The other day, I took you through a simplified guide of understanding what Fundamental Analysis is in regards to stock trading, and I briefly told you about technical analysis as another method investors and traders like to use to analyze the stock markets before deciding on what kind of stock to invest in.
Today, we will look at Technical Analysis in much deeper detail to help you understand it better so you can employ it in your market analysis, which will help you make informed decisions during stock trading, but before we get to it, it is important to note that technical analysis is used alongside fundamental analysis for better results.
By definition, technical analysis is the process of examining historical market data like the price of the stock and its volume in active trade to determine its real value. Technical analysis involves analyzing past and present statistics, and behavioural economics of stock markets to help traders determine the intrinsic value of stocks.
Just a reminder, intrinsic or real value of a company’s stock is that figure arrived at by analysts after a thorough examination of different market factors related to the company, which may include analyzing the entire state of the economy. Investors regard the intrinsic value of by investors stock as the real price of such stock, and it can be either higher or lower than its current market price.
Technical analysis approaches
Stock traders, depending on their needs, have two technical analysis approaches to choose from namely, the Top-down approach and the Bottom-up approach.
This macroeconomic analysis looks at the overall economy before focusing on individual securities. With the top-down approach, a trader focuses on the economies first, then industries or sectors, and finally examines the performance of individual companies in the case of stocks.
Short-term traders looking for short-term gains in contrast with long-term valuations mostly use the top-down approach. Traders looking for buying opportunities in stocks that broke out from their 50-day moving average use the top-down technical analysis approach to make their trading decisions.
This the direct opposite to top-down approach I discussed earlier. With the bottom-up approach, traders focus on individual stocks as opposed to a broad macroeconomic view of the entire economy. With this approach, traders and investors analyze a stock that appears to be deeply interesting for potential entry and exit points.
For instance, an investor finds an undervalued stock in a downtrend and uses technical analysis to identify a specific time when to buy the stock that is most probably bottoming out. At this point, the stock is either trading at its lowest point or it is undervalued so it presents an opportunity for the trader to buy with the expectation of its value to rise so they can sell high.
This is the approach for traders looking for long-term gains on their investment.
With that said, your choice of a technical analysis approach depends on whether you are looking for something short term in the market or you are in for a long ride.
In addition to top-down and bottom-up approaches, traders might decide to use other forms of analyzing the stock market like using simple trend lines, volume indicators, chart patterns and technical indicators to make their decisions.
Different stock traders and investors enter the market at different times with different needs that may require different approaches that will give them their desired results, which is nothing but profits. Therefore, it is important to them that the decisions they make regarding their investment are well-informed using data collected through these different analyses of the stock market.
Steps to get started with technical analysis
There are five steps to follow as you get started with technical analysis
Choose a trading strategy or develop a trading system
For starters, you need to pick a trading strategy or develop a trading system depending on your needs. You could decide to follow a moving average crossover strategy, where you will track two moving averages of short-term 50-day and long-term 200-day verges on a particular stock price movement.
A buy signal will be generated if the 50-day moving average goes higher than the 200-day moving average, indicating an upward price trend. Alternatively, a sell signal will be generated if the short-term 50-day moving average goes lower than the long-term 200-day moving average, indicating a downward price trend.
After picking a trading strategy, you will have to identify stocks that will fit in your chosen trading strategy. It is import to put into consideration that highly liquid and volatile stocks may require different trading strategies from the illiquid or stable stocks.
Your choice of stocks to trade or invest in should fit into your trading strategy or system to get your desired return on investment.
Find the right brokerage for your chosen security
You have the trading strategy, and you have selected the securities that fit it. Now you need to find a trading account that supports your chosen stock that will help you track and monitor the technical indicators for your stocks.
Make sure your trading account is cost-effective so that you can maximize profits. Remember keeping operation costs low but with optimum production will maximize your profits.
Track and Monitor Trades
In the previous step, I talked about finding a trading account with functionality that allows you to track and monitor your trades. Once you have that, which a basic account can do at a lower cost, you need to actively monitor your trades. Day stock traders should get a margin account, which brings Level II quotes and market maker visibility to their disposal.
Take advantage of additional software
Modern traders are tech-savvy. They take full advantage of a plethora of trading software available on the internet to maximize performance and enhance their overall trading experience. Numerous trading software packages make it possible for you to trade anytime, anywhere on any device with real-time reporting through notifications on your desktop or mobile device.
Alternatively, some investors use Robo-advisors to trade on their behalf. These are algorithms designed to automatically make smart trading decisions on behalf of their clients so you can easily be sleeping or in the shower but a set system is investing your money on valuable stock somewhere.
More tips to consider that reduce the risk involved in stock trading
Stock trading is risky because small mistakes can lead to big loses but these should only motivate you to learn more and prepare better for your next trade. If you prepare adequately and make the right decisions, the risk ceases to exist and you could easily make profits after profits on your investment.
In addition to the above-mentioned steps, here are a few more tips to follow to reduce or do away with trading risks altogether.
Understand the basis and logic behind technical analysis
Technical analysis is broad and it encompasses many things. To understand it clearly so that you can use it to make informed trading decisions, you need to look out for resources on the internet that demonstrate both its efficiency and limitations. Thousands of books have been written about it you could look out for them too.
Back-test trading strategies to know their past performance
Earlier, I talked about picking a trading strategy depending on your trading needs. Before you decide on what strategy you should go with, it is important that you first test how that specific strategy has performed in the past in the market. You do not want to go with a strategy that has posted little to no results. Strategies with past success stories promise to continue performing well, all factors remaining constant.
Practice trading in a demo account before committing real capital
They say practice makes perfect, and it is true in this case. You have made several investments and traded in different sectors but stock. This is a new field for you so it is wise to first trade in a demo account, get the required knowledge and essential industry practices before you commit real capital to stock trading. You have to play it safe so you can win in the end.
Start small and expanding as you gain experience
Just because you have billions set aside to invest in stock and other securities does not mean you pour it into the trade all at once in the beginning. I know big investments promise bigger returns but it is advisable to start with reasonably small amounts and then expand your volume of trade as you gain experience. They say experience is the best teacher so it will surely teach you how to make better decisions as you move along.
Other tips include knowing the limitations of technical analysis, being flexible about the scalability and future requirements, and having a free trial of your chosen trading account. This will help you avoid costly failures and surprises.
As I said at the beginning of this long article, most investors use both fundamental and technical analysis to make investment decisions. Knowing the overall performance of the economy, industry, company management and the history of stock prices will give you a wealth of information to help you decide better on what type of investment to make and when.