Technical analysis is one of the core skills that have to be part of any trader’s repertoire. It is important that traders know how to evaluate stocks using various technical analysis tools so theory can understand the price movements as well as its volatility that is a part and parcel of the stock markets. When we talk about technical analysis, for an average investor or trader, they seem to be too many technical terms that can often be scary. However, there are a variety of technical analysis tools that are simple to understand are basically mere functions of set formulas that help them understand the stock markets in a better fashion.
Some of the common technical analysis tools often used by most traders are discussed below.
What is technical analysis?
Before we understand the tools used by most traders for technical analysis, it is important to first understand the meaning of the term technical analysis. The term technical analysis is merely the study of price movements of a stock based on its demand and supply functions. It also helps in analyzing the current market trend so the traders and investors can make a fair estimate of its future price movements. The study of the price movement of a stock based on its technical analysis stands on three main assumptions. These assumptions are,
- The stock price is all indicative
- The stock price moves in trends
- History always repeats itself
Some of the common terms used in technical analysis are support and resistance, charts and candlestick patterns, trend lines, etc. it is important for a trader or investor to have a thorough knowledge of all such terms to ensure that they can do an effective technical analysis of their target stocks or sectors.
What are the top 5 technical analysis tools?
Now that we have understood the basic meaning of the term technical analysis, let us now further understand the top five technical analysis tools that are often sued by traders and investors.
a. Simple Moving Averages (SMA)
SMA is one of the simplest and basic technical analysis tools used by traders. This tool provides the average of the stock prices for any number of days as per the preference of the trader (example – 25, 50, 100, 200, etc.). The interpretation while using the Simple Moving Averages is quite basic. When the target SMA is moving upwards, it indicates an increasing trend. On the other hand, when the target SMA is moving downward, it will indicate a downward trend. This basic analysis and interpretation allow even novice traders to understand the price volatility and take suitable positions or trades.
On-Balance Volume is a tool to indicate the positive or the negative pressure of the volume of any stock that can influence the stock prices thereby increasing it or decreasing it. An increasing or rising OBV can be interpreted as the presence of more buyers creating a positive volume pressure. This ultimately results in rising prices for such stocks. On the other hand, a decreasing or falling OBV can be interpreted as the presence of more sellers creating a negative volume pressure. This ultimately results in lower prices for such stocks. The calculation of OBV is based on the closing price of the stocks and is done in the following manner.
- If today’s closing price is higher than yesterday’s closing price,
Current OBV = Previous OBV + Today’s Volume
- If today’s closing price is lower than yesterday’s closing price,
Current OBV = Previous OBV – Today’s Volume
- If today’s closing price is equal to yesterday’s closing price,
Current OBV = Previous OBV
c. Aroon Indicator
This technical analysis tool is used to measure if the stock or the asset is in trend and if the trend is likely to change. It is used to measure the time taken by the security for its prices to reach the highest and the lowest points in a given time period.
Aroon Indicator basically has two lines, Aroon Up and Aroon Down. The former measures the strength of the upward trend while the latter measures the strength of the downward trend. When these lines cross each other, it indicates a trend change. Traders can consider the stock to have an upward trend when the Aroon Up line stays near 100 and the Afroon Down Line is near 0. On the other hand, a downward trend can be considered when the Aroon Down Line is near 100 and crosses the Aroon up line.
d. Relative Strength Index (RSI)
Relative Strength Index (RSI) is the tool used to indicate the speed of changes in stock prices. It is also used to identify any price trend reversals. RSI is analyzed based on the default period of 14 days.
The formula to calculate the RSI indicator is mentioned below.
RSI = 100 – [100/ (1+ Average gains / Average losses)]
The range of the RSI indicator is from 0 to 100. The interpretation of the RSI indicator is done in the following manner.
- If the RSI is above 70, it indicates the stock is overbought.
- If the RSI is below 30, it indicates the stock is oversold.
Therefore, the traders are advised to go long if the RSI moves from below to above the oversold line. On the other hand, it is advisable to go short when the RSI moves from above to below the overbought line
This is a common tool used by traders and investors to determine the direction as well as the momentum of a trend in the market. It helps in understanding the relationship between two moving averages and the stock prices. Under this tool, the traders have to calculate three basic components the MACD Line, the Signal Line, and the MACD histogram. The formula for the same is,
- MACD Line: (12-day EMA – 26-day EMA)
- Signal Line: 9-day EMA of MACD Line
- MACD Histogram: MACD Line – Signal Line
When the MACD line crosses the Signal line from above, it indicates a bearish trend. Conversely, if the MACD line crosses the Signal line from below, it indicates a bullish trend.
The understanding of the various technical analysis tools is what distinguishes between a good trader and a better trader. There are many types of technical analysis tools that can be used by traders based on their convenience and preference. They all involve the study of price movements and help the traders interpret them in a better manner.
Some other popular technical analysis tools used by traders are Parabolic SAR, Stochastic Oscillator, the Average Directional Index (ADI), Accumulation/Distribuiton Line, etc
The basic meaning of technical analysis tools are the various tools used to understand and interpret the stock charts, price and volume movements, and the market trends.
No. Technical analysis provides the short-term view of the stock price and volume movements. Hence, for efficient trading, it is important to use a combination of technical and fundamental analysis.
The easiest technical analysis tool that can be used by beginners in trading is Simple Moving Averages (SMA).
Parabolic SAR (also known as the Stop and Reverse System) is used to identify the potential reversal in the price movements.