What is Technical Analysis?
Technical analysis is a method used by traders to predict future price movements of stocks by reading candlestick Chart patterns and statistical numbers are used extensively by technical analysts
fundamental analysis means that the market value of a stock may not always match the true value of the stock. As a result, fundamental analysts try to calculate the intrinsic value of a stock and benefit by investing in undervalued stocks.
On the other hand, technical analysts believe that the fundamental elements of a stock’s value are already represented in the stock price. In addition, they believe that stock prices move in identifiable trends over a period of time. learn more about technical analysis in the stock market and technical stock screener india
As a result, they evaluate the past price patterns of stocks in order to find out how the stock price moves in the future.
3 Principles of Technical Analysis
The price movement of a stock (or even the market) can seem quite random. But over a period of time, trends and price patterns might emerge.
Technical analysts try to exploit these patterns in order to make huge gains in the stock market. This method is mainly used for short-term trading or long-term position buying by investors.
- 1. Getting Started with Candlesticks: Candlestick charts are a type of financial chart for tracking the movement of securities. Each candlestick usually represents one day’s worth of price data about a stock. Over time, the candlesticks group into recognizable patterns that investors can use to make buying and selling decisions.
- 2. Single Candlestick pattern 1: As the name suggests, a single candlestick pattern is formed by just one candle. So as you can imagine, the trading signal is generated based on 1 day’s trading action. The trades based on a single candlestick pattern can be extremely profitable provided the pattern has been identified and executed correctly.
As the name suggests, a single candlestick pattern is formed by just one candle. So as you can imagine, the trading signal is generated based on 1 day’s trading action. The trades based on a single candlestick pattern can be extremely profitable provided the pattern has been identified and executed correctly.
One needs to pay some attention to the length of the candle while trading based on candlestick patterns. The length signifies the range for the day. In general, the longer the candle, the more intense is the buying or selling activity. If the candles are short, it can be concluded that the trading action was subdued.
The following picture gives a perspective on the long/short – bullish, and bearish candle.
The trades have to be qualified based on the length of the candle as well. One should avoid trading based on subdued short candles. We will understand this perspective as and when we learn about specific patterns.
The Marubozu is the first single candlestick pattern that we understand. The word Marubozu means “Bald” in Japanese. We will understand the context of the terminology now There are two types of marubozu – the bullish marubozu and the bearish marubozu. Before we proceed, let us lay down the three important rules pertaining to candlesticks. We looked at it in the previous chapter; I’ve reproduced the same for quick reference:
- Buy strength and sell weakness
- Be flexible with patterns (verify and quantify)
- Look for prior trend
Also Read: How to start trading in stock market
Marubozu is probably the only candlestick pattern that violates rule number 3 i.e look for prior trends. A Marubozu can appear anywhere in the chart irrespective of the prior trend, the trading implication remains the same.
The textbook defines Marubozu as a candlestick with no upper and lower shadow (therefore appearing bald). A Marubozu has just the real body as shown below. However, there are exceptions to this. We will look into these exceptions shortly.
The red candle represents the bearish marubozu and the blue represents the bullish marubozu.
The absence of the upper and lower shadow in a bullish marubozu implies that the low is equal to the open and the high is equal to the close. Hence whenever the Open = Low and High = close, a bullish marubozu is formed.
A bullish marubozu indicates that there is so much buying interest in the stock that the market participants were willing to buy the stock at every price point during the day, so much so that the stock closed near its high point for the day. It does not matter what the prior trend has been, the action on the marubozu day suggests that the sentiment has changed and the stock is now bullish.
technical analysis in the share market
The expectation is that with this sudden change in sentiment there is a surge of bullishness and this bullish sentiment will continue over the next few trading sessions. Hence a trader should look at buying opportunities with the occurrence of a bullish marubozu. The buying price should be around the closing price of the marubozu.
