In this blog, we will dive into the fascinating world of technical analysis and explore how it can help us make informed trading decisions. When we decide to buy a stock, there are two main types of analysis we can use. One is fundamental analysis, where we look at the company’s financial health and overall performance to make an investment decision. The other is technical analysis, where we study the price action and market trends to predict future price movements. If you’re interested in trading, buying stocks, or learning about technical analysis, you’re in the right place. This blog is part of a series where I teach my younger brother step-by-step about the stock market. Today, we’re going to cover some essential concepts in technical analysis in simple and easy-to-understand language.

Let’s start from the very beginning. Whenever we decide to buy a stock or an ETF (Exchange-Traded Fund), we need to know how to analyze whether the price will rise or fall. We want to know if it is the right time to buy or sell. The first thing we do is look for what I like to call a “running horse.” This means we look for something that has a high probability of moving in a certain direction, rather than trying to catch a “falling knife,” which is a stock that is rapidly decreasing in value. Essentially, we want to invest in something that is already showing positive momentum.

As an ETF investor, I often look for ETFs that seem to be at the right price. ETFs are essentially baskets of stocks, and analyzing them requires looking at various indices like Nifty, Bank Nifty, and Sensex. For example, Nifty might be at its all-time high. If there’s a dip in the market due to specific news or events, it usually recovers. These short-term events are less important in the grand scheme of things compared to the overall market patterns.

In technical analysis, the first thing we look at is price action. We want to identify the current trend. If I show you a chart, you can often visually see whether the price is going up or down. To make this clearer, technical analysts draw trend lines. A trend line helps us identify the direction in which the market is moving. Drawing a trend line might seem simple, but it requires connecting the maximum number of lows in an upward trend or the maximum number of highs in a downward trend.

For instance, if we have a trend line that we draw from the bottom of the price movement to the top, and the price stays above this line, we can say that the trend is upwards. If the price breaks below this trend line and closes there, it indicates a change in trend. This break is a signal that the price might start to fall. Traders often use this break to make decisions about selling or holding their positions.

Let’s take an example. Suppose we’re looking at an ETF on the NSE (National Stock Exchange) chart. If we draw a trend line connecting several lows and the price breaks below this line, we take it as an indication that the upward trend has ended. Even if the price moves up slightly after breaking the trend line, as long as it doesn’t close above the line again, we maintain our bearish outlook.

Understanding candlestick patterns is also crucial in technical analysis. Candlesticks give us insights into the market sentiment during a specific time period. For instance, a long shadow below a candle is often referred to as a “hammer,” indicating potential bullish reversal, while a long shadow above a candle might suggest a bearish reversal. These patterns are important, but what matters more is the closing price in relation to the trend line.

When analyzing an ETF, one might notice that there are fewer transactions compared to individual stocks. This is because ETFs typically have lower liquidity, meaning fewer buy and sell transactions happen at any given time. This can cause the charts to appear less noisy and more stable. Despite this, the principles of trend lines and candlestick patterns apply just the same.

To make this concept even clearer, let’s imagine we’re analyzing a stock. If the stock’s price is trending upwards, we draw a trend line from one low to the next. If the price breaks below this trend line and closes there, it suggests that the trend is changing. If it only dips below but doesn’t close there, it might just be a temporary pullback.

Suppose an investor noticed that a stock’s price fell from ₹1,000 to ₹800, but then it started rising again. If they draw a trend line and see the price closing below ₹800, they might decide to sell. This is because the break of the trend line suggests a potential further drop. If the price rises above ₹800 again but closes above the trend line, it could be considered a false breakdown, and the upward trend might continue.

Understanding stock market trends and patterns is essential for making informed investment decisions. Among the various theories and tools available, Dow Theory, often attributed to Charles Dow, provides a foundational approach to analyzing market movements. According to Dow Theory, prices do not move in a straight line; instead, they follow a specific pattern that can indicate the direction of the market. This pattern involves a series of highs and lows, where prices move up to form a high, then down to form a low, then up again to a higher high, and down again to a higher low. As long as this pattern of higher highs and higher lows continues, it indicates an uptrend. However, when this pattern is broken, it signals a potential reversal of the trend.

