Technical analysis is the use of past data to predict future prices. Online trading platforms feature a wide variety of different types of technical analysis; each type, either by itself or in conjunction with others, generates buy and sell signals for a trader’s consideration. The Efficient Market Hypothesis states that all trading information is already reflected in market prices and therefore discounts the value of technical analysis. Nonetheless, it continues to be the technique of choice for many traders.
The most fundamental type of technical analysis is charting of the high, low, opening and closing prices for a sequence of time periods, usually hours or days. Japanese candlestick charts are a very popular form of charting; they quickly reveal the major trend of a market. Moving averages are often superimposed upon a price chart to indicate areas of support of and resistance to price trends. You can specify how many periods of data to include in a moving average; the mean low and high prices are then plotted on the price chart to form bands of supply and resistance, respectively. A trading signal is generated when actual prices pierce a moving average band: buy on an upward penetration of high prices, sell when you fall through the low prices band.
Trading volume can be superimposed upon a chart to qualify trend analysis. For example, if a stock rises or falls on falling volume, the indicated trend is not confirmed and a reversal may be near. Price moves on increasing volumes do confirm trend. On Balance Volume (OBV) is a running tally of volumes on up days (days where a closing price exceeds an opening price) minus down-day volumes. OBV trend may predict upcoming price trends, so it is considered a leading indicator.
Invented is 1981 by trader John Bollinger, this technique consists of a 21-day moving average of prices bounded above and below by values that are at least two standard deviations removed from the average price. The bands widen when markets are volatile and narrow when markets are calm. A sharp tightening of Bollinger Bands is regarded as a signal that volatility is about to increase dramatically, indicating the possible start of a new price trend.
Relative Strength Index and Stochastics
RSI is a trend-following system that varies in value between zero and 100 (explained in Reference 3). RSI is used by technical analysts to signal trend reversals. Values that fall below 20 (an “oversold” condition) predict the start of a new uptrend; values above 80 (“overbought”) indicate the possible start of a downtrend. The Stochastic Momentum Index is used in conjunction with candlestick charts. It is based on the notion that, in an uptrend, closing prices are clustered closely around high prices. Downtrends are characterized by closing-price clustering around low prices. Stochastic indicators are based on momentum: sharp price movement accompanied by high volume.