At any point in time, stock prices are trending upward, trending downward or trading in a range.
That’s it. As a trader, it may be useful to know which of these scenarios you’re seeing.
Technical analysis uses charts to track price and volume ranges over various time frames in an effort to gauge which way the stock may move.
Identifying trends in price action can help you decide when to enter a new trade, or exit an existing position.
For the technician, “price is king”. Technical analysis takes the emotion out of trading, because it assumes that all of the news, the earnings potential, and consumer sentiment are already factored into the price. That means you trade based on what you see happening, not on what you think should happen.
Because psychological factors also drive markets--and are often predictable--technical analysis uses charts to offer a picture of how markets act when a stock reaches certain price levels.
By watching for changes in price action and trading volume, you can gain insight into what other traders are doing and that can help you make better decisions with your trades.
Let’s look at an example.
If a stock has a history of retreating to $50 per share and then moving higher from there, you could enter the trade near the supporting price of $50 per share and selling once it moves higher. Keep in mind that you shouldn’t rely on past performance to assure success no matter what indicator you’re following.
In this example you would set your stop order just below $50, to help limit losses in case the stock reverses and falls through the $50 level of support.
Falling through this $50 level of support would be a clear departure from what the stock had been doing. It can indicate a shift in sentiment, meaning many traders might have lost interest in the stock. Once that happens, the price could continue lower to the next support level, making your stop order very important. Remember that there’s no guarantee that your stop order will be filled at or near your stop price.
Keep in mind that technical analysis is not a guarantee of success. It works best when you use a combination of tools and indicators to get a full picture of what the market is doing.