Advanced Stock Market Trading - Level 1_5. Introduction to Technical Analysis

Lesson 5: Introduction to Technical Analysis

#Introduction to Technical Analysis

There are basically two methods used to analyze securities and make investment
decisions, these are fundamental analysis and technical analysis. Fundamental
analysis involves analyzing a company’s financial statements to determine the fair
value of the business, while technical analysis assumes that a security’s price
already reflects all publicly-available information and instead focuses on the
statistical analysis of price movements. This lesson focuses on technical analysis.

Technical analysis may appear complicated on the surface, but it boils down to an
analysis of supply and demand in the market to determine where the price trend is
headed. In other words, technical analysis attempts to understand the market
sentiment behind price trends rather than analyzing a security’s fundamental
attributes. If you understand the benefits and limitations of technical analysis, it can
give you a new set of tools or skills that will enable you to be a better trader or
investor over the long-term. Let’s go into what technical analysis is all about.

Principally, technical analysis is the study of price movements in a stock or other
asset in order to identify price trends. Technical analysis is a method of analyzing
and evaluating markets and securities by statistically examining charts showing, for
example, past price action and volume. Technical analysts do not attempt to
measure a security’s intrinsic value, but rather, use charts and other tools to identify
patterns that can be used as a basis for investment decisions.

Technical analysis can help a trader: Analyze the market; Understand the market;
Develop trading ideas. There are many different forms of technical analysis: Some
rely on chart patterns, others use technical indicators and oscillators, and most use a
combination of techniques. In any case, technical analysts’ exclusive use of historical
price and volume data is what separates them from their fundamental counterparts.
Unlike fundamental analysts, technical analysts don’t concern themselves with a
stock’s valuation – the only thing that matters are past trading data and what
information the data might provide about future price movements.

It should be noted that technical analysis is based on three assumptions, which are:
The market discounts everything, price moves in trends, and history tends to repeat
itself.

The Market Discounts Everything

Many experts criticize technical analysis because it only considers price movements
and ignores fundamental factors. The counterargument is based on the Efficient
Market Hypothesis, which states that a stock’s price already reflects everything that
has or could affect a company – including fundamental factors. Technical analysts
believe that everything from a company’s fundamentals to broad market factors to
market psychology are already priced into the stock. This removes the need to
consider the factors separately before making an investment decision. The only thing

remaining is the analysis of price movements, which technical analysts view as the
product of supply and demand for a particular stock in the market.

Price Moves in Trends

Technical analysts believe that prices move in short-, medium-, and long-term trend.
In other words, a stock price is more likely to continue a past trend than move
erratically. Most technical trading strategies are based on this assumption.

History Tends to Repeat Itself

Technical analysts believe that history tends to repeat itself. The repetitive nature of
price movements is often attributed to market psychology, which tends to be very
predictable based on emotions like fear or excitement. Technical analysis uses chart
patterns to analyze these emotions and subsequent market movements to
understand trends. While many form of technical analysis have been used for more
than 100 years, they are still believed to be relevant because they illustrate patterns
in price movements that often repeat themselves.

Note: Technical analysis can be used on any security with historical trading data,
which includes stocks, futures, commodities, fixed-income, currencies, and other
securities. However, for the sake of this lesson, we’ll focus on stocks.

#Support & Resistance

The concepts of support and resistance are undoubtedly two of the most highly
discussed attributes of technical analysis. Part of analyzing chart patterns, these
terms are used by traders to refer to price levels on charts that tend to act as
barriers, preventing the price of an asset from getting pushed in a certain direction.
At first the explanation and idea behind identifying these levels seems easy, but as
you'll find out, support and resistance can come in various forms and it is much more
difficult to master than it first appears.

Resistance Level - A price level which a stock has previously had difficulty rising
above; At this point seller strength prevents the price from going higher; The more
often the stock tests the resistance line, the stronger the resistance line; The longer
the stock tests the resistance line, the stronger the resistance line.

Upward price action will typically approach a resistance level, and then retrace to a
lower level before retesting the resistance level again. In the case of a range bound
market, price may trade down to a near term support level at the lower end of the
range before attempting again to break through the resistance level. The more times
that the market attempts to unsuccessfully break through the resistance level, and
the greater the amount of time between attempts, the more formidable the resistance
level.

Reasons for Resistance - Buyers who bought the share at a low price closing their
positions; A share approaching a previously visited high will attract short sellers
looking for a technical entry point; Disappointed buyers who are below their entry
point and are waiting for the share to return to the entry point in order to exit without
a loss.

The overwhelming supply that creates a resistance level may be the result of a large
institutional investor liquidating a very large position in a stock at a particular price.
Until that large sell order is absorbed by the market, the price will remain at the
particular level of the order, creating a resistance level. Another underlying cause of
resistance levels is the use of popular technical price patterns. When enough market
participants react to the sell trigger points of widely used technical price patterns,
resistance levels may be created.

Support Level - A price level which a stock has previously had difficulty falling
below; At this point buyer strength prevents the price from going lower; The more
often the stock tests the support line (re-test), the stronger the support line; The
longer the stock tests the support line, the stronger the support line.