In the chart above (ACC Limited), the encircled candle is a bullish marubozu. Notice the bullish marubozu candle does not have a visible upper and a lower shadow. The OHLC data for the candle is: Open = 971.8, High = 1030.2, Low = 970.1, Close = 1028.4
Please notice, as per the textbook definition of a marubozu Open = Low, and High = Close. However in reality there is a minor variation to this definition. The variation in price is not much when measured in percentage terms, for example, the variation between high and close is 1.8 which as a percentage of high is just 0.17%. This is where the 2nd
rule applies – Be flexible, Quantify and Verify.
With this occurrence of a marubozu the expectation has turned bullish and hence one would be a buyer of the stock. The trade setup for this would be as follows:
Buy Price = Around 1028.4 and Stoploss = 970.0
As it is evident, candlestick patterns do not give us a target. However, we will address the issue of setting targets at a later stage in this module.
Having decided to buy the stock, when do we actually buy the stock? The answer to this depends on your risk appetite. Let us assume there are two types of traders with different risk profiles – the risk-taker and the risk-averse.
The risk-taker would buy the stock on the same day as the marubozu is being formed. However, the trader needs to validate the occurrence of a marubozu. Validating is quite simple. Indian markets close at 3:30 PM. So, around 3:20 PM one needs to check if the current market price (CMP) is approximately equal to the high price for the day, and if the opening price of the day is approximately equal to the low price of the day. If this condition is satisfied, then you know the day is forming a marubozu and therefore you can buy the stock around the closing price. It is also very important to note that the risk-taker is buying on a bullish/blue candle day, thereby following rule 1 i.e buy on strength and sell on weakness. technical analysis in the share market
The risk-averse trader is who would buy the stock on the next day i.e the day after the pattern has been formed. However before buying the trader needs to ensure that the day is a bullish day to comply with rule number 1. This means the risk-averse buyer can buy the stock only around the close of the day. The disadvantage of buying the next day is that the buy price is way above the suggested buy price, and therefore the stop loss is quite deep. However, as a trade-off, the risk-averse trader is buying only after doubly confirming that the bullishness is indeed established.
As per the ACC’s chart above, both the risk taker and the risk-averse would have been profitable in their trades.
Here is another example (Asian Paints Ltd) where both the risk-taker, and the risk-averse trader would have been profitable.
Here is an example where the risk-averse trader would have benefited :
Notice in the chart above, a bullish marubozu has been encircled. The risk-taker would have initiated a trade to buy the stock on the same day around the close, only to book a loss on the next day. However the risk-averse would have avoided buying the stock entirely because the next day happened to be a red candle day. Going by the rule, we should buy only on a blue candle day and sell on a red
technical analysis in the share market
The Stoploss on Bullish Marubozu
What if after buying, the market reverses its direction and the trade goes wrong? As I had mentioned earlier, candlestick patterns come with an inbuilt risk management mechanism. In the case of a bullish marubozu, the low of the stock acts as a stop loss. So after you initiate a buy trade, in case the markets move in the opposite direction, you should exit the stock if the price breaches the low of the marubozu.
Here is an example where the bullish marubozu qualified as a buy for both the risk-averse and the risk-taker. The OHLC is : O = 960.2, H = 988.6, L = 959.85, C = 988.5.
But the pattern eventually failed and one would have booked a loss. The stoploss for this trade would be the low of marubozu, i.e 959.85.
Booking a loss is a part of the game. Even a seasoned trader goes through this. However the best part of following the candlestick is that the losses are not allowed to run indefinitely. There is a clear agenda as to what price one has to get out of trade provided the trade starts to move in the opposite direction. In this particular case booking a loss would have been the most prudent thing to do as the stock continued to go down. technical analysis in share market
Of course, there could be instances where the stop-loss gets triggered and you pull out of the trade. But the stock could reverse direction and start going up after you pulled out of the trade. But unfortunately, this is also a part of the game and one cannot really help it. No matter what happens, the trader should stick to the rules and not find excuses to deviate from it.
