This article will breakdown which metrics, charts or data points investors use to identify stock trends. For investors looking for an alternative or a supplement to traditional fundamental stock analysis, technical analysis of stock trends can be the way to go. Investors using a technical analysis style of investing use trading statistics to find stock to invest in.
Technical analysis uses trends like momentum, patterns, or trading volume to predict future stock price movements. This style contrasts fundamental analysis, which attempts to find stocks based on the underlying company’s prospects.
Technical analysts, sometimes known as chartists, often use tools like charts of price movements to identify changes in patterns. Chartists also use trading volume to identify supply and demand for stocks. Technical Analysts can use these tools to profit from short-term moves in a stock. Trading for short-term profits can lead to more frequent trading than a fundamental style.
Let’s look at some of the common techniques used by technical analysts.
Relative Strength Index (RSI)
Relative Strength Index is a technical analysis tool is based on momentum or the magnitude of recent price movements of a stock. The tool assigns each stock a score on a scale from 0 and 100. The score given to each stock changes over time and can be shown on a chart.
Investors use the Relative Strength Index to identify reversals. The faster a stock price moves up, the higher its score. Likewise, the quicker a stock declines, the lower the score. For instance, if stock scores over 70 on the scale, the stock is ‘overbought.’ A stock being overbought may indicate that the stock is moving up too fast and may soon reverse.
On the other hand, if the Relative Strength Index assigns a stock below 30, the stock is ‘oversold.’ A stock being oversold may indicate that it will soon reverse and go back up.
The calculation used to produce the score is pretty complex. The first step is to identify the average return of a stock in the recent past. If a stock advances faster than average, it gets a higher score. Alternatively, if a stock starts to decline faster than average, it will receive a lower score.
Keep reading for more info on the technical analysis of stock trends.
Bollinger Bands® were copyrighted by famous technical trader John Bollinger. They are like the Relative Strength Index in that they can both be used to identify overbought and oversold stocks.
The major difference between the Relative Strength Index and Bollinger Bands® is the score used to determine overbought and oversold stocks. Instead of using a single score, Bollinger Bands® use standard deviations from the average stock return. Also, the user can adjust standard deviations.
The use of standard deviation creates another difference. Standard deviation can change over time. That also means that the score produced by Bollinger Bands® to determine if a stock is overbought or oversold can change. For example, if a stock price doesn’t change much, it will have a lower standard deviation. Therefore, Bollinger Bands® would indicate a lower score for an overbought stock. The score indicating oversold will be higher.
Likewise, a stock price that moves wildly will have a higher standard deviation. In that case, Bollinger Bands® would indicate a higher level for the overbought stock. The score indicating oversold will be lower.
Analysts use Support Levels to find the lowest price a stock will reach before trending back up. It is one of the simpler technical analysis tools.
An analyst may look at a stock’s price chart for the past several years to identify Support levels. If the price chart indicates the future movement of the stock, then the investor may buy the stock next time it falls into the $10-12 range. For example, a stock may move up and down for several years but never fall below $10-12.
Investors typically using Support Levels also use Resistance Levels.
Resistance Levels are the exact opposite of Support Levels. For instance, the analyst looking at the price chart from the example above may see that the stock hasn’t moved above $14-16 in the past.
Again, if the past price movement indicates future price movements, then the analyst who bought shares at $10-12 may wait to sell the stock at the $14-16 range.
Risks of Technical Analysis of Stock Trends
Analysts use thousands of different tools. Some tools are complex and require a math background. On top of that, some tools need sophisticated trading to use the analysis.
The one thing that all tools have in common is that to work, past stock performance needs to stay constant. If it doesn’t, many tools can fall apart, and your returns can suffer.
Sometimes significant trends in stock markets can disrupt technical analysis of stock trends. Take, for example, stock market crashes. During a stock market crash, almost all stocks will decline precipitously. In this scenario, stocks can go below Support Levels or Bollinger Bands® and continue to drop.
On the other side of the token, bull markets can last for many years. If all stocks rise for a long time, they can keep rising past your Resistance Levels or Bollinger Bands®. If stocks continue to rise, your returns will be muted.