or sell the security. Many people may prefer this method rather than fundamental analysis because they do not want to constantly keep an eye on fundamental activities.

Another reason why you should use technical analysis is that it is convenient and quick to use. Studying fundamental analysis involves reading a lot of past history and current performance to see if a stock is a good buy. On the other hand, using technical analysis means pulling up a chart on your computer with the latest prices for a particular stock, and employing technical indicators to make a decision about that stock. With our recent technology and improvements in computer-assisted techniques, this process can range from a few minutes to an hour. Of course, first you must understand and study the technical indicators. Then you must choose the indicators that you are comfortable using, but mostly importantly, the ones that work for you. Everyone has different technical indicators that they prefer to use. Make sure you use a select few because some technical indicators may contradict one another.

Lastly, there is a common belief that a stock price represents all known information about that particular stock. Therefore, everything that you need to know about this stock is already reflected in their price.

In the end, you should consider using both technical analysis and fundamental analysis. A mix of technical and fundamental analysis can help you better predict a company’s future performance.

Technical analysis, as opposed to fundamental analysis, is the study of market action, primarily through the use of charts. The technician believes that anything affecting the price, such as fundamentally or psychologically, will be reflected on charts. Technicians believe that the market discounts everything and that any news about a company is already priced into the stock. Keep in mind that the charts do not cause market action, but rather, they reflect the actions of the marketplace and what has already happened. However, this does not mean you should not study fundamental analysis, since it is just as important.

Technical analysis is applied social psychology because when you analyze charts, you are analyzing the behavior of traders. Charts reflect trades by all market participants: buyers, sellers, and even insiders. Each price on the charts reflects the actions or lack of actions by all the traders in the market.

Technical indicators help make our analysis more objective as it seeks to recognize trends and changes in crowd behavior so that intelligent trading decisions can be made. Technical analysts study charts to find out whether the bulls or bears are in control. They look at past charts for repetitive price patterns and study to recognize the early stages of uptrends and downtrends.

There are 2 main types of technical analysis: classical and computerized.

1. Classical analysis – This is based only on the study of charts, without using anything more complex than a pencil and a ruler. This is mainly the focus on uptrends and downtrends, support and resistance zones, as well as repetitive patterns, such as triangles and rectangles. Its main drawback is its subjectivity: if you are bullish, your ruler will tend to inch up and likewise, if you are bearish, your ruler will tend to inch down.

2. Computerized analysis – This is more of a modern approach whose signals are much more objective. The 2 main types are trend-following indicators and oscillators. Trend-following indicators include moving averages, Directional System, and MACD (moving average convergence-divergence), which all help to identify trends. Oscillators, such as Stochastic and Relative Strength Index (RSI) help identify reversals.

As you can observe, technical analysis is partly a science and partly an art—partly objective and partly subjective.

But be careful because charts are full of false breakouts, false reversals, and flat trading ranges.

Technical analysis is the study of past market data, through the use of charts, to predict a stock’s future price. Technicians believe that anything that affects a stock price is reflected in the stock’s price. Thus, if everything is already reflected in the market price, then we only need to study market prices. Just by studying price charts, you are indirectly studying the fundamentals of a company and whether the psychology of the marketplace for that company is bullish or bearish. For example, if prices are going up, we assume that demand must be exceeding supply, indicating that the fundamentals are bullish. If prices are falling, we assume that supply must be exceeding demand, indicating that the fundamentals are bearish.

An assumption of technical analysis is that history repeats itself. Because chart patterns have worked well in the past, we assume that they will continue to work well in the future.
With that understanding, the purpose of trading using technical analysis is to identify trends in their early stages so that you can trade favorably in the direction of those trends until it shows signs of reversing.

While technical analysis does not focus on the factors affecting the stock price, fundamental analysis does. Employing fundamental analysis includes studying a company’s financial statements and earnings to determine a company’s intrinsic value, or its actual worth. If the intrinsic value of a company is less than its market price, then the stock is overvalued. Similarly, if the intrinsic value of a company is greater than its market price, then the stock is undervalued and should be bought.

To sum up, trading using fundamental analysis studies the causes of market prices while trading using technical analysis studies the effect. As technicians, we believe that we do not need to know the reasons why the market moves since those reasons should already be reflected in market prices.

Many traders consider themselves as either fundamentalists or technicians. However, there are overlaps and some traders do study both methods. For our trading purposes, we are going to focus more on technical analysis techniques and tools.

