Trading in the stock market is no less risky then trying to make a living off a roulette wheel; there are significant fluctuations in the price movements. However, unlike the roulette, the randomness here is fuelled by the perception of the participants. One of the tools to identify such perceptions is technical analysis, which is a study of two aspects — the price and the traded volume of a stock. These observations are plotted on a graph across a specific timeline for better analysis. The idea is to understand the mood of the market conveyed through the movements on the chart.
Supports and resistances
Every stock price is the result of an ongoing tussle between buyers and sellers. Not all traders agree upon the prevailing prices, hence the constant movement. But there comes a level when a seller is unwilling to sell and the buyer feels the prices can’t go down further. This is labelled as the ‘support’ level.
At this level, buyers will come in to buy the stock and even sellers with a bearish view may not see the price falling further. A similar agreement on overheated prices between buyers and sellers creates a hurdle or ‘resistance’ for the stock price from going up. These levels are vivid and recurrent. The stock price falls to a particular point and bounces back taking support. At ‘resistance’ points, stocks hit a barrier, restricting further rise.
Break-out
Now, if the stock price penetrates a ‘support’ or a ‘resistance’, that means that the general consensus on what the price should be has changed. This is known as a ‘breakout’. It can be the result of a fundamental change in the stock, and is usually abrupt in nature.
Again, one must see it in conjunction with decent increment in volume, signifying a mass change on the consensus about the new prices levels. Once a resistance is crossed convincingly, it becomes a significant support and once a support is penetrated strongly, it turns in to a resistance.
Trend
Every stock trades with a consistent direction in prices called a ‘trend’. A rising trend is characterised by higher lows and highs. In other words, a consistently rising support level. The opposite holds good for a falling trend. Joining the lows in a rising trend and highs in a falling trend, helps one draw a trend line. A breakout, penetrating the trend line, accompanied with higher volumes, indicates a reversal of the trend. Much like breakout of a resistance and supports, the trend line penetration signals fresh entry or exit points.
Moving averages
There are many indicators used in this science. A look at one of the most popular ones — the moving average (MA). MA is nothing but moving average of successive sets of daily prices, plotted in the price chart. Eg. A 50 day-MA is the average of the past 50 days prices (Pt, Pt-1, …..Pt-49). A stock is bought when this MA is penetrated from below or sold once the price moves below the MA. From a longer term perspective, a 200-day MA is a well-respected indicator.
Technical analysis has several such indicators or tools which can be used to interpret stock price patterns and trade them profitably.
But the most important tool is discipline in trading within the visibility provided by the technical tool. Set your biases aside and restrict the losses and take profits wherever the tools indicate!
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