There are 2 key ways to analyse stocks. The first is called technical analysis, while the second is called fundamental analysis.
In this lesson though we will discuss technical analysis, which is primarily about trying to identify particular patterns in stock chart data.
Technical analysis is mostly used by traders that are buying and selling stocks across a short period of time.
The validity of technical analysis is always questioned as it’s a very simplified way to assess stock price movements.
The common view is that technical analysis is only useful around half of the time, which highlights immediately that it is not necessary the most reliable type of analysis.
Nonetheless, here are a number of patterns that technical analysts look for in stock chart data.
When one of these patterns is identified, the trader believes that it is a sign that the market will shortly go up (or down).
Moving averages, to some extent at least, are self explanatory. The concept is based on the idea that an investor can calculate the average stock price across a period of time.
As the time passes by, the moving average will change as the price of a stock goes up and down – hence why it’s called a moving average.
Technical analysts are tracking the moving average of a stock in hope that the stock price will go above the moving average. The belief is that when this happens, the stocks price will go up.
On the flip side, when a stock goes below the moving average, the belief is that the stock price will go down.
The flaw of moving averages is that it can change drastically depending upon the time frame that an investor picks. The moving average of a stock over the last 7 days could be drastically different to the moving average across the last month.
Moving averages are calculated using past stock chart data, which may or may not reflect the future prices – which is why technical indicators don’t always work.
Above is an example of how a moving average might look visually. You can typically find settings to show the moving average on websites like the Financial Times or Yahoo Finance.
The blue line represents the moving average. When the stock price is above the blue line, it’s supposed to be a buy signal for investors.
As you can from the image, moving averages are not an exact science as there are times where the stock price is above the blue line, but the stock price has gone down shortly after.
Equally, there are times when the moving average is signalling for an investor to sell but the stock price actually continued to go up.
Another well known technical indicator is called a ‘head & shoulders’, which has unsurprisingly been given that name as the shape of the pattern is similar to a head and shoulders.
When a head & shoulders pattern forms, it is believed that this means that the trend will reverse.
So if the price of a stock was going up before the head & shoulders pattern, it is believed that this is a signal that the stock price will shortly start going down.
The opposite scenario involves an ‘inverse head & shoulders’, which is basically the same concept but upside down.
When the price of a stock is going down and an inverse head & shoulders pattern forms, it’s thought that this means that the stock price will start going up.
Much like with moving averages, head & shoulders patterns are not an exact science and there are many examples of where stocks have not responded in the right way to head and shoulder patterns.
Above is an example of a head & shoulders pattern. An inverse head & shoulders patterns is exactly the same as this, just upside down.
Essentially it is three triangles – one large triangle in the middle, with two slightly smaller triangles to each side.
Triple tops and triple bottoms are very similar to the head & shoulder patterns.
The simply difference is that triple tops and bottoms are formed with three triangles that are of equal height.
This is clearly different to head & shoulders, which requires one larger triangle to be formed in the middle of the three triangles.
The triple top and bottom patterns are interpreted in the same way as head and shoulder patterns.
When a triple top is formed, it is assumed that the market will go down. Likewise, when a triple bottom is formed, it is assumed that market will go up.
You can see that triple tops and bottoms are basically three similar triangles in a row.
In order for a pattern to be considered as triple top or bottom, the peak of each triangle has to meet at a similar point.
If they don’t, they can’t be regarded as a triple top or bottom.
I’m explaining this so that it is not confusing as to why there are a number of triangle formations in the triple bottom example.
There is a triangle formation in between low 1 and low 2, as well as low 2 and low 3, which would not count as the peak of each triangle does not meet at the same point.
You guessed it, rounded tops and bottoms are similar to head & shoulders and triple tops and bottoms.
When each patterns forms, it suggests that the stock market will move in the opposite direction – which was the case with the other two patterns as well.
Rounded tops and bottoms are arguably the easiest to identify as you simply need to look for a smooth, circular shape.
Below are examples of what they look like.
Many technical analysts say that it’s best to wait for the end of the rounded top or bottom to go to a higher point than when it started.
This way, they claim that traders will know that a new trend is actually going to form.
They claim that if the end of the rounded top or bottom does not go higher than the entry point, the stock price will likely continue with the previous trend.
The short answer is not really. There are a number of traders that would refute that answer but the reality is, they are the minority.
Most professional investors, do not use technical analysis. If they do, it’s simply to inform an entry point after undertaking fundamental analysis.
A lot of finance academics and investors will even tell you that technical is a load of nonsense.
The reason for this is that the patterns don’t always work and often that the stock chart data is completing random.
Technical analysis has no regard for the underlying business and is purely speculative. Anything can happen at any moment and the best way to ‘trade’ is to observe new information that may affect the market.
With that said, there are traders that report good returns using technical analysis. The truth is though that they make up a tiny fraction of people that give it a go. Most people fail when they only use technical analysis.