Simple Moving Average

Most technical analysts use the Simple Moving Average, or the arithmetic mean.

A simple Moving Average adds up prices in its time frame and divides the sum by the width of the time frame. For example, for a 20-day simple MA of closing prices, add up closing prices for the past 20 days and divide the sum by 20. However, there are a few criticisms about the simple MA such that:

1)      Each price affects a simple MA twice—once when it comes in and another when it drops out.

2)      Only the days in the time frame that the average is based on are taken into account (for example, the last 20 days)

3)      It gives equal weight to each day’s price. The last day’s price receives the same weight as the first day’s price, which some analysts believe that there should be a heavier weight on the more recent data instead.

Exponential Moving Average

An Exponential Moving Average (EMA) helps overcome these criticisms. It assigns greater weight on the more recent data. It does not drop old prices from its time window, but rather, they slowly fade out after time.

Few people calculate indicators by hand these days since computers can do the calculations much faster and more accurately. But if you are interested in knowing how to do the calculation yourself, here it is:

EMA = P_today* K + Ema_yesterday * (1-K), where
- K = 2/(N+1)
- N = the number of days in the EMA (chosen by trader)
- P_today = today’s closing price
- EMA_yesterday = Yesterday’s EMA

How does Moving Average Work?

The most important part of a moving average is the direction of its slope.

-When the EMA rises and slopes up, trade the market from the long side.

-When the EMA falls and slopes down, trade the market from the short side.

-When an EMA starts constantly sloping up and down, it signals a trendless market and you are recommended to stop using trend-following methods until a new trend emerges.

EMA works in all timeframes but the best in weeklies, where it helps you stay better with the major trend. Therefore, many traders prefer trading in the direction of a weekly moving average.

Trading Techniques

When the prices move above MA, it is a buy signal.
When the prices move below MA, it is a sell signal.

When we buy near the moving average, we are maximizing our gains and minimizing our risks. The same rule applies to shorting in downtrends, where you are better off shorting near the EMA.

You can also use dual moving averages to identify trends and entry positions. For example, you can use the longer EMA to identify the trend, and the shorter EMA to find entry positions.  Moving averages in general help identify trends, decide whether it is better to trade long or short, and give us hints on when to enter a trade. To find exit points, we can use channels.

Moving average is a trend-following indicator and is one of the oldest, simplest, and most useful tools for traders. Whereas chart analysis is subjective and difficult to test, moving average signals are objective, precise, and not open to debate. Its purpose is to help traders identify if a new trend has started or if an old trend has ended, generating specific buy and sell signals. Moving averages are represented by lines plotted on price charts, each point reflecting the latest average price. In general, they reflect the average consensus of value at a specific period of time.

A moving average adds new prices as they occur, while dropping old ones. A rising moving average shows that the market is becoming more bullish, signaling you to stay long. A falling moving average shows that the crowd is becoming more bearish, signaling you to hold shorts.

• Which data should I average?

Traders who use daily and weekly charts usually apply moving averages to closing prices. However, the construction of moving averages should be whatever works best for you. You can even add the Closing price + High + Low of each bar and divide the result by three, if you feel that this works better for you. Some people prefer to use a midpoint value, which is the result when you divide the day’s range in half.

• How long should I set the Moving Average?

After you construct the data that you will be using, you also need to choose the width of your time window:

1) Longer Averages (Slower)

• Catch longer trends
• Advantage:  Have smoother moving averages
• Disadvantage:  Responds to trend changes slower, can miss important reversals

2) Shorter averages (Faster)

• Catch minor trends
• Advantage: Tracks prices better; able to signal trends earlier in the move
• Disadvantage: Its average is more sensitive to trend changes and the more sensitive it is, the more likely it is to pick random “noise” and produce false signals or deviations from the main trend, also known as whipsaws.

The longer time frames work better as long as the trend continues, but a shorter average is better to use when the trend is reversing. Nevertheless, make sure you test whatever width you choose to use on your own set of data.

Rectangles are usually continuation patterns but you still have to be alert for signals of a reversal pattern.

Rectangles enable traders to trade the swings within the pattern, buying dips and selling rallies. They take about 1-3 months to form and complete.

