Basics of Stock Picking For Retail Investors Using Technical Analysis

Technical analysis is one of the most potent methods that most retail investors use in stock evaluation and selection. It deals with price and volume changes over time to predict future price movements. Technical analysis is a useful tool for retail investors if they really understand how to make sense of it and make proper trading decisions.

Understanding technical analysis

Technical analysis is the study of past market data, primarily price and volume, to establish trends that forecast future price movements. It is opposite to the mechanism of operation for fundamental analysis, which attempts to project the intrinsic value for a company based on the financial statements. Technical analysis involves identifying certain patterns and trends that might indicate trading opportunities. This, thus, particularly helps individual investors hoping to benefit from short-term market movements.

Key concepts in technical analysis

1. Price trends and patterns: One of the central principles of technical analysis is that past price changes are a useful indicator of future trends. Analysts scan patterns like head and shoulders, double tops and bottoms, and wedges to identify a possible reversal or continuation in price action.

2. Volume analysis: Volume forms the backbone of a price movement and is an intrinsic part of technical analysis. For instance, high volumes in the midst of a price increase might connote strong buying interest. Low selling volume during periods of price decline might indicate weak selling pressure.

3. Technical indicators: These are calculations based on the price and volume of the data and is used to determine trends and entry and exit points. Such indicators include moving averages, the relative strength index, and the moving average convergence divergence.

Tools and techniques for retail investors

Charting software

Charting software is used to visualise price movements and, based on these movements, identify patterns within. In most of the cases, it provides customised charts with a number of technical indicators that help the investors shape their analysis towards certain strategies.

Some key technical indicators

1. Moving averages: Moving averages smoothen price data for trends over a given period. The 50-day and 200-day moving averages are normally used for determining long-term trends and generating buy or sell signals.
2. Relative strength index (RSI): The RSI considers the speed and change of price movements and indicates if a stock is overbought or oversold. If the reading of the RSI comes out higher than 70, the security is overbought; when it drops below 30, it becomes oversold.
3. MACD: The MACD is a trend-following momentum indicator that expresses the relationship between two moving-averages of the price of a stock. Crossovers between the MACD line and its signal line can indicate a possibility of buy or sell signals.

Chart patterns

• Head and shoulders: This is a trend-reversal pattern from bullish to bearish when the price breaks below the neckline after the formation of three peaks.
• Double top and bottom: A double top pattern is an indicator for the reversal of a downtrend, while a double bottom is an indicator for the uptrend reversal.
• Cup and handle: This is a bullish pattern of continuation, whereby the rounding bottom is followed by the consolidation phase, which indicates that an uptrend may probably occur.

Developing a trading strategy

1. Pick up a strategy: Choose a particular trading strategy based on your investment goals and risk tolerance. For example, the moving average crossover strategy involves tracking two moving averages and generating buy or sell signals based on their crossovers.
2. Identify securities: Not all stocks are usable by any strategy. Consider only highly liquid and highly volatile stocks that correspond to your strategy.
3. Tracking and monitoring trades: Keep constant track of the trades and ongoing development of the strategy. The charting tools and technical indicators will help to see whether the trade is working out positively or negatively to further decide on the strategy.
4. Manage risk: Implement the techniques of risk management, such as stop-loss orders, that would prevent huge losses. The diversification of the portfolio would also distribute the risks among various assets.

Challenges and considerations

• Market noise: Due to noise, short-term price movements may not lead to meaningful trends and instead, they may be random in nature.
• Overconfidence: Technical analysis can make retail investors overconfident in their ability to predict the movements of markets, leading to excessive trading and subsequently huge losses.
• Transaction costs: Intensive trading on technical signals may result in high transaction costs that might erode profits over time.

Conclusion

Technical analysis can become a strong aid for a retail investor sailing through the intricacies of the stock market. It comprises major concepts, charting tools, and technical indicators that can turn out to be very helpful in making any meaningful investment decision and enhance the possibility of better returns. However, you need to be aware of the challenges and limitations of using technical analysis and use it in conjunction with other approaches to investing to have a well-rounded strategy.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.