Support or support level refers to the price level below which, historically, a stock has
had difficulty falling. It is the level at which buyers tend to enter the stock. If the price
of a stock falls toward a support level, it is a test for the stock: the support is either
confirmed or eradicated. Confirmation occurs as buyers move into the stock, causing
it to rise. If the price moves past the support level, it means the support level failed,
and the market is looking for a new level.

Support is a threshold or price point along this channel below which a stock price
does not want to fall. Think of it as a floor. The floor is a sticky place for prices. From
an auction perspective, this is a place where many buyers and sellers converge.
Buyers and sellers know that when a stock hits a certain price, it brings in more
volume. If it brings in more buyers, the price bounces off the floor, confirming the
support level; however, if it brings in more sellers, or if buyers fail to show up, the
price falls below the floor or support level. When this happens the support, level can
turn into a new resistance level or ceiling.

Reasons for Support - Short sellers who sold the share at a high price closing their
positions; A share approaching a previously visited low will attract buyers looking for
a cheap entry point; Disappointed short sellers who are above their entry and are
waiting for the share to return to the entry point in order to exit without a loss.

For example, assume ABC stock has attempted to fall below an ascending trendline
several times over the past few months, but although the price approaches this line
several times, it fails to move below it. In this case, the trendline is known as a
support level because it corresponds to a price level where most investors feel
comfortable buying the asset, preventing the market from sending prices drastically
lower. On the other hand, traders use resistance to describe when the price of an
asset has difficulty moving above a given price level, which then forces the price of
the asset to decline.

Support and Resistance – Role Reversal

Many traders who use technical analysis often hear phrases that suggest a "broken
support level will become a future area of resistance" or that a "previous level of
resistance will become a support". For beginner traders, phrases like this sound like
they're spoken in another language, and even many experienced traders never fully
understand or appreciate this intriguing role reversal. This article will attempt to shed

light on the importance of support and resistance and illustrate why traders should
take note when they reverse roles.
Remember: Support and resistance are terms used by technical traders to refer to
specific price levels that have historically prevented traders from pushing the price of
an underlying asset in a certain direction.
One of the most interesting phenomena regarding support and resistance occurs
when the price of the underlying asset is finally able to break out and go beyond an
identified support or resistance level. When this happens, it is not uncommon to see
a previous level of support change its role and become a new area of short-term
resistance. As you can see from the chart below, the dotted line represents the price
that was able to prop up the price movement at points 1 and 2, but this support turns
into resistance once the price falls below it, as illustrated by points 3 and 4.

The opposite of this process occurs when the price breaks above resistance. As you
can see in Figure 2, points 1 and 2 begin as price barriers, but once the bulls are
able push the price above the dotted line, it becomes an area of support (illustrated
by points 3 and 4).

Using Support and Resistance
To use support and resistance effectively we first need to understand how asset
prices typically move, so we can then interpret support and resistance from that
framework. There are also different types of support and resistance, such as minor
and major/strong. We expect minor levels to be broken, while strong levels are more
likely to hold and cause the price to move in the other direction. With this information
we can start making better decisions based on support and resistance.
#Trading Ideas -Breakouts
One of the best ways to improve your trading skills is to see what others are doing.
Trading ideas can be predictions, market analyses or trade set-ups based on
concrete market conditions. With the Play button you can see how predictions
actually played out. Ideas can also contain educational material and show how
trading methods; analysis approaches or tools exactly work. There are many areas

of technical analysis, some are basic, others more sophisticated and all are
supported with intelligent drawing tools, many bar styles, lots of data and a host of
indicators.
Trading ideas can relate to any asset class like currencies, stocks or futures or any
trading method like harmonic patterns, wave analysis or chart patterns. Often traders
use a combination of several methods and look for confluence and increase their
odds. There are also ideas on risk management, trading psychology and trading
plans. Regardless of the method you use, it's indisputable that the cycle of creating,
sharing, collaborating and learning based on well-thought-out ideas will help you
improve your trading skills. Therefore, trading ideas are your research and
preparation for the next trading day and will be visible on the daily chart. Warning! Do
not enter a trade without having a clear trading idea.
Why Do Breakouts Occur
A breakout is a price movement of a security through an identified level of
resistance, which is usually followed by heavy volume and an increased amount of
volatility. Traders buy the underlying asset when the price breaks above a level of
resistance or when it breaks below a level of support.

This chart shows a stock that has historically encountered resistance near $37 over
a six-month period, followed by a subsequent breakout approximately five months
from the last time the resistance level was tested. In practice, a breakout is most
commonly used to refer to a situation in which the price breaks above a level of
resistance and moves higher. Once a resistance level is broken, it often becomes the
next level of support when the asset experiences a pullback. Most traders use chart
patterns and other technical tools, such as trend lines, to identify possible resistance
price points that are likely to experience breakouts. Similar price movements to the
downside are more often referred to as breakdowns.
Breakouts manifest more often in market conditions where potential upward price
movement is expected. For example, when the market is range-bound and price
action is approaching the upper end of the range, savvy traders prepare for a price
breakout above the upper range resistance level.
Technical chart patterns such as head-and-shoulder, triangles and flags that are near
completion in their formation and signify upward price movement are also common

spots for breakouts. Once price action makes a final movement to confirm the
pattern, a price breakout usually follows.

Significant news events may also cause price breakouts. These breakouts are more
unpredictable and depend on the effects that the news has on a particular security.