Technical Analysis of the Financial Markets: Key Tools and Strategies for Smart Investments

We always wonder whether it is possible to predict the twists and turns of the stock market or even what stocks to buy and when to sell. These are the very common questions of traders and investors trying to make wiser decisions.

That’s where technical analysis of the financial markets comes in. It has nothing to do with gut feelings, after all. It relies on real data to guide one’s decisions.

What is the technical analysis of the financial markets? How does it work? Why is technical analysis so important for anyone serious about trading? All these will be covered in this blog.

Technical Analysis of the Financial Markets: What Is It?

Technical analysis, hence, analyses the future probable movement in terms of the price change by studying the past data. In fact, it is a lot like weather prediction. Meteorologists predict a storm when they see the pattern of the weather; similarly, a stock’s prices can be predicted by observing the past patterns of the price.

The key here is data. We do not rely on rumours and predictions about companies’ performance; we focus on charts of price, volume, and patterns. The idea is quite simple: prices are moving in patterns, and sometimes these patterns are repeated. If we can identify those patterns, then we will have the ability to make better trading decisions.

Suppose we want to watch the Tata Motors stock price. We would worry more about how the price has moved recently over the last month. Was it up? Did it drop drastically? How was the volume when moving? Having these gives us an educated guess of what might happen going forward.

Three very essential principles form the core of technical analysis:

• The market discounts everything: The price takes into account every influence on a stock, from political to economic to those relating to the company itself. We don’t need to search through newspaper reports because the price itself tells it all to us.
• Prices trend: Whether the trend is upward, downward, or sideways, stock prices do not just move for no reason. Once a trend begins, it will continue until something significant changes about its pattern.
• History repeats itself: Because human behaviour does not change, and as a result, the financial markets often behave in predictable ways. Patterns that occurred in the past often occur again.

So what does that mean for us? It means that when we see a pattern, we can anticipate what to expect next. For instance, when we see the price movement of Reliance Industries going up steadily for weeks, we can safely assume that it will keep going until there’s some indication otherwise.

Also Read: Types of Financial Market

Types of Technical Analysis Charts: Understanding Fundamentals

Technical analysis without charts is nothing. Of course, impossible. Now that we have established the above fact let’s walk through the three chart types in technical analysis.

Line Charts:

It’s the easiest chart. It draws connecting lines between the closing prices of a stock over some period of time. It is the most basic way to gauge whether a trend in a stock is up or down. Pretty useful for getting a quick snapshot of how a stock like Infosys is doing over time.

Bar Charts:

More details are indicated in the bar charts. They display the opening, closing, high, and low prices of the stock for each time period on the bar charts.

Candlestick Charts:

While bar charts can give you a good sense of price action, there is this chart called the candlestick chart that can be all the more visual. Each “candle” indicates its opening, closing, high, and low prices, but the body of the candle has been coloured to either mean the stock went up or down. Candlestick charts can give you a sense of whether the market is holding an upward trend or a downward trend, and thus, you can trace if it is bullish or bearish.

How Price Trends Drive Market Predictions: Spotting Trends That Matter

One of the major things we do in technical analysis is the identification of trends. The trends tell us whether a stock is moving up or down sideways. Here is how we can spot and hence use these trends to predict market movement:

• Uptrend: This pattern makes highs of consecutive increases and lows of successive increases in the stock. This pattern means the buyers are dominant.
• Downtrend: A downtrend is the opposite. The stock is always making lower highs and lower lows. This means the sellers are in control.
• Sideways Trend: At times, the stocks move in a sideways trend without which direction of the trend might be up or down. That means it is indecisive in the market, and we might wait for a breakout in one direction.

These trends help us decide when to buy, sell, or hold.

Volume Analysis in Measuring Market Strength: Volume Tells the Real Story

Volume is like the heartbeat of the market. It reveals to us the strength behind a price movement. If there’s a lot of interest in a particular stock, it means high volumes. On the other hand, low volume testifies to the opposite.

Here’s how we apply volume to our analysis:

• Confirming trends: If the stock price increase goes hand in hand with the rise in volume, it is actually a very powerful indication that the trend will indeed be rising steadily.
• Spotting weakness: If the stock’s price moves up, but volume starts to come down or remains minimal, then it might suggest that the trend of the stock is losing steam.
• Predicting breakouts: When a stock has been moving sideways, and we see a sudden spike in volume, it often signals a breakout is coming. This means the price is about to move sharply in one direction.

