Many investors analyze stocks based on their fundamentals (such as income, valuation, or industry trends), but fundamental factors are not always reflected in market prices. Technical analysis aims to predict price movements by examining historical data (mainly prices and quantities).
It helps traders and investors navigate the gap between intrinsic value and market prices by using techniques such as statistical analysis and behavioral economics. Technical analysis helps guide traders on what is most likely to happen based on past information. Most investors use both technical and fundamental analysis to make decisions.
- Technical analysis, or the use of charts to identify trading signals and price patterns, may seem overwhelming or esoteric at first glance.
- Beginners should first understand why technical analysis can be used as a window to understand market psychology to identify profit opportunities.
- Focus on a specific trading method and develop a disciplined strategy that you can follow without letting emotions or afterthoughts get in the way.
- Look for a broker that can help you execute your plan in an affordable way, while also providing the trading platform with the right tool kit you need.
Technical analysis strategies for beginners
Choose the right method
There are usually two different methods for technical analysis: a top-down approach and a bottom-up approach. Many times, short-term traders will take a top-down approach, while long-term investors will take a bottom-up approach. In addition, there are five core steps to start technical analysis.
The top-down approach is a macroeconomic analysis that looks at the overall economy before focusing on individual securities. Traders focus first on the economy, then the industry, then the stock, and then the company. Traders using this method focus on short-term gains rather than long-term valuations. For example, a trader may be interested in stocks that break through the 50-day moving average as a buying opportunity.
The bottom-up approach focuses on individual stocks rather than macroeconomic perspectives. It involves analyzing stocks that seem to be fundamentally interested in potential entry and exit points. For example, an investor may find an undervalued stock in a downtrend and use technical analysis to determine a specific entry point where the stock may bottom out. They seek value in their decisions and intend to hold a long-term view of their transactions.
In addition to these considerations, different types of traders may prefer to use different forms of technical analysis. Day traders may use simple trend lines and volume indicators to make decisions, while swing or position traders may prefer chart patterns and technical indicators. Traders who develop automated algorithms may have completely different requirements, that is, to use a combination of volume indicators and technical indicators to drive decision-making.
1. Choose a strategy or develop a trading system
The first step is to determine a strategy or develop a trading system. For example, a novice trader may decide to follow a moving average crossover strategy, where they will track two moving averages (50-day and 200-day) of specific stock price changes.
For this strategy, if the short-term 50-day moving average is higher than the long-term 200-day moving average, it indicates that the price is on an upward trend and generates a buy signal. The situation with a sell signal is just the opposite.
2. Identify securities
Not all stocks or securities are suitable for the above strategy. This strategy is very suitable for highly liquid and volatile stocks, rather than poorly liquid or stable stocks. Different stocks or contracts may also require different parameter choices-in this case, different moving averages, such as 15-day and 50-day moving averages.
3. Find the right broker
Get the correct trading account that supports the selected security type (such as common stocks, penny stocks, futures, options, etc.). It should provide the functions needed to track and monitor selected technical indicators while keeping costs low to avoid eroding profits. For the above strategy, a basic account using a moving average on the candlestick chart will work.
4. Track and monitor transactions
Traders may require different levels of functionality, depending on their strategy. For example, day traders will need a margin account that can provide access to secondary quotes and market maker visibility. But for our example above, a basic account may be more suitable as a lower cost option.
5. Use additional software or tools
Other features may be needed to maximize performance. Some traders may need to move alerts or trade anytime and anywhere, while other traders may use automated trading systems to execute trades on their behalf.
Tips and risk factors
Trading can be challenging, which means that it is important to complete the work beyond the points mentioned above. Some other key considerations include:
- Understand the basic principles and basic logic behind technical analysis.
- Backtest trading strategies to see how they have performed in the past.
- Practice trading in a demo account before investing actual funds.
- Be aware of the limitations of technical analysis to avoid costly failures and surprises.
- Considerable and flexible in terms of scalability and future needs.
- Try to evaluate the functionality of the trading account by requesting a free trial.
- Start small and expand with the accumulation of experience.
Many investors use fundamental and technical analysis at the same time when making investment decisions, because technical analysis helps to fill the knowledge gap. By understanding technical analysis, traders and investors can improve their long-term risk-adjusted returns, but it is important to understand and practice these techniques before investing actual capital to avoid costly mistakes.