Understanding the Benefits and Techniques of Technical Analysis in the Stock Market

The stock market can be a complex and often unpredictable place, making it crucial for investors to have a well-rounded approach to their investments. Among the various strategies, technical analysis stands out as a powerful tool that, when used correctly, can significantly enhance an investor's ability to pick the right stocks. Here, we'll explore the reasons why technical analysis is beneficial, when to use it, and how to use it properly to avoid common pitfalls.

Why Technical Analysis Helps

Across the investment community, the consensus is clear: technical analysis definitely helps. In fact, most investment firms utilize a combination of fundamental analysis and technical analysis, applying varying levels of importance to each. One of the most common approaches is the techno-fundamental one, where a fundamental filter is applied first to select a subset of stocks, which are then further analyzed using technical indicators.

When to Use Fundamental Analysis and When to Use Technical Analysis

Long-term investing depends heavily on fundamental analysis. A company that doubles its post-tax profits every year should, in theory, see its stock price double over a similar period. Therefore, many investment firms start with a fundamental analysis to filter out promising stocks that meet specific criteria. However, in the short term, technical analysis becomes increasingly important. Even if a company is growing at an astronomical rate, its stock price can experience intermittent corrections, making technical analysis critical for determining optimal entry points.

Using Technical Analysis Effectively

While technical analysis can provide valuable insights, its misuse can lead to negative outcomes. Overreliance on simple rules or third-party signals without a rigorous approach can be counterproductive. In a personal experience, I have seen how a disciplined and robust system can lead to profitability, rather than relying on shortcuts that often fail due to transaction costs.

In this article, we will explore some key techniques and principles of technical analysis to help you get the most out of this powerful tool:

Always Start on the Higher Time Frame

When performing technical analysis, it's crucial to start with a higher time frame. Higher time frames provide a broader view of trends and can help identify significant support and resistance levels. For example, a monthly resistance level is stronger than a weekly or daily one. It's important to be coherent across different time frames to avoid misleading conclusions. Here's a practical example using the EURGBP currency pair:

Monthly Time Frame: Resistance around 0.9300 Weekly Time Frame: Support on the Bollinger Bands moving average Daily Time Frame: Breaking the lower Bollinger Bands acting as support

This incoherence highlights the need for a robust trading framework. Checking multiple correlated pairs can provide more insights and confirm signals on different time frames. A neutral bias on one or two horizons is also acceptable as a reason to proceed with the analysis and trade.

Avoid Overreliance on Graphical Analysis

While graphical analysis can provide initial insights, it is not foolproof. Instead of relying on a single level, it's better to use a small zone that covers the extremities of the candles. This takes into account some excess and closing prices to form a more subjective zone. For example, a clear ascending channel provides confirmation of both support and resistance levels, but it is more of a downside and upside confirmation rather than providing straightforward support or resistance.

Check Whether Markets are Ranging or Trending

Markets operate in cycles of being in a range or trending. Understanding whether the market is currently in a range or trending is crucial for selecting the appropriate strategy. Strategies for ranging markets and trending markets are different, and knowing the current market state helps in following a successful strategy.

Conclusion: Technical analysis is a valuable tool in the stock market, but it requires a disciplined and rigorous approach. By understanding the differences between fundamental and technical analysis, starting with the higher time frame, avoiding overreliance on graphical analysis, and checking the market state, investors can make more informed and effective trading decisions.