Thus, tracking volume helps to increase one’s chances of making the right judgement about whether some type of price movement is strong and might be continued or is weak and on its way to reversal.

Support and Resistance Levels: What They Are and How They Can Be Used

Have you ever been annoyed when the price of a stock fluctuates between two figures with no clear signal as to whether you should purchase or sell?

Two important ideas in financial market technical analysis are support and resistance levels. They may provide us with advice on when to engage or quit a deal.

• Support Level: The support level is the price point at which the stock does not fall. It is like a floor. Once such a price point hits, it bounces back. Think of Infosys’ stock falling to ₹1,300 multiple times but not going lower than that. That ₹1,300 becomes the support.
• Resistance Level: The resistance level is the opposite. It’s like a ceiling. Prices struggle to break through this point. Suppose Reliance Industries touches ₹2,600 again and again. Still, every time it reaches ₹2,600, it falls back. ₹2,600 is the resistance.

So, how do we make use of these levels?

• Buying at support: If a stock hits the support, it is a good buy.
• Selling at Resistance: If the stock reaches its resistance level, it could be time to sell.

These levels serve as signposts on a chart. They have pointed out the place where prices may change direction so that wise decisions in trading can be made.

Must have Tools and Indicators for Every Trader

No need to guess what the markets are going to do next- there are tools that can help.

Technical analysis of the financial markets encompasses many tools whereby one tracks trends and catches opportunities. Some are quite simple, while others imply a deeper analysis of price movements. Knowing all this helps us apply sense to the market as well as refrain from emotive trading. Let’s break them down:

How Moving Averages Can Help Traders Identify Trends

Sometimes, however, the prices of the stocks may increase and then drop as well, making it impossible to analyse what is going on. Moving averages can help filter noise and give us a broader picture.

Why are moving averages so useful?

Moving averages are like having a good GPS that can keep you on track, to some extent, and warn of an upcoming turn in the market.

Simple Moving Average (SMA):

It gives the average price of a share for a given number of days.

For example, if the last 50 days of Tata Steel’s price have been worked out, the 50-day SMA allows us to see the trend and not the day-to-day fluctuations. If the stock price happens to be above its 50-day SMA, then it signals that further upward scope is also present.

Exponential Moving Average (EMA):

The EMA gives more weight to recent price action and, therefore, moves with the price in a much more responsive manner than the SMA.

If the EMA for SBI is increasing, it shows that the stock is trending higher and upward. It responds faster than the SMA, which can be very useful when looking for advanced trend reversal.

Fibonacci Retracements: Identifying Market Reversals

The market never moves straight up or down. Prices often re-bound before continuing to move in the direction they were moving. That’s where the Fibonacci retracement comes in.

These retracement levels will let us predict how far a stock will pull back before resuming its trend. They are based on the Fibonacci sequence. Fibonacci retracements tell us when the price might pull up and stop, allowing us to better plan our next move.

Here’s how to apply this:

Suppose the stock price of Tata Consultancy Services (TCS) rises from ₹3,000 to ₹3,500. That, too, cannot shoot up limitlessly. It might correct a little, but how far? Fibonacci levels (23.6%, 38.2%, 50%, 61.8%) help us identify where the price will reverse.

Suppose TCS corrects to 38.2% retracement level and then starts coming up. That’s our clue that the uptrend will continue.

If we see a stock pull back to its 50% retracement level, it is time to sit up and take notice. It’s a level that many traders just expect the price to bounce back at.

Popular Candlestick Patterns for Predicting Market Movements

Candlestick charts are more than just cool visuals, however. They can tell powerful stories about price movements, too.

Let’s talk about some of the candlestick patterns which will help us predict the next move in the market:

• Bullish Engulfing Pattern: When a small red candlestick is followed by an even larger green candlestick, we call that bullish pattern. This is actually a bull sign indicating a reversal in a trend from falling to rising.
• Hammer and Inverted Hammer: A hammer forms after some downtrend, with a very small body and a long lower wick, showing that sellers tried to push the price lower, but buyers bailed out. This might be a clue for prices to reverse upward.
• Shooting Star: This is just the opposite of a hammer. This pattern indicates that the price tried to move upwards but was pushed downward by the sellers. It is a sign that a stock could fall off after rallying.

With this knowledge, we would have better timing of entry and exit points in the market.

