Technical Analysis: What to Know and How to Get Started

Technical analysis has been around for a long-time and the most successful traders use technical analysis to find out where price will be moved.

Fun fact: Before the use of computers technical analysis was very time-consuming because traders had to plot price on graph paper with a pencil, and the use technical analysis to identify the trends, and support and resistance levels, and other chart patterns.

What is Technical Analysis, Exactly?

Alright, you want to buy calls or puts on a stock, right? Unless you want to gamble your money, and potentially lose it all, you need some sort of reasoning behind your decision; that’s where technical analysis comes into play.

Technical analysis is a term used to identify price action patterns, support and resistance levels, and other candlestick patterns to help you, the trader, to determine where the price of a stock is going to go next.

Why Does Technical Analysis Work?

The reason why technical analysis work is because human behavior tends to be predictable, causing their decisions and behavior to be repeatable.

Imagine a Time Square, New York, where the streets are flooded with people walking. Now, let’s say their’s a street performer who has a hat set out for tips. If a few people stop to watch, and leave a tip, than others are likely to follow. This is because people tend to look to others to determine what is socially acceptable behavior during a given situation. This is known as the “herding effect.”

Similar to the stock market, the herding effect can be observed when investors and traders start buying or selling a stock, because they see others doing the same.

This is where technical analysis comes to save the day! By identifying repeatable price behavior. If a stock sells off hard at a certain price, you may want to grab some puts or short the stock.

If a stock price goes to a certain price level and bounces, you may want to grab some calls or buy equity.

Pros and Cons

Pros

• Provides the trader with an entry and exit point.
• Gives the trader more confidence on their trade.
• Allows the trader focus on the chart only and block out noise.
• Gives the trader a plan to follow.

Cons

• Can be invalidated with news or world economical events.
• Can be easily over analyzed and causing the trader to be less confident.

How to Create Technical Analysis

There are number of different ways to do technical analysis, but in this article we’re going to show you one of the many ways.

Step 1. Find a Stock

If you have a favorite stock, go there first.

Step 2. Finding Trend Lines and Support and Resistance

Now there, are many candlestick patterns, and strategies to find support and resistance but in this example, I’m going to use the stock Baidu (BIDU).

In the example above, my technical analysis is finding a broadening formation pattern, after a strong downtrend for many days. This type of pattern is also called a Megaphone Bottom.

In my technical analysis, I have identified a support and resistance line (blue line).

So this example I want to go long (calls or buy equity) because my technical analysis is telling me when the price of Baidu is above the blue line, it may reach the top of trend line (black line).

If the price is below the blue line, I may want to short (puts or short equity), because my technical analysis is saying that price area acts a level of resistance.

Step 3. Execute Trade

Pick your poison, whether it’s going long or short, and monitor your trade based on your technical analysis.

Step 4. Review the Trade

After your position is closed, journal your trade and write notes if your technical analysis was true or false, and what you could do better next time.

Should you use Technical Analysis for your Trading?

Technical analysis isn’t for everyone, but for some traders, it can be a good fit.

• Traders who are not into long-term investing. If you’re thinking short-term timeframe, technical analysis is your best friend. Long-term investors are not focused on short-term movements.
• Traders who are not news-driven. There are traders who are heavily focused on market news and events, and if you’re not, technical analysis is will be the most effective approach.
• Traders who value historical data. History has a funny way of repeating itself, and traders can capitalize on those historical patterns.
• Traders with low risk tolerance. Technical analysis can come with high risk, as your stop-loss may be far away or short.

To Sum It Up

When you don’t know whether to go short or long a stock, technical analysis will help you make that decision but identifying trends, and support and resistance levels. But just like any trading strategy, technical analysis comes with some risks. With some careful planning, you can use technical analysis to guide you through these wild rides.

Other Asked Questions

Do Options Traders Use More Technical Analysis than Fundamentals?

Short-term option traders should use technical analysis since it’s focused more on price movements. There have been plenty of examples of a stock performing well on earnings and revenue, only for the stock to sink the next day.

If you’re long-term option trader (leap calls), then fundamentals are important just as technical analysis.

How Accurate is Technical Analysis?

Technical analysis is not a 100% guaranteed result but the goal is to improve your odds of being right about the movement of the price. The more your do technical analysis the more odds will increase.

Does Warren Buffett use Technical Analysis?

Warren Buffett said in a interview once, that he used to use technical analysis until he, “realized that technical analysis didn’t work when the chart upside down and didn’t get a different answer.”

Warren Buffett strategy is long-term, and goal is to not look at technical analysis but to look into the fundamentals of a business.