What is Technical Analysis?
PeakBot’s automated stock trading software is based on technical analysis. Technical analysis as a trading discipline is becoming increasingly relevant as the industry gets more advanced trading technology. The central belief that technical analysts hold is that the past price action of a stock can provide valuable insight into future price movements of that same stock.
Technical analysis is used to identify potential trading opportunities through the use of historical and real-time data. The data that is collected depends on the types of technical indicators that are being used in the trading strategy. There are hundreds if not thousands of technical indicators and patterns that can be used to create a technical trading strategy.
Technical Indicators
All types of indicators are unique and provide a valuable insight into the stock’s price changes. The goal for any efficient technical strategy is to find the right blend of indicators to confidently trade when the criteria is met.
Some of the most well known indicators are:
- Moving Averages
- Relative Strength Index
- Volume & Volatility Measures
When preparing a technical trading strategy, it is vital to understand the information that each indicator provides and how to properly determine what impact that may have on the stock price.
Moving Averages:
A moving average (MA) is a simple indicator that provides an average price that is updated constantly depending on the time frame selected. A simple moving average is often used to form more complex technical indicators.
The two common types of moving averages are simple moving averages (SMA) and exponential moving averages (EMA).
The SMA adds up the closing prices of each candlestick and divides the figure by the amount of periods selected to study to create an average price. A 20-period moving average would find the average closing price for the last 20 days (or whatever you set your timeframe for) and show that on the stock chart. The example below shows what the SMA20 would look like on a stock chart (blue line).
An exponential moving average is a weighted moving average. A weighted moving average is created to give more relevancy to the most recent data. This is done by multiplying each price point by a certain weighting factor. The more recent the data, the greater it will impact the average price calculation. Below is an example of the EMA20 and SMA20 on the same chart. Notice the EMA (purple) rises faster and falls quicker than the SMA (blue).
Exponential moving averages are used to create one of the most popular technical indicators for modern investors, MACD.
MACD
MACD stands for “moving average convergence divergence.” The MACD is typically calculated by subtracting the 26-period EMA from the 12-period EMA. Although it sounds complex, it is one of the simplest and most effective indicators to measure trend direction and momentum. There are four main components to consider when looking at your MACD indicator.
The MACD line, the signal line, the zero line and the MACD histogram. In the example below the MACD line is represented by the orange line. The signal line is represented by the blue line, and it is the EMA9 (average of 9 periods) of the MACD line. The MACD histogram is the bars that range above and below the zero line. These bars are calculated by subtracting the signal line from the MACD line.
When interpreting the MACD indicator it is important to know what movements indicate what potential price changes. The MACD line ranges above and below the zero line. The histogram graphs the difference between the MACD and the signal line, and is used by traders to identify when positive or negative momentum is high. If the MACD is above the signal line the histogram will be positive and if it is below it will be under the zero line.
The further the histogram ranges in either direction shows the strength of trend & momentum in that direction. Take note of the correlation between the MACD histogram and the stock price in the upper section of the chart.
Relative Strength Index (RSI)
The RSI indicator is another momentum indicator that analysts often pair with the MACD to interpret a more complete technical analysis of a stock. The RSI measures the magnitude of price action to determine whether a stock is oversold, overbought, or somewhere inbetween.
RSI is represented by an oscillator (a line graph that moves between two extremes) and it will return a number between 0-100.
The technical analysis industry typically interprets an RSI value of 30 or below as oversold. When the RSI calculates that a stock is oversold that means that the stock price is undervalued and may be on the verge of upward momentum. When the RSI returns a value of 70 or above that represents an overbought condition. This means the stock may be primed for a pullback or a trend reversal. Below is an example of the RSI indicator represented with a stock chart.
The RSI formula is a simple equation once broken down:
In the following example you have an average gain of $1.20 during up periods, and an average loss of $1.00 during down periods.
Volume
Volume is one of the most vital statistics for trading stocks. In the stock market volume represents the number of shares of stock exchanged during a timeframe or a specific transaction.
For example if you purchased 10 shares of a stock, the volume of your specific trade was 10 shares. Volume as an indicator, keeps track of all transactions in a given time period and totals the number of shares. The volume indicator is typically a histogram displayed at the bottom of a stock chart. In the example below the volume bars are representing an entire day of trading.
On this particular date nearly 13.5 million shares were exchanged for this particular stock.
Volume is an important indicator for activity within the stock but it does not necessarily determine direction of the stock price. In the example above you can see a large jump in volume that corresponds with a rise in stock price. This is not always the case.
Volatility
Volatility is another technical indicator that is constantly monitored by investors and often used as a key metric for decision making when it comes to buying or selling a stock. In investing, volatility is a measure of uncertainty or irregularity in a stock’s price range. If volatility is high it means that the stocks value is spread between a larger range of price points. An increase in volatility often means that price movements are larger, thus more risky. Although when combined with other indicators it can prove as a great addition to a trading algorithm or strategy.
There are multiple different ways to calculate and interpret volatility. The most commonly used for trading stocks is historical volatility. This gauges the price movement of a stock over predetermined periods of time. There is also implied volatility which is also referred to as projected volatility. This metric is forward looking, and often the most important indicator to consider for options traders.
When selecting stocks to invest in it is smart to keep volatility in consideration. For example, you won’t find many high volatility stocks in a portfolio that is designed for safe, but minimal growth. If you are trading intraday and more actively, increased volatility may be one of the first things on your checklist when analyzing a stock.