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The importance of Technical Analysis

Updated: Jun 22, 2022

Reading charts to make trading decisions.

In its most uncomplex form, a chart is a depiction of demand and supply of an instrument. It tells you how buyers and sellers behaved at different points in the lifetime of trading of the instrument.

For example, here is a story of the video conferencing star “ZOOM” in one chart

After the initial IPO euphoria, Zoom’s stock got cold as markets across the world sold off late 2019.

Then COVID struck the world and Zoom got a new life despite the struggling broader markets. Such was the interest in the stock that it quite literally zoomed a whopping 9x in a short span of 8 months.

Was there a possibility to catch this gigantic move if you did not know about the company back in early 2020?

Yes, if you focused on the price chart and worked backwards.

If you learn to read the charts well, you will come to understand how the market participants behaved in different junctions in the stock price journey.

For example, from ZOOM’s chart, there a few key points one must note

· The stock took out its new high much before the market hit a new high from the bear market bottom, indicating that there was something up with the stock

· Stock took out these highs on very high volumes, higher than any time in its trading history, meaning that big hands were accumulating the stock

· The consolidations in the interim were low volume and short lived, meaning supply was not coming in and the sellers were too few and had little say in determining the price

· Price topped near the point when Zoom became a household name, indicating that it may not be a great time to get in when everyone is talking about the story

· The price went into a deep and prolonged decline afterwards, indicating that when there is a lack of triggers, the same buyers who queued up in large numbers earlier, turn into big sellers. The lack of big buyers to support the price at this juncture leads to an accentuated decline.

For those who follow my channel, they will know I like the weekly MACD indicator, and by simply following the cross of the MACD line would have seen you capture most of the uptrend and miss out of most of the downtrend. *Trading does not need to be hard....*

If you had a screen that showed you stocks with such technical characteristics at the height of COVID panic, you would have made a fortune trading Zoom.

If we go by the history, the markets don’t remain the same. They change and evolve. So, such opportunities keep on coming all the time. All you have to do is to prepare yourself for such times and be disciplined in doing your homework every day, week and month to never miss such opportunities.

Why is the technical information important?

Price is often a leading indicator of what is coming. That means that price moves first, before the news and story is known to general public. If that is so, you might be too late in the trade if you wait for a qualitative confirmation for your trade.

Therefore, if you have set technical parameters that can point you towards trades that hold potential beforehand, you can be ahead of other traders and investors in profiting from the story.

If you have a good understanding of technical parameters, you will have a set of tradable ideas all the time. That’s not it, your technical parameters will also help you stay out of trading when necessary. It will give you a clear path to follow to identify trade ideas and manage your trades.

This wouldn’t be possible if you simply depend on other people or news streams for your trading ideas. You will be clueless when other people change their mind. You will freeze when the losses mount and will be out of the markets when they enter a bad phase.

Most importantly, a good chart reading skill helps you gauge the collective wisdom of market participants without getting carried away by the sea of information that’s available nowadays.

Where do charts fit?

The technical parameters, like the price performance relative to an index or volumes can help you filter trade ideas, but the conviction on the trade will develop only when you take a good look at the chart.

Some securities could show up in the technical parameters but the chart could be all over the place, with nowhere to take a low-risk trade. Other charts will have a uniform price movement which would be more in line with what you would look for in a low-risk trade.

For example, in the Zoom chart above, the price had least resistance on the upside and any dip was with low volume and quickly bought into. If the dips were deep and high volume, this chart would not have qualified as being good, because the higher prices were met with higher supply.

Similarly, no matter how positively you thought about Zoom when it topped in October 2020, the chart never signalled a buy afterwards. It did not set up constructively for any astute trader to get in on it. The ones who knew how to decipher charts got saved from the precipitous decline that followed.

How much can you trust charts?

Trading is a game of probability and you can be wrong as much as you can be right. Therefore, even when you come across the best of the charts, you will have to keep practicing risk management when you trade. You must not let a trade ruin your account just because the chart looked great to begin with.

I always point to this table as a reminder of the importance of good risk management:

The final word

Charting or technical analysis is an important tool in every trader’s tool book. It makes life easier for them and keeps the ideas flowing. Learning about charts and reading them properly takes some time, but once you can do this well, your trading sees a marked improvement.

While you are at it, you must also not get lost in the sea of indicators that you can put on a chart. Just focus on a few important ones like MACD, Volume, Moving averages and Price Action itself. Keep your charts as simple as possible. Less is more when it comes to trading using charts.

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