4/12/2024

How to use technical analysis to trade stocks

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While fundamental analysis focuses on the intrinsic value of a stock by assessing its financial performance (revenue, profitability, price-to-earnings ratio) and macroeconomic conditions, technical analysis uses historical price and trading volume data to predict future price movements.

Even if you are a big fan of fundamentals, you should also rely on technicals when trading stocks.

Benefits of technical analysis

It is important to remember that fundamental analysis has a number of limitations. First, it does not always reflect actual market sentiment. Fundamentals do not always accurately reflect current market sentiment and investor psychology, which can play a significant role in pricing. Changes in fundamentals may not immediately affect stock prices, resulting in information lags.

On the other hand, technical analysis has a number of advantages:

  • Takes into account market psychology: helps to understand the behavior of market participants by studying their past actions.
  • Forecasting Short-Term Movements: more effective at predicting short-term price movements than long-term ones.
  • Variety of Tools: there are many technical indicators and patterns that provide traders with a wide range of analysis tools.

Develop a trading strategy

The initial stage in trading is defining a strategy or developing a trading system.

One example for a novice trader would be the moving average crossover strategy. It involves tracking two moving averages, the 50-day and the 200-day, to determine the direction of the stock’s price. If the short-term 50-day moving average crosses below the long-term 200-day moving average, it signals an uptrend and generates a buy signal. Conversely, when the 50-day moving average crosses above the 200-day moving average, it indicates a downtrend and generates a sell signal.

Identify characteristics of securities

It is worth noting that the strategy described above is not universal and is not suitable for all stocks or securities. It is most effective for highly liquid and volatile stocks; it is not recommended to apply it to illiquid or stable assets. It should also be taken into account that different stocks or contracts may require different sets of parameters. For example, instead of the 50-day and 200-day moving averages, the 15-day and 50-day moving averages can be used.

Choose the account you need

The required set of trading account functions for a trader depends on his strategy. For example, day traders require a margin account. However, for the purposes of our example, it may make more sense to use a basic account as it is a more affordable option. It is important to note that the choice of account type should be based on the individual needs and trading goals of the trader.

What else should a trader consider?

  • Learn the basics and logic of this method.
  • Understand the limitations of technical analysis to avoid costly mistakes and unforeseen situations.
  • Consider the scalability of your chosen strategies and be prepared to adapt to changing market conditions.
  • Start with small amounts and gradually increase your investment as you gain experience.
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