How to trade effectively based on technical charts - Motilal Oswal
How to trade effectively based on technical charts - Motilal Oswal

How to trade effectively based on technical charts

There was once an experiment conducted in the United States where the past performance of a team of technical analysts and another team of fundamental analysts were fed into a supercomputer. The supercomputer was asked to decide who among the two sets of analysts were more reliable. After tabulating reams of data the supercomputer concluded that the technical analysts were more reliable. Obviously, the fundamental analysts were not convinced and they decided to download the logic behind the conclusions. The supercomputer’s logic was that while fundamental analysts were sometimes correct, the technical analysts were always wrong. That made them more reliable from a decision making point of view.

The story is, most likely, apocryphal and also a tad unfair to technical analysts. The truth is that technical analysis forms the basis for most traders and even for investors it does form the basis on which the entry and exit is timed. The whole story becomes a lot simpler when we look at technical analysis as an adjunct to the investment decision process rather than an alternative decision process. What are the best technical indicators for stock trading and how to trade with technical charts? More importantly, how to use technical analysis to trade stocks?

Leveraging the power of technical charts:
Technical charts capture the mountains of intelligence on stocks through simple and elegant graphs. Then these graphs are further sliced to identify critical trends and turnaround signals. That is what makes trading exciting and meaningful. Here are 4 such technical indicators to apply..

Trading with Moving Averages
Moving averages form one of the basic pillars of the use of technical charts for trading. In fact, moving averages make it easy for a trader to identify trading opportunities within the overall direction of the market. Moving averages are used to identify the trend and also the right time to buy or sell the stock. Not only for technical analysts but even for fundamental analysts, it is quite useful. The moving averaging is a typical average where the data point keeps skipping and calculating. Popular moving averages are the 50 DMA, 100 DMA and the 200 DMA. The moving averages are very useful in identifying the supports and resistance levels of the stock. Normally, supports and resistances are created when the stock chart keeps consistently hitting around the 200 DMA.

Trading with Relative Strength Index (RSI)
The Relative Strength Index (RSI) is also called an oscillator. This helps you to credibly identify if the stock you are looking at is overbought or oversold. Normally stocks that are overbought tend to become a classic case for either selling or shorting and stocks that are oversold become candidates for buying at lower levels. The question is when to enter the market and buy the stock? That question is answered by the RSI. The RSI being an oscillator is plotted on a scale of 0-100. An RSI level of 100 indicates that the stock is extremely overbought while a level of 0 indicates that the stock is extremely oversold. While 100 and 0 are theoretical levels, the RSI for most stocks ranges between 30 and 70. Stocks are considered to be oversold around the RSI of 30 while stocks are considered to be overbought around the RSI level of 70. That is the ideal level to initiate appropriate trades!

Trading with Stochastics
Like the RSI, the stochastic are also an oscillator, in the sense that they also give indications of when a stock is overbought and when it is oversold. Relatively, the Stochastics is more reliable and affirