In this post, Technical Analysis Explained – Stock Market 101 Guide For Beginners, I’ll be discussing the important points that surround this approach.
If you’re new to the stock market, please read my article on how the stock market works first before jumping into the technical analysis topic.
I’ve talked about how to approach the stock market using fundamental analysis in my previous post – the methodologies, the framework, and the ideas behind it.
Now, it’s time to discuss its counterpart – technical analysis. 🙂
I’ll be answering common questions that are involved in technical analysis and most importantly I’ll be talking about the basics of this approach and how you can leverage them to win in the stock market.
So again, ready your pen and papers, and let’s get right to it! ?
Technical Analysis Explained – Stock Market 101 Guide For Beginners
Technical Analysis is the study of price movement in a market.
And technicians (people who use technical analysis) studies previous price movement to determine the future movement of price.
A technician’s best friend in the financial markets would be the stock chart.
In a stock chart, it consists of data and real-life decisions that traders and investors make.
Reading charts are more convenient for traders because it’s much easier to come up with a decision on whether to buy or sell.
With technical analysis, you rid the process of calculating numbers, reading income statements, and studying the company.
For a technician, the chart is already enough.
To start off this guide, you’ll need to know first what’s the most important aspect in a chart, which is the price.
The price movement is basically what you see in a chart. In most charts, it’s represented by candlesticks which we’ll discuss in a minute.
In stock trading, price is king.
Each investor and trader has their own bias before buying a stock but it will only be confirmed by price.
If they buy a stock but price goes down by a certain percentage, they’ll have to sell that stock. This process is also known as “cut” or “cutting your losses”.
If they buy and the price goes up further, another decision is to be made – should they buy more or sell already.
Therefore, everyone that participates in the stock market usually make a decision based on price action.
Price action is simply the movement of price.
What if I tell you that during the time when the US stock market opens and closes, you can determine the price action in less than 10 seconds?
This is made possible by candlesticks.
Price action in charts is most commonly represented by candlesticks.
Candlesticks in a chart would look like this:
It might look odd and strange at first but to understand price action in a candlestick, let’s focus on two candlesticks first.
In the charts, you’ll see these two candlesticks – green and red.
A candlestick is composed of two parts:
The Body – This is the solid colored portion of the candlestick.
The Wick – This is the thin line above and below the candle.
The body and the wick are not just designs, they tell a story of what happened to the price action that day.
A green candlestick means that price has gone up and a red candlestick means that price went down.
The wick represents the highest and lowest point of the price within that day. And in a daily time frame, a single candlestick summarizes the whole trading day.
Anatomy Of A Candlestick
There are 4 important points that you’ll need to observe: Open, High, Low, Close. (OHLC).
Open – This is the opening price of a stock during that day.
High – This is the highest price of the day. It is represented by the highest point on the upper wick of the candle. If there is no upper wick in the candle, this means that the high is the topmost part of the candle.
Low – This is the lowest price of the day. It is represented by the lowest point on the lower wick of the candle. If there is no lower wick, then the lowest price would be the bottom part of the candle.
Close – This is the last price traded within that day.
In a real chart example, here’s a daily candlestick of Netflix on 8/13/2020:
Can you determine the OHLC of Netflix that day?
When looking at a candlestick, you can already make a story on what happened to its price that day – Netflix’s opening price was at 478.40, it went as high as 484.45 and as low as 476.45 but it managed to close at 481.33. Since the candlestick body is green, then we already know that the price closed above the opening price. Meaning it went up.
Here’s another example, a daily candlestick of Microsoft Inc on 8/13/2020:
Can you determine the OHLC during that day?
At first glance, you already know that the stock price went down because the candlestick’s color is red. To zoom in further, the opening price of Microsoft that day was at 209.44 and the highest price would be 211.35, and the lowest was at 208.15 and it closed at 208.70.
Buyers And Sellers
You might be wondering why are there wicks or low and high on a candlestick? Why didn’t the price stay there?
In a market, there are generally two participants – the buyers and the sellers.
A person becomes a buyer when he or she thinks that the price is cheap and can still go up.
A person becomes a seller if he or she thinks that the price is already expensive or that person has incurred some losses already.
If you look at the Netflix example above, at some time in the day the price increased from 478 to 484 but the buyers were overwhelmed by the sellers. If the sellers “overpower” the buyers, the stock price goes down.
The same concept happened when the price went down to 476.45, the sellers were overwhelmed by the buyers which caused the price to go up.
Now that you can tell a story behind a single candlestick, let’s try a multiple of them.
Let’s look at Zoom’s chart starting from August 3 to August 13, 2020:
Can you determine the OHLC from that group of candlesticks?
On August 3 (first trading day of august), Zoom opened at 256.83, on August 5 it made a high of 275.09, but the buyers were overwhelmed by the sellers and pushed the price down to 230 which was the low of Aug 11, 2020, but Zoom quickly recovered and had a closing price at 247.25 on August 13, 2020.
Now that you know how to read a candlestick, it’s time to learn about trends.
When technicians look at a chart, they always look at the bigger picture of the price action – they’re trying to answer what is the current trend of the stock.
Price action tends to move in a certain trend. If there’s a big trend that’s established in the chart, then most often, the price will continue moving towards the direction of the trend.
Essentially there three trends in a chart – uptrend, downtrend, and a sideways trend.
Here’s an example of an uptrend:
Even with just one look, you can already determine that the price is moving upwards.
A downtrend would look like this:
It’s very clear that the trend is going down.
And lastly, a sideways trend would look like this:
A sideways trend happens when it has no clear direction – it’s neither going up or down.
It’s important to know the trend so you won’t go against it. You don’t want to be buying in a downtrend stock and hoping it would go up.
You want to buy a stock where the direction of the trend is going up. Because that’s where the most profitable trades are.
Identifying Trends Objectively
If you want to be more technical when identifying trends, there’s a way to do that.
BUT YOU NEED TO LEARN THESE TERMS FIRST:
Higher High (HH) – This means that the price from the previous high was surpassed and the current price is already higher than the previous high.
Higher Low (HL) – This means that prices did not go below the previous price low but it still went down but not beyond the previous low.
Lower High (LH) – This means that the current price action didn’t surpass the previous high.
Lower Low (LL) – This is when the price goes beyond the previous low and made a new low.
A bit confusing? Let’s put it on a line to see it visually.
Here’s an illustration with HH’s and HL’s:
When a stock chart prints out a series of higher highs and higher lows, that’s a sure way to determine that trend is up.
Here’s another illustration with LH’s and LL’s:
If the stock chart displays this kind of price action, then it’s obvious that it’s on a downtrend.
To apply this on a chart, let’s use the examples below:
If the trend is up it has Higher Highs and Higher Lows.
If the trend is down it has Lower Highs and Lower Lows.
Now that we’ve discussed how to read a candlestick, how to determine the trend of a chart, it’s now time to talk about the two most important areas when looking at a chart.
Identifying Support and Resistance
Support and resistance are areas in the chart where there’s evidence of people buying and selling.
Support – This is the area or price level where there’s a lot of buying pressure.
Resistance – This is the area or price level where there’s a lot of selling pressure.
a) Understanding Support Areas
Support in the chart looks like this:
Support is created when the drop pauses and the stock moves upward when a certain area or a price level is hit.
As you can see in support 1, the stock was dropping until it reached that area. When another drop happened, it stopped in that area as well. The drop stopped because the buyers who were supporting that area. Those buyers overwhelmed the sellers causing the stock to stop the drop and go up again.
When you see multiple candlesticks that have lower wicks on the same area, that’s evidence that people are buying in that area thus creating support.
After support 3 happened, you can see that the stock came from 140+ to reaching more than 220+. After it peaked around 220+, the stock was free-falling until it reached the area of support 2 and 3 – creating another support (support 4).
That scenario is used by many traders when looking for an area or price level to buy. Previous support from months or years back can still act as a current area of support.
That’s how traders utilize the chart when it comes to buying a stock – they’re looking for support areas.
Here are a few more examples:
It’s ideal to buy at these levels because you know that if price breaks beyond that area, your bias of price going up is invalidated. If prices break below the support, that an indication that there’s still heavy selling pressure.
b) Understanding Resistance Areas
The counterpart of support is resistance.
Resistance is an area where sellers are placing their orders. Typically when you see a candlestick that has an upper wick, that means that it encountered an area of resistance. An area where sellers like to sell their stocks. That’s why as mentioned earlier, those upper wicks are evidence that sellers overwhelmed the buyers in that area.