To visualize these movements, most traders use candlestick charts, which offer a detailed view of price action over a specific period. Each candle on the chart represents the open, high, low, and close prices for that period. For instance, the wick of a candle shows the high and low prices, while the body represents the opening and closing prices. By analyzing these candles, traders can gain insights into market sentiment and potential future movements.

There are different types of charts available for traders, including bar charts, kappa candles, hollow candles, and Heiken Ashi candles. Among these, the candlestick chart and line chart are the most commonly used. Heiken Ashi candles, in particular, are popular for identifying trends due to their ability to smooth out price fluctuations and reduce noise. This makes it easier to see the overall direction of the market, with sequences of green candles indicating an uptrend and sequences of red candles indicating a downtrend.

When analyzing a chart, traders often draw trend lines to identify the direction of the market. An uptrend line is drawn by connecting the lows of the price movements, while a downtrend line is drawn by connecting the highs. These trend lines help traders identify the general direction of the market and potential support and resistance levels. Support is a price level where a downtrend can be expected to pause due to a concentration of demand, while resistance is a price level where an uptrend can be expected to pause due to a concentration of selling.

For instance, if a price is in a downtrend, traders will draw a line connecting the maximum closings or highs. As long as the price stays below this line, the trend is considered to be down. Conversely, if the price breaks above this line, it indicates a potential trend reversal. Similarly, in an uptrend, traders draw a line connecting the lows, and as long as the price stays above this line, the trend is considered to be up.

In addition to uptrends and downtrends, the market can also exhibit a sideways trend, where prices move within a range without a clear upward or downward direction. Identifying sideways trends involves understanding support and resistance levels. For example, if the price repeatedly falls to a certain level and then rises, this level is considered support. Conversely, if the price repeatedly rises to a certain level and then falls, this level is considered resistance. When the price moves between these levels without breaking through, it indicates a sideways trend.

To illustrate, let’s consider an example of a stock that has been in a downtrend. The price falls, then rises, then falls again, and so on, forming lower highs and lower lows. A trend line drawn from the top to the bottom shows the direction of the downtrend. As the price continues to move below this line, it confirms the downtrend. However, if the price breaks above the trend line, it signals a potential reversal. Traders then look for additional confirmation, such as a series of higher highs and higher lows, to establish a new uptrend.

Similarly, if the price is in a sideways trend, traders identify the range within which the price is moving. By plotting horizontal lines at the support and resistance levels, they can see where the price is likely to bounce. For instance, if the price repeatedly falls to a level of ₹33 and rises to a level of ₹40, these levels act as support and resistance. Traders can then make decisions based on these levels, such as buying at the support level and selling at the resistance level.

An example of this approach can be seen in the case of IT ETF. Suppose the price of IT ETF falls to ₹33 and then rises, forming a support level at ₹33. If the price breaks above this level and continues to rise, it indicates a potential uptrend. Traders who identify this support level and buy at ₹33 can benefit from the subsequent rise in price. Conversely, if the price falls below this support level, it indicates a potential downtrend, and traders may decide to sell.

There are different types of investors, including value investors and momentum investors. Value investors look for opportunities to buy undervalued assets, often during downtrends or sideways trends, with the expectation that the price will eventually rise. They focus on the intrinsic value of the asset and are willing to hold their investments for a longer period. For example, a value investor might buy IT ETF at ₹33, considering it undervalued, and hold it until the price rises to a higher level.

Momentum investors, on the other hand, seek to capitalize on the momentum of the market. They buy assets that are already trending upwards and aim to ride the trend until it reverses. For instance, a momentum investor might wait for the price of IT ETF to break above the support level and show signs of an uptrend before buying. They may also use retracement levels to identify entry points during the trend.

