Day 7: Technical Analysis Part 1 - Unlocking Chart Types & Trend Basics

Namaste investors! Welcome back to our 15-day journey into the basics of the stock market. We’re on Day 7, and today we’re stepping into the fascinating realm of Technical Analysis. If fundamental analysis (which we’ll touch upon later) is about understanding a company’s health, technical analysis is about understanding the market’s mood through price charts and trading volumes. It might sound complex, but we’ll break it down into simple, digestible pieces.

What is Technical Analysis?

Technical Analysis (TA) is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts believe that all known information is already reflected in the stock’s price, and that prices tend to move in identifiable trends.

The core assumptions of technical analysis are:

• The market discounts everything: All information, whether it’s company news, economic data, or political events, is already priced into the stock
• Prices move in trends: Stock prices don’t move randomly; they tend to follow specific trends (up, down, or sideways) for a period
• History tends to repeat itself: Market psychology influences trading, leading to recurring price patterns over time

For beginners in India, TA can be a valuable tool to identify potential entry and exit points, especially for short to medium-term trading.

Types of Charts: Visualizing Price Action

Charts are the technical analyst’s primary tool. They help visualize historical price action to identify patterns and trends. Let’s look at the three most common types:

1. Line Charts

The simplest type, a line chart, is created by connecting a series of closing prices over a specific period. It gives a clear, uncluttered view of the general trend but lacks detailed information like the day’s high, low, or opening price. They are great for spotting long-term trends.

2. Bar Charts (OHLC Charts)

Bar charts provide more information than line charts. Each bar represents a specific period (e.g., a day) and shows four key pieces of data:

• Open (O): The price at which the stock first traded (a small horizontal line to the left of the vertical bar)
• High (H): The highest price traded during the period (the top of the vertical bar)
• Low (L): The lowest price traded during the period (the bottom of the vertical bar)
• Close (C): The last price traded during the period (a small horizontal line to the right of the vertical bar)

3. Candlestick Charts

Originating from Japan, candlestick charts are the most popular among traders today.

Reading Candlesticks: Decoding Market Sentiment

Each candlestick tells a story about the battle between buyers (bulls) and sellers (bears) during a specific period.

• The Body: The wide part of the candlestick is called the “real body”. It represents the range between the opening and closing prices.

  • If the close is higher than the open, the body is usually green (or white), indicating buying pressure (a bullish candle)
  • If the close is lower than the open, the body is usually red (or black), indicating selling pressure (a bearish candle)

• The Wicks (or Shadows): These are the thin lines extending above and below the body.

  • The upper wick shows the highest price reached during the period
  • The lower wick shows the lowest price reached during the period The length of the wicks can indicate volatility and price rejection. For example, a long upper wick suggests that buyers tried to push the price up, but sellers pushed it back down.

Basic Candlestick Patterns

Individual candlesticks and combinations of them form patterns that can signal potential market reversals or continuations. Here are a few basic ones:

• Marubozu: A candlestick with a full body and no (or very short) wicks. A green Marubozu indicates strong buying interest from open to close, while a red Marubozu shows strong selling pressure
• Doji: Has a very small or non-existent body, meaning the open and close prices are nearly identical. It signals indecision in the market
• Hammer: Appears at the bottom of a downtrend. It has a small body, a long lower wick (at least twice the body length), and a short or no upper wick. It suggests that sellers pushed prices down, but buyers stepped in and pushed prices back up, indicating a potential bullish reversal.
• Shooting Star: The opposite of a Hammer, appearing at the top of an uptrend. It has a small body, a long upper wick, and a short or no lower wick, signaling a potential bearish reversal
• Engulfing Pattern (Bullish/Bearish): A two-candle pattern. A Bullish Engulfing occurs when a small red candle is followed by a larger green candle whose body completely engulfs the previous red candle’s body, suggesting a potential uptrend. A Bearish Engulfing is the opposite.