1. First, there is a sharp market move, resembling almost a straight line (flagpole) on heavy volume.
2. Prices pause for 1-3 weeks on light volume, forming a consolidation pattern.
3. Prices break out and the trend resumes in the direction prior to the flag or pennant on heavy volume.

Both patterns usually appear in the middle of a market move and, therefore, the move after the flag or pennant will travel the same distance of the move preceding the pattern.

The Flag

The flag is shown below, indicated by 2 parallel trendlines in the shape of a parallelogram, which tends to slope against the trend.

The Pennant

The pennant is shown below, indicated by 2 converging trendlines, resembling a symmetrical triangle.

EMA = Ptoday* K + Emayesterday * (1-K), where
- K = 2/(N+1)
- N = the number of days in the EMA
- Ptoday = today’s closing price
- Emayesterday = yesterday’s Ema

Trading Signal:
- A buy signal is triggered when closing prices cross above the EMA.
- A sell signal is triggered when closing prices cross below the EMA.

Example:
Let’s look at the stock charts of Apple and Citigroup as examples. A buy signal is generated when prices cross above the 9 day EMA, as circled below. A sell signal is generated when prices cross below the 9 day EMA.

How Do We Calculate Simple Moving Average?
A simple moving average is calculated by computing the average closing price of a security over a specified number of periods. For example, a 10-day moving average is calculated by adding the closing price for the last 10 days and dividing the result by 10. 1+2+3+4+5+6+7+8+9+10=55, 55/10 = 5.5 (Assuming that the closing prices for the 10 days are 1-10 consecutively). When you plot the moving average for each date on a graph, it forms a curve.

Trading Signals:
- A buy signal is triggered when closing prices cross above the moving average (MA).
- A sell signal is triggered when closing prices cross below the moving average (MA).

Example:
Let’s look at the stock charts for MSFT and YGE as an example. A buy signal is generated when prices cross above the 10 day moving average  as circled in 1, 2, 3. A sell signal is generated when price crosses below the 10 day moving average.

Disadvantage:
The main disadvantage of a  simple moving average is that it does not reflect the current trend quickly. For example, if the stock prices in the last 10 days for a certain stock were 100, 99, 98, 45, 44, 45, 43, 42, 43, 42, the simple moving average would be 60.1. This moving average is 50% above the current price which wouldn’t be accurate to trigger an entry signal. In other words, if there is an extreme high or extreme low in the stock price, it distorts the true value of the stock. For this reason, another type of moving average called exponential moving average (EMA) was developed, giving more weight to the most recent prices.

Triangles usually represent continuation patterns. A triangle is a congestion area where resistance, forming the upper boundary, and support, forming the lower boundary, converge on the right. The triangle’s upper boundary represents sellers overpowering buyers, preventing the market from rising. Its lower boundary represents buyers overpowering sellers, preventing the market from declining. As the two boundaries start to converge, a breakout forms.

There are 3 types of triangles:

1) Symmetrical Triangles-

- A fair balance of power between bulls and bears. Both are equally confident since bulls keep paying up and bears keep selling lower.
- Represented by the convergence of an ascending support line and a descending resistance line.
- The breakout is likely to resume in the direction of the trend that preceded the formation of the triangle.

2) Ascending Triangles
- These triangles are bullish patterns, with a flat upper boundary and a rising lower boundary, converging on the right.
- The flat boundary shows that bulls are becoming more aggressive while bears are losing their ability to drive down the prices. Bears are defending the line that they’ve drawn, but if they collapse and the attacking bulls succeed, its breakout is likely to be steep.
- An ascending triangle is more likely to result in an upside breakout, thus the logic of buying upside breakouts from ascending triangles is derived.

3) Descending Triangles
- These triangles are bearish patterns, with a flat lower boundary and a declining upper boundary converging on the right.
- The flat boundary shows that bears are becoming more aggressive while bulls are losing their ability to drive up the prices. Bulls are defending the line that they’ve drawn, but if they collapse and the attacking bears succeed, its break is likely to be sharp.
- A descending triangle is more likely to result in a downside breakout, thus the logic of shorting downside breakouts from descending triangles is derived.

Broadening Formation (Inverted Triangle)

This inverted triangle is basically a triangle turned backwards and is relatively rare. Instead of trendlines converging at the right, the trendlines actually diverge in a broadening formation. It is also known as a megaphone top.This type of pattern usually occurs at major tops and is usually a bearish formation.

MORE ABOUT TRIANGLES