Technical analysis of stocks is one of two main methods of analysis. The other is fundamental analysis. Technical analysis uses charts to identify entries, exits, trends, and the overall strength or weakness of a stock.
Another component of technical analysis is price projection. Traders use the information on the chart to predict where the price of a stock might go. Some traders have a lot of conviction that price will go to a specific point. Others are more flexible about what prices may do.
In today's article, we'll look at some of the most common ways that traders user technical analysis of stocks to inform their trade decisions. In the examples below, I’ll be using charts from Yahoo Finance! Check out our favorite brokers and trading apps >>>
Identifying Support
A support area is usually a price range that the stock has come down to and then moves back above. In Image 1, below, the dashed horizontal line represents support.
The price is just above 200. You can see that the stock has come down to this area three times. On the second move down, the price moved below 200. This appears to break the support area.
However, because the price quickly moved back up, the 200 area is still in play as support. Later, we get another test of this area, showing that it is an important area. This is an area that day or swing traders are likely to buy at, which is why the price keeps bouncing off of it.
There is a diagonal line as well, representing four more support areas. On this line, the price made higher lows. Once the line was drawn for the third support area around 210, it provided an area for a potential buy in the future.
Support doesn’t have to line up perfectly on the line. Some margin of error or a range can be used. That is what happened in the image below.
Identifying Resistance
Support is a price below the current market price while resistance is above. The significance of these numbers for technical analysis of stocks is that they represent areas where price has been rejected.
In Image 1 above, the resistance line (i.e., the solid horizontal line), isn’t lining up perfectly. But the line generally contains the low stock prices. This bit of vagueness can make defining support and resistance subjective, but they're usually fairly close.
Recognizing Trends
A trend is the overall direction or pattern a stock. When a stock is trending, it's either moving up or down. In the above image, MSFT did not trend for a while as it moved sideways. This is called consolidation.
The diagonal support line does show the beginnings of an upward trend, as the stock made four higher lows before breaking out of the horizontal channel. These higher lows were a precursor to a change in trend (or consolidation in this case).
And because higher lows are bullish, this gives a high probability that a break higher was coming and could be a good entrance point. Conversely, if the stock had been making lower highs, we might conclude that a break lower was coming and may consider exiting our position.
Related: Hone Your Technical Analysis Skills In A Paper Trading Account
Using Technical Indicators
A technical indicator is a formula-based indicator represented on a chart. Most technical indicators provide a metric for measuring the strength/weakness of a stock.
In the next image, we've made some additions to the chart. At the bottom of the chart is the RSI, which shows when a stock is overbought or oversold.
There are also two new lines. Both are moving averages (MAs). The red line is the 50-day, while the black line is the 200-day. These lines plot the average price over 50 and 200 days, respectively.
The 50 MA is faster than the 200 MA. This means it sticks closer to the price. The 50 and 200 MAs are considered support and resistance lines by traders. In our MSFT example, the MAs considered support, although MSFT never reached the 200 MA.
Notice that the 50 MA is above the 200 MA. This configuration is considered bullish. At some point farther to the left, the 50 MA crossed above the 200 MA. For many traders, this is a signal to go long (i.e., buy the stock). The further above the 200 MA that the 50 MA is, the stronger the trend.
MSFT is in an upward trend. It is making higher highs and higher lows. The 50 MA is also far above the 200 MA, showing a strong bullish trend. This is further confirmed by the RSI.
When RSI moves above 80, it means the stock may be overbought. When it moves below 20, it means the stock is most likely oversold. With a reading of 66, MSFT is neither. According to the RSI, MSFT can continue up for longer. Right now, all of our indicators on the chart confirm that MSFT is in a strong upward trend.
Final Thoughts
This was only an introduction to technical analysis of stocks. There are lots of additional technical indicators that can be added to a chart. Different indicators usually say the same thing but in different ways.
It might seem like adding more indicators and lines to a chart can provide for better confirmations. But, in some cases, it can create confusion as the chart becomes too busy to really understand what is happening. Starting with a small number of indicators and getting used to them is usually better than splattering a chart with every indicator possible.
In the end, technical analysis isn’t a sure thing. But, used correctly, it can aid traders in their endeavor to make a profit. See all of our favorite free trading apps >>>
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.