In the dynamic world of stock trading, particularly on the National Stock Exchange (NSE) in India, traders often encounter large wicks on candlestick charts. These wicks can be misleading as they suggest prices that are not easily achievable in real trading. Many traders think they will be able to sell at the wick, but in reality, these prices are often the result of a quantity deal involving a significant amount of stock, rather than a true reflection of market prices.

For example, when analyzing a chart and observing a sideways trend, it is crucial to recognize the patterns forming over time. In some instances, what appears to be an uptrend might only be temporary, followed by a halt or even a decline. This is particularly evident in sectors like FMCG (Fast-Moving Consumer Goods), which have periods of stagnation. From 2023 to 2024, FMCG stocks did not deliver extraordinary returns. Therefore, understanding support and resistance levels is essential.

Support and resistance lines help traders identify zones where the price has previously held or fallen. When these lines are drawn, they indicate areas of demand where prices are likely to bounce back. For instance, a hammer-type candle or a pin indicates a strong demand zone. If the price falls into this zone again, it is a good opportunity to buy. Personally, I have bought stocks in such zones, averaging my purchase price at ₹56. This strategy of averaging allows me to accumulate stocks at different price points, ensuring a balanced portfolio even if the market fluctuates.

One important aspect of investing in FMCG stocks is their defensive nature. On days of significant market events, such as election results, FMCG stocks tend to be less volatile. For example, on June 4th, when the Bank Nifty fell by almost 8%, FMCG stocks rose by 2.17%, demonstrating their stability. Companies like Hindustan Unilever saw an increase, showing that these stocks are less impacted by market downturns due to their essential nature.

Diversification is another critical factor in maintaining a stable portfolio. During market crashes, a well-diversified portfolio ensures minimal losses. For instance, while some portfolios may drop by 10-20%, a diversified portfolio might only see a 1-2% dip. This is because it includes defensive stocks like FMCG, which are less likely to plummet during market turbulence.

When it comes to market reactions to major events, price action can be unpredictable. On days of significant news, such as political upheavals or international conflicts, normal price action patterns do not apply. For example, if there’s a sudden announcement of the Prime Minister’s resignation or a geopolitical conflict, the market might react drastically, causing large candlestick wicks that do not reflect normal trading conditions.

Understanding these market nuances is crucial for making informed investment decisions. For instance, in a typical scenario, if the Bank Nifty is down 8% and Nifty is also down significantly, it’s a sign of a potential buying opportunity. Such market corrections are rare but when they occur, they present a chance to buy at lower prices before the market rebounds.

Investors often wait for these dips to deploy their funds, maintaining liquidity for such opportunities. Liquid funds serve as a safety net, allowing quick access to cash for buying opportunities during market dips. This strategy ensures that investors are prepared to take advantage of sudden market corrections.

Moreover, market reactions to news often follow the adage “sell the news, buy the rumor.” When positive news is widely known, it’s usually already factored into the stock prices. Conversely, rumors can lead to speculative buying, creating opportunities for savvy investors to sell at higher prices. This principle helps investors navigate the psychological aspects of trading, ensuring they make decisions based on market behavior rather than emotions.

Support and resistance are key concepts in technical analysis. Imagine you’re standing on the ground; this ground acts as your support. If you create a hole in the ceiling and climb a ladder, the ceiling now becomes your new support. In financial terms, support is a level where the price tends to stop falling and might bounce back up. Conversely, resistance is where the price stops rising and may fall back. Once the price moves beyond a resistance level, that level often becomes the new support, just like climbing higher and standing on the roof.

In conclusion, in this blog, we’ve attempted to simplify these concepts. For instance, consider candlestick patterns. A candlestick shows price movements for a specific time period and can indicate market trends. Patterns like the “Hanging Man” or “Hammer” can signal potential reversals. The “Hanging Man” appears at the end of an uptrend, suggesting a possible downturn, while the “Hammer” at the bottom of a downtrend suggests an upward reversal. The “Dragonfly Doji” in bankruptcy scenarios indicates potential bullish reversals.

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