What is the direction of the market? At what price should I buy? At what price should I sell if I am making money? At what price should I sell if I am losing money? How much should I invest in a stock?
Technical Analysis is a study of price that aids us in finding answers to the above questions by looking at historical data and how the market reacted in the past.
Why do we use Technical Analysis? Why is it important to compute entry or exit levels while trading?
It’s the same thing as asking why do we prefer to do our own online research before buying a laptop or a phone? We compare different brands and find the one which suits our budget, the features that we need and good feedback from other customers. Similarly, we filter trading opportunities which have a low risk and a high reward potential.
What are we trying to find out using Technical Analysis?
Simply put, Supply and Demand! The price levels at which wealthy investors and financial institutions are buying and selling become supply and demand zones . Institutions end up leaving clues about their positions due to the large volumes that they trade. Technical Analysis helps us identify these important price areas and we can plan our rules of engagement with the market around these important zones.
Basis of Technical Analysis-
1. Price reflects everything
The price of a stock or currency has already factored in all variables including supply and demand
2. Market trends
Price moves in short term and long term trends instead of moving in a random order
3. History repeats itself
The speed at which the price fluctuates is directly proportional to the emotional state being experienced by the traders. Greed and Fear are the primary emotions that move the market. People react similarly in these states and this behavior forms price patterns which repeat over time.
How do we apply Technical Analysis to trade?
The most important information while trading is the direction of the short term and the long term trend. Just like it is not very smart to walk down an escalator going up, it is always smarter to trade in the direction of the prevailing market trend. After this, we figure out the best price that we can get to buy or sell, known as the entry price. We now find out what would be the maximum price until we hold our trade if things don’t go in our favor. This is called Stop Loss. Finally, we compute a profit level where we plan to book our profits if the trade goes as per our expectation. This is the exit or target price. It is ideal to engage in the trade if our target is at least twice our stop loss. In a nutshell, Technical Analysis is a study of price movements to identify market trend, entry price, stop loss and exit price in order for us to take an informed trading decision.