Price Formations That Signal Key Market Changes

Some price formations will give you an idea of the timing of when the big moves are likely to take place in the market. These are the patterns we look for.

Double Top and Double Bottom:

Strong reversal pattern. A double top occurs when the price has touched a resistant level twice and cannot break through that level. It depicts the idea that the price may decline.

There is the opposite, which is a double bottom. If a stock returns to a support level twice and does not slide lower, then that is a signal that the price is ready to go up.

Head and Shoulders:

This is the classic reversal pattern in the stock that has three peaks. It’s made of a middle peak, the “head,” that is more significant than two side peaks, the “shoulders.” When the price breaks below the “neckline” of the pattern, it means the stock is in for a drop.

Flags and Pennants:

Continuation patterns indicate that the trend will go on for some period of time after a slight pause. Let’s say we are trading Bajaj Finance, which is in an uptrend. The uptrend might resume after a small sideways movement, thus, the flag. So, if we see this, we hold our position.

Price formation is like putting up a road sign. It gives us a warning of when something big has to occur so that we can react in time before others do.

Market Cycles: Riding the Waves of Bull and Bear Markets

Why do markets have a tendency to go up and down in waves?

Not at random. Markets undergo cycles, and being informed about them will put us ahead of the pack.

There are four major stages in a market cycle:

• Accumulation Phase: This phase happens after a market decline. The prudent investor starts to buy stock at cheaper prices when it appears to be worth something.
• Markup Phase: Now, while more people realise the market is in recovery, prices begin to rise. This is when everyone wants to jump into the fray.
• Distribution Phase: Here, some traders start selling because prices are peaking. The market sentiment is still positive, but on the side, there is more selling than buying.
• Trough Phase: The market begins to decline. People do start panicking about a loss because prices are falling, and most of the investors run out. To those who can be patient, this is the time to begin preparing for the accumulation phase.

Knowing which phase the market is in gives us a better option for decision-making. We buy during an accumulation phase or sell during a distribution time; it just all depends on timing.

Technical Analysis vs. Fundamental Analysis: A Detailed Comparison

What is technical analysis, and what is fundamental analysis?

Simply, technical analysis is seeing charts, price movements, and patterns. It reads the behaviour of the market. Fundamental analysis, on the other hand, looks into the health of the company—profits, debts, and the economy around it.

Both methods have their strengths:

• Technical analysis is excellent for short-term traders. If we discuss Tata Motors in terms of buy-and-sell for the short term, technical indicators are going to tell us when to come in and get out.
• Fundamental analysis is perfect for long-term investors. If we think of holding Reliance Industries stock for years and years, then we consider such things as earnings and growth potential and whether a particular industry is moving forward.

But why one over the other?

Actually, we can use technical analysis to time our trades and make sure we’re picking strong stocks by using fundamental analysis. It’s kind of like using a map and reading the weather forecast to plan a road trip.

Also read: Financial Instruments

The Limitations and Risks of Reliance on Technical Analysis

Technical analysis is not perfect.

One very specific kind of danger is overreliance on patterns. Just because a stock followed a pattern last year does not mean it is committed to doing the same this year.

If many traders see a common pattern, all of them will respond likewise. It drives the price either up or down, not because that is what the market wants it to do, but just because everybody is waiting for it to go in a certain direction.

Technical analysis also fails to provide an overview. The global situation or economic or political changes can shift markets greatly. We witnessed this in 2020 when the markets were moved not by any chart pattern but by global lockdowns.

Therefore, the more technical analysis can be strong, one must at all times remain open to changing and keeping close tabs on news and fundamentals.

Conclusion

Technical analysis of the financial markets is very effective in predicting price movements through past trends, patterns, and data.

This method relies upon the knowledge of basic principles like support and resistance, volume analysis, and market cycles in order to determine the major opportunities. Although it gives information for short-period trading, a combination with fundamental analysis best provides a balanced approach toward long-run success.

Using tools such as moving averages, Fibonacci retracements, and candlestick patterns helps one navigate market shifts with confidence.

Knowing the strengths and weaknesses in technical analysis leads to smarter decisions and insight that will not go wrong in any market scenario.

If you want to learn more about financial market, risks associated in it, finding trends, and making good predictions, you can join Hero Vired’s ‘Financial Analysis, Valuation, & Risk Management’ certification course. The course will not only help you to have a better understanding of financial market, but it will also help you to secure a good job in this domain.