Here’s an example of a resistance area in a chart:
Ever since June of 2017, traders and investors were trying to break that resistance in Tesla. The resistance was ranging from 375-390. Every time price gets near that area, it’s always rejected by sellers – the buyers were again, overwhelmed.
That area of resistance has been a hurdle even up to 2019. But if a resistance that’s been strong throughout several years, when it’s broken or when the price finally pushes further above it, the stock usually goes up…or goes crazy.
On December 19, 2019, the buyers of Tesla has finally broken the resistance. As you can see it went crazy after breaking it. It went up for about 150% until February 2020.
Here are a couple more examples of resistances in the charts:
Resistances are there for one reason – to resist prices going up. And good traders know that too.
They don’t wish and hope for the resistance to break, as soon as they see price reacting or being denied at a resistance area, they sell their stocks already.
To summarize these two important points…
1. Support is an area where most people buy. It “supports” the price from going down. And if something is not going down, you’re only left with two choices – its either going up or sideways. In this area of the chart, the demand is stronger than the supply.
2. Resistance is an area where most people sell. This area is where supply is stronger than the demand which causes the price to go down.
Support and resistance are not lines in the chart they are areas or zones.
Buy On Support, Sell On Resistance
This a principle that should be followed when trading the market but a lot of traders seem to have forgotten this one.
Instead of buying on support, they sell. Instead of selling at resistance, they buy.
They do this because sometimes when they see a stock that’s going up, that’s when it’s attractive to them. After all, it’s already moving but they fail to recognize that it’s already near the resistance zone.
They don’t buy at support because the price isn’t moving. It just “resting” or pausing at the support area.
So when trying to trade the market, always remember this principle – buy on support and sell on resistance.
Guidelines In Support And Resistance
1. As mentioned earlier, support and resistance are not one line and exact numbers, they are areas or zones in the chart.
2. Support and resistance can have role reversals wherein previous resistance can be a new support area and previous support can be a new resistance area.
3. The more times the resistance and support are tested, the stronger and significant that area is.
4. If strong resistances are broken, the “crazier” the price increases:
5. If these strong supports are broken, the greater the drop in price:
Common Trading Systems
There are thousands of trading techniques and systems that go around the stock market. But most of them just boils down to two important things – support and resistance.
Most systems use support and resistance to determine if a stock is already a “buy” for them or if it’s time to “sell” already.
The first strategy that we’ll be talking about would be one of the most common trading styles – trading breakouts.
1. Trading Breakouts
Breakouts happen when price breaks out of resistance.
Breakouts are moves going to the upside that has momentum behind it. When a breakout happens, it usually means that there will be a change of trend or a continuation of the uptrend.
But before breakouts happen, consolidation usually takes place first.
Consolidation is when price moves in a sideways manner. When consolidation happens, it’s like there’s pressure building up. And the longer the consolidation takes place, the next move will be even more explosive – whether that’s to the upside or downside.
Here’s a chart of Tesla with a 6-year consolidation:
Consolidation usually happens inside a box. When prices are not trending, they go sideways and form a box. The bottom of the box serves as a support and the top of the box serves as resistance.
As you can see, the support area has been tested multiple times, proving that is where the buyers are. And the resistance area has been tested multiple times as well, showing that is where the sellers are.
But there comes a time when price breaks out of consolidation…and this time it broke the resistance.
A breakout happened just this year, and when it did, the price went high for 130% in just a couple of weeks!
And when sellers were taking control, pushing the price down, can you see where the buyers were?
They were buying at the previous resistance of the consolidation – following guideline #2 – Support and resistance can have role reversals.
And in this case, the previous resistance turned to support.
Here are a few more examples of trading breakouts:
In all of the examples above, you can see that price doesn’t go up in a straight line. It always has ups and downs.
Before an uptrend resumes its movement going up, a consolidation happens this is what we call a pullback (we’ll explain pullbacks later).
And for investors and traders who just saw the stock and want to enter, they capitalize on the consolidation and wait for a breakout!
Another technique that people do when they see a consolidation happen, is they buy at the support area and anticipate a breakout. If the price reacts to the resistance and goes down, they sell their shares already.
But why do traders prefer breakouts than buying on the support of consolidation?
As mentioned earlier, they prefer trading breakouts because the price is already moving as compared to being on support.
When the price is still on the support area, price is stagnant and not trending plus there’s that possibility that it might be rejected at resistance.