Bearish Marubozu indicates extreme bearishness. Here the open is equal to the high and close the is equal to low. Open = High, and Close = Low.
A bearish marubozu indicates that there is so much selling pressure in the stock that the market participants actually sold at every price point during the day, so much so that the stock closed near its low point of the day. It does not matter what the prior trend has been, the action on the marubozu day suggests that the sentiment has changed and the stock is now bearish. technical analysis in the share market
The expectation is that this sudden change in sentiment will be carried forward over the next few trading sessions and hence one should look at shorting opportunities. The selling price should be around the closing price of the marubozu.
In the chart above (BPCL Limited), the encircled candle indicates the presence of a bearish marubozu. Notice the candle does not have an upper and a lower shadow. The OHLC data for the candle is as follows:
Open = 355.4, High = 356.0, Low = 341, Close = 341.7
As we had discussed earlier a minor variation between the OHLC figures leading to small upper and lower shadows is ok as long as it is within a reasonable limit.
The trade on the bearish marubozu would be to short BPCL approximately at 341.7 with a stop loss at the high point of the candle. In this case, the stop loss price is 356.0. Of course, at this stage, we still haven’t dealt with setting targets, and we will figure that out much later in this module. technical analysis in the share market
Do remember this, once a trade is initiated you should hold on to it until either the target is hit or the stoploss is breached. If you attempt to do something else before any one of these events triggers, then most likely your trade could go bust. So staying on course of the plan is extremely crucial.
Trade can be initiated based on the risk appetite of the person. The risk-taker can initiate a short trade on the same day around the closing. Of course, he has to make sure that the candle is forming a bearish marubozu. To do this at 3:20PM the trader has to confirm if the open is approximately equal to the high and the current market price is equal to the low price. If the condition is validated, then it is a bearish marubozu and hence a short position can be initiated. technical analysis in share market
If the trader is risk averse, he can wait till the next day’s closing. The short trade will go through only by 3:20 PM the
next day after ensuring that the day is a red candle day. This is also to ensure that we comply with 1
- 3. Single Candlestick patterns 2: The Doji and Spinning top candlestick patterns are explained in detail and how these patterns play a key role in developing a view on markets. ..
- 4. Single Candlestick patterns 3: This chapter explores how to identify hammer and hanging man. We understand the thought process behind these patterns and how to set up trades based on these patterns. ..
- 5. Multiple candlestick patterns 1: In this chapter, we understand how two or more candlesticks can be combined to identify trading opportunities. To begin with we understand the bullish and bearish engulfing pattern with real examples f ..
- 6. Multiple Candlestick Patterns 2: Continuing from the previous chapter, we discuss the bullish harami and the bearish harami patterns with real examples taken from the Indian markets. ..
- 7. Multiple Candlestick Patterns 3: In this chapter, we discuss price Gaps, which are common occurrences in the markets. We then explore the morning star and the evening star candlestick formation. ..
- 8. The Support and Resistance: A detailed insight into Support and Resistance price levels, its relevance in technical analysis, its construction, drawbacks, and insights into setting price targets. ..
- 9. Volumes: This chapter outlines the importance of volume in technical analysis. Learn how to associate the volume and the price information to analyze the markets ..
- 10. Moving Averages: Moving average is a simple technical analysis indicator used to detect the price trend. Learn about the moving average and how to set up a simple moving average trading system. ..
- 11. Indicators1: Learn about the Relative strength indicator (RSI) and how it can be used to predict the short-term movement in the market. Learn about the merits and drawbacks of RSI indicators. ..
- 12. Indicators 2: An extensive explanation of the Moving average convergence and divergence (MACD) and Bollinger Bands. ..
As an investor, it is very important to use discretion when applying the principles of technical analysis for investment decisions. This is especially relevant for beginners in the stock market. technical analysis in the share market
Study the different technical analysis tools carefully so that you can determine which ones fit best with your trading strategy.