Technical analysis is all about projecting the future movements and targets with the help of chart patterns or peak-and-trough analysis to enter at the right time into the emerging trend and hold the position till the trend remains intact. In brief, technical analysis is defined as the study of mass psychology to determine future price action. Its study includes understanding the price, trend and volume actions to forecast the future direction. It is more about understanding the price action as the branch believes that price works in pattern and continuously repeat itself and it is possible to identify those patterns and use them to enter an asset to generate a rate of return.
Basic Concepts: The foremost basic concept underlies in technical analysis in the trend. And, we are always suggested to not go against the trend and if we do it then it should be on some concrete evidence or solid prices actions such as trend reversal.
Type of trends and how to identify those trends: There are three types of trend. 1) Up-trend 2) Down-trend 3) Sideways.
- When prices make higher highs and higher lows the asset is said to be in an uptrend.
- When prices make lower highs and lower lows the asset is said to be in a downtrend.
- When Prices make unsymmetrical high and low the asset is said to be sideways.
A trendline is defined as a line which either connects all the lows in case of an uptrend or connects all the highs in case of a downtrend. To draw a trendline in an uptrend draw a line that combines all the lows and connect all the tops in case of a downtrend.
Data Visualization: Tracking the daily price action on a piece of paper or excel file requires a lot of hard work and is time-consuming. To ease the tracking of the daily price we visualize the prices on a chart. Charts are the most basic requirement to perform technical analysis, and we are blessed to be alive in such a world where charting is readily available, and we have various free sites and software to perform that task for us and price data is also freely available across the web.
The main types of charts used in Technical analysis:
- Line chart
- Bar Chart
- Candlestick Chart
How do we do a technical analysis: To perform technical analysis, the first thing we do is to identify the existing trend and look for various chart patterns that exist on the charts. There are a lot of chart pattern that exists in the real-time scenario to identify such chart patterns requires a lot of careful observations. To show an example of how to determine such a chart pattern we are providing here a case study and our observation on Zinc (commodity) prices.
The chart pattern here formed is known as Head & Shoulder pattern (a reliable trend reversal pattern).
If we observe the chart, we will see the previous trend before the formation of Head & Shoulder pattern was an Up-trend. Head & Shoulder as a trend reversal formed on the weekly chart of zinc. The bottom line is known as the neckline. After forming such a pattern if price breaks the neckline, we mark a trend reversal. As can be seen on the chart after breaking the neckline the prices fell sharply.Â To determine the price objective, we must gauge the separation between the neck area as well as the headâs top. A general assumption is that the distance between the neckline and head usually reaches downside after breaking the neckline.
Second, once the trend or the pattern is identified, we will look for any divergence existing on various technical indicators, which we will explain later.
Volatility: What is it and how to identify it?
Volatility is defined as the deviation from the mean value of anything. To measure the volatility, we use various indicators such as the Bollinger band, Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), etc. Measuring volatility is crucial as it helps to identify the risk associated with entering the asset based on technical analysis. After identifying the risk and return associated with the asset, we make decisions to either enter into the asset or leave it. Once we decide to enter the asset, we periodically review the price action to judge whether to stay into it or exit from it.
How do we judge when to exit?
To judge when to exit we continuously see for any divergence associated with the price actions. To measure the divergence, we use various technical indicators such as relative strength index (RSI) and volumes. A divergence in the technical indicator is defined or observed when the prices make new lows, but the indicator is unable to create a new low. Further, if we notice any divergence on the indicators, we consider exiting from the asset as a divergence is considered to be a sign of trend reversal.
Stop loss and its importance: Stop loss ensures that loss remains limited. In other words, stop loss is defined as the maximum loss one can bear or must take if they decide to enter the asset. Stop loss also help in identifying the risk profiling of the investor. Understanding the risk profiling of the clients is the most important concern.
What is risk and types of risk takers?
Risk is defined as the deviation from the expected outcome or the difference between the actual and expected return. There is various type of people in this market but can be divided into two groups.
- Risk averse: Risk-averse people are those people who don't expect a higher rate of return but in turn, need a minimum deviation from the expected rate of return and are more concerned about capital preservation.
- Risk takers: Risk taker are those people who expect a high rate of return and take a maximum deviation from the expected rate of return and are more concerned about capital appreciation.
Once we identify the risk profiling of our client, we advise them individually as per their need for capital protection or capital appreciation. In this market, a general assumption is more the risk taken, more should be the expected rate of return.
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