So they prefer to buy on breakouts because if the price breaks the resistance, that represents overwhelming demand – buyers overwhelm the sellers in their area (resistance).
Where to Buy And Cut On Breakouts
To “cut” means cutting your losses. It’s selling your losing investment before it loss gets bigger.
When prices break the resistance area, that what you call a breakout.
So in this example, if you’re trading breakouts, if a candle goes above 187.60, that means you should buy already. And your bias of the stock going up is proven wrong if the price goes below the low of the breakout candle.
Basically, you buy on 187.70 and cut on breakout candle’s low (184.40)
Some traders sell when the price goes back to the consolidation box. If this is your plan, then you buy 187.80 and cut if the price goes below the breakout point which is at 187.60.
A more conservative way of buying breakouts would be waiting for the end of the day and to see if the price closed above the resistance.
How should we know if it does this? We observe the candlestick!
Here’s why sometimes being conservative and waiting for the price to close that day is beneficial – it allows you to avoid fake breakouts.
To read that false breakout candle, within that day it broke out of the resistance but within the day as well, the price went back to the consolidation box giving out a false impression that it’s a breakout.
So if you were conservative in this approach, then you would have avoided some losses.
Another system that’s commonly used would be taking advantage of ranges.
2. Trading The Range
A trading range is formed when the chart does not go above and below a certain price. Take a look at this one:
As you can see, the price was moving sideways and not going beyond the resistance and support.
It’s like consolidating but the size of the box is bigger.
So how do we trade this range?
If the price is going back and forth between the resistance and support then it makes sense that we buy when the price is near the support area and in this case, the support is 166.19 – 168.76.
When we buy because of the range, we assume that it’s going to hit the resistance again. So the percentage of difference of the support and resistance will be the indication if the trade is worth it or not.
In the example above, the range is about 18% which is already enough to make a profit for weeks or months. Whether the range is worth it or not, will depend on the trader. Some think that a 10% range is enough while others think that it’s not worth the time.
Here’s an example of what your trade thought process should be when it comes to finding ranges:
1st scenario – You see the price going down after it hit a resistance. How’d you know if resistance is met? Price is being rejected – it can be shown via the upper wicks and price can’t go further:
Now that you saw price being rejected and the stock is going down, you’re now looking for support areas to buy your shares.
As mentioned above, you can look for previous resistance that can possibly turn to support or look for proven support areas.
So in the next scenario, you place potential areas on where the price can find its support and go back to the resistance. And since you’re looking for a range trade, you want the percentage range to be big so you can maximize your profit.
You have drawn 3 possible areas.
With support #1 support, the range doesn’t seem to be so attractive, it’s just 3% below the resistance.
With support #2 support, it’s the same thing.
But with support #3, giving a possible 10% return if the price moves up back to the resistance, then the range trade is much more attractive.
Let’s see how this plays out.
I placed arrows on where it has proven to be a good support area. Support areas can be previous resistances as well.
As you can see, it was on assumed support #3 where the price stopped dropping and the candlesticks have lower wicks already.
Having lower wicks mean that there is some buying coming from traders because it means that they are pushing the prices up from that support area.
This is also ideal for us since the range from the resistance to support #3 is about 10% which makes the range worth it to trade.
Although the support was tested again, it really showed that is where the buyers are because the price was staying in that area and eventually moved up to hit the resistance and breaking it eventually.
If you also observe, whether it was support #1, #2, or #3, the price really reacted to those areas. Whenever price goes to the assumed supports, it goes up in price which tells us that the guidelines above can really be trusted.
3. Trading Pullbacks
Trading pullbacks is another common strategy used by traders especially when they get left behind after a move from a breakout.
Pullbacks happen when price “rest” from going up. You can consider it a temporary weakness and an opportunity for you to enter.
Trading pullbacks allows you to “hitch” the ride to the upside.
Pullbacks can also be in the form of consolidation but before the pullback, there should be an uptrend move before the “rest” to call it a pullback.
Here is another example of pullbacks:
How do you trade pullbacks? It’s the same thing when trading breakouts! You wait for the price to break the resistance of the consolidation and then you buy.
Those are the common trading strategies that are used by many. No matter how complicated a system or strategy is, support and resistance would always be part of the equation.
Another important topic to know under technical analysis would be knowing the market cycle.
The market cycle is basically how a stock market moves. This also can be applied to individual stocks.
