How Technical Analysis Supports Short-Term Trading
In trading, technical analysis is the process in which traders use price data and patterns to predict a financial instrument’s future activity. Technical analysis uses two types of tools – buy and sell indicators (based on price data), and identifiable patterns.
Among buy and sell indicators, two widely used indicators are the relative strength index and the stochastic oscillator. These sound like complex and esoteric phenomena, yet they are relatively simple once clearly defined.
Relative Strength Index
The relative strength index (RSI) shows a financial instrument’s positive or negative momentum using a ratio of higher closing prices to lower closing prices. RSI numbers fall on a scale of 0 to 100, with a 80 score considered high and 20 score considered low. The higher the score, the higher the positive momentum, and the lower the score, the greater the financial instrument’s negative momentum. High scores signal a financial instrument’s overbought condition and low scores an oversold condition.
Stochastic Oscillator
The stochastic oscillator indicator is similar to the RSI, except that it compares a single day’s closing price for a security to a range of its prices over a period of time. Stochastic indicators are also used to gage an overextended market.
Both the RSI and Stochastic models are used as indicators for when the market might be looking to reverse trend.
Identifiable Patterns
In contrast to the RSI and stochastic oscillator, identifiable patterns in the price of a financial instrument require a keen eye and experience looking at chart patterns to determine future direction. Some of the most common technical patterns are head and shoulders, triangle patterns, double tops, and double bottoms.
When trying to identify a head and shoulders patterns: 1. The left shoulder forms when prices rise followed by a decline in price. 2. The head forms when prices rises again higher than the left shoulder followed by a decline. 3. the right shoulder is formed after the market stabilizes and again attempts to move higher but does not increase above the head and is similar to the right shoulder. This usually signals the upward trend has exhausted itself. Buyers are not as keen to enter, momentum has run out, recent bullish price action is fading which leads to selling and lower prices in the future.
Triangle patterns occur when drawing lines connecting a financial instrument’s recent highs and its recent lows, extended into the future, intersect, creating either ascending, descending, or symmetrical triangles. An ascending triangle indicates an upward price trend, and a descending triangle indicates a downward trend. Following the consolidation of lower highs and higher lows typically that signals a breakout is nearing.
Double top patterns occur when a peak high is followed on the chart by another peak high of about the same price. Double top patterns can indicate a coming long-term reversal in price. Once the market has not extended past the prior high (or low for double bottom) you can often look for a reversal and place a stop just above the recent high.
If used correctly technical analysis provides good risk adjusted trading opportunities. These basic patterns along with other technical set ups are discussed in our live stream community each day.