I wrote a piece of introductory article on Technical Analysis for a Young Investor Newsletter sometime back.
The article was meant to provide young undergraduates some background about what Technical Analysis is about, why it is such an important and useful tool and some basic ways to use technical analysis.
I thought it will be a great idea to share it here with you to start you off on some insights about what Technical Analysis is basically about.
So read on and have fun learning about the usefulness of applying TA in your investment analysis!
If you have any questions after reading through, feel free to drop your questions in the comments area below.
Introduction to Technical Analysis
Technical analysis of the stock market is basically the use of a stock chart with past price action to anticipate future price trends.
While fundamental analysis is helpful in studying the business potential of a listed company, technical analysis is as important in determining the optimal time to buy and sell the stock.
The rationale behind the use of technical analysis is that price movements of stocks are not totally random.
Stock prices do trend and by charting these price trends, an investor can determine when the existing downtrend of a stock has ended and an uptrend has started.
He will then be able to buy that stock near the bottom at the best risk to reward ratio (assuming that this stock has strong business fundamental as well).
Why is Technical Analysis an important analysis tool?
Technical analysis is an especially useful market analysis tool during stock market bubbles.
During a stock market bubble, the strong demand for stocks and their persistently surging prices can continue to defy business fundamentals for an extended period of time.
One example was the tech bubble that happened from late 1900s to early 2000s.
In December 1996 when the NASDAQ index was around 1250, Alan Greenspan, the Federal Reserve Chairman then, had warned the market of “Irrational Exuberance”.
However, NASDAQ rallied another 300% to around 5200 over the next 4 years before the bubble finally burst.
While an investor would have exited the market earlier on valuation grounds, there was a huge opportunity cost of getting out way too early in this case.
With the use of technical analysis, he would have continued to ride the uptrend much further and exit just after the end of the major uptrend, yet way before the big market crash hit.
Learn the basics of charting
There are many different technical analysis techniques but the most basic and critical skill is learning how to identify existing support/resistance levels and price trend.
Support is defined as the price level in which the counter stops its decline, forms a bottom and subsequently rebounds to a higher level.
When there is a series of at least two bottoms in which the second one is at a higher price level than the first, we can then draw an uptrend line linking these two bottoms.
This uptrend line can be projected forward into the future to establish its current trend.
As long as this uptrend line is not violated on the downside, there is no reason to sell the stock.
What lies ahead?
All in all, to become a proficient market technician, one needs to spend time honing his skills, just like how an apprentice develops into a true craftsman.
If you are keen to learn more about stock charting, do register for my free “Trading Sense Seminar – The Technical Analysis Way”!
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