The most popular market cycle diagram would be from Richard Wyckoff.
Richard Wyckoff is one of the pioneers when it comes to technical analysis. In his years of trading, he developed a theory that price action has 4 stages namely Accumulation, Markup, Distribution, and Markdown.
His cycle, in theory, looks like this:
Stage 1: Accumulation
Wyckoff believes that before a stock goes up in price, it should first experience a moment of neglect. A moment where only a few are buying thus keeping the movement in the chart flat.
And this is where institutional money comes in. Institutional money or smart money is money that’s coming from banks, hedge funds, or any big players in the market.
This is the time where they “accumulate” shares as silently as possible. Why? Because if they buy all the shares they need in just one go, this will increase prices immediately and making them buy their shares at an expensive price.
Stage 2: Markup
This is where the price starts to breakout of the resistance and the stock is now moving towards being in an uptrend. From being flat and no direction to going up in an uptrend.
Stage 3: Distribution
This stage is evident when it seems like price can’t go up any further. You will see upper wicks in the candlesticks which means being price is being rejected. This is the stage wherein sellers are trying to take control. They are overwhelming buyers in this area.
Stage 4: Markdown
This stage is where the sellers have completely dominated and the buyers and the stock now are going down.
Below are stock charts that have the same look as Wyckoff’s cycle:
What can we learn from Wyckoff’s market cycle?
The “easiest” money to be made would during stage 2 – markup. It’s the easiest because the general move of the stock is behind us. When in stage 2, the stock is in an uptrend. It’s in this stage as well that you see the price breaking resistances.
So how do we capitalize on Stage 2?
By using the strategies above.
Although the stock is in an uptrend, it doesn’t go up in a straight line. It will have pauses, it will rest, it will have consolidation periods. And with your knowledge of support and resistance, you will be able to ride the uptrend or be in the stock before it creates a move the upside.
To know more about Wyckoff’s market cycle, you can check out this video! He mentioned an important statement – This theory should only act as a guide to know where you are in the cycle. Which I totally support! This market cycle shouldn’t be an indicator of whether to buy or sell. It should just serve as a guide on where you are in the big picture.
Since we’ve discussed the important topics on what we should observe in charts, it’s time to know the different types of trading.
3 Types Of Trading
1. Day Trading – When one hears about trading, this type of style is what probably comes into mind immediately. Day trading is buying within the trading day and selling it on the same day as well.
2. Position Trading – This style is the closest the investing or buys and hold strategy. But the only difference is the trader monitors his stock more frequently than investors. And when the trader thinks that the price will reverse to the downside, he will sell it.
3. Swing Trading – This style only captures the swings or temporary up moves of the stock. They don’t wait for the stock to go down, as soon as price reacts to resistance, they sell.
How Often Does Technical Analysis Work?
Technical analysis doesn’t have a 100% accuracy.
If it did, no one would be using fundamental analysis anymore.
Investors and traders can make money in the market using both frameworks. No one style is better than the others and no system is far superior from the rest.
To go deeper into these trading styles, you can watch Rayner Teo’s video on this! He’s been posting educational videos on all things trading 🙂
- Technical analysis is the study of price movement in the market.
- Technicians studies previous price movement to determine the future movement of the stock.
- In technical analysis, price is king.
- There are three trends in the market: Uptrend, Downtrend, and sideways.
- An uptrend consists of Higher Highs and Higher Lows.
- A downtrend consists of Lower Highs and Lower Lows.
- Support is the area where there’s a lot of buying pressure.
- Resistance is the area where there’s a lot of selling pressure.
- Don’t buy at resistance and sell at support.
- Support and Resistance are areas or zones in the chart.
- Previous support can be turned to resistance and previous resistance can be turned to support.
- Support and resistance become more significant when it is tested multiple times.
- If significant support breaks, the greater the drop.
- If a significant resistance breaks, the “crazier” or more explosive the move is.
- There are four stages to a market cycle – accumulation, markup, distribution, markdown.
- The three common types of trading are Swing, Day, and Position Trading.
- Technical Analysis doesn’t work 100%.
Technical analysis involves timing the market. Timing in the sense of being precise where to buy and sell your stock.
Since this is easier said than done, this approach requires a lot of study and research.
Let this post serve as your in-depth introduction to the vast world technical analysis and I hope you learned a ton on this post! 🙂