Support and Resistance Levels: The Market’s Floor and Ceiling

Support and resistance are key concepts in technical analysis. These are price levels on a chart where the price of a stock tends to stop and reverse.

• Support: A price level where demand is thought to be strong enough to prevent the price from falling further. Think of it as a “floor”. When the price approaches a support level, buyers tend to step in, causing the price to bounce back up
• Resistance: A price level where selling pressure is thought to be strong enough to prevent the price from rising further. Think of it as a “ceiling”. When the price approaches a resistance level, sellers tend to take profits or initiate short positions, causing the price to fall

These levels are formed due to market psychology and past price action. Traders remember past price points where the market reversed, and they often act similarly when those levels are retested.

Identifying S&R: Look for historical price points where the price has struggled to move beyond. Connecting multiple such lows creates a support line, and connecting multiple such highs creates a resistance line.

Role Reversal: An interesting phenomenon is “role reversal”. When a support level is decisively broken, it can turn into a new resistance level. Conversely, if a resistance level is broken, it can become a new support level.

Trendlines and Channels: Riding the Wave

Prices move in trends, and trendlines help us visualize and confirm these trends.

• Trendlines: These are diagonal lines drawn on a chart.

  • An uptrend line is drawn by connecting at least two significant swing lows (the troughs). The line slopes upwards and acts as a dynamic support level
  • A downtrend line is drawn by connecting at least two significant swing highs (the peaks). The line slopes downwards and acts as a dynamic resistance level

• Channels: When you draw a parallel line to an existing trendline, you create a channel.

  • In an uptrend channel (ascending channel), the lower line is the uptrend line (support), and the upper parallel line acts as resistance
  • In a downtrend channel (descending channel), the upper line is the downtrend line (resistance), and the lower parallel line acts as support Prices often oscillate between these two lines within a channel.

Identifying Trends: Up, Down, or Sideways?

Understanding the prevailing trend is crucial for making trading decisions. There are three main types of trends:

1. Uptrend (Bullish Trend): Characterized by a series of higher highs (HH) and higher lows (HL). Each peak is higher than the previous peak, and each trough is higher than the previous trough. This indicates that buyers are in control.
2. Downtrend (Bearish Trend): Characterized by a series of lower highs (LH) and lower lows (LL). Each peak is lower than the previous peak, and each trough is lower than the previous trough. This indicates that sellers are in control.
3. Sideways Trend (Consolidation or Range-bound Market): Occurs when prices move within a relatively narrow horizontal band, without making significant higher highs or lower lows. This often indicates a period of indecision or balance between buyers and sellers.

Volume Analysis Basics: Gauging Market Strength

Volume refers to the total number of shares traded during a specific period (e.g., a day). It’s usually displayed as a histogram at the bottom of a price chart.

Why is Volume Important? Volume helps confirm the strength or weakness of a price trend or a chart pattern.

• Trend Confirmation: In a healthy uptrend, volume should ideally increase as prices rise and decrease during pullbacks. In a healthy downtrend, volume should increase as prices fall and decrease during rallies.
• Breakout Confirmation: When a stock price breaks out of a key support/resistance level or a chart pattern, high volume accompanying the breakout gives more conviction that the breakout is genuine and likely to continue
• Divergence: If price makes a new high in an uptrend, but volume is significantly lower than on previous highs, it could be a sign of weakening momentum and a potential reversal (this is called divergence)

Putting It All Together

Phew! That was a lot to cover, but these are the foundational building blocks of technical analysis. Understanding chart types, candlestick signals, support & resistance, trends, and volume will give you a solid base.

Remember, technical analysis is part science and part art. It requires practice, observation, and continuous learning. No single indicator or pattern guarantees success, but using these tools together can help you make more informed trading decisions.

In Day 8, we’ll delve deeper into technical analysis, exploring more advanced chart patterns and indicators. Stay tuned!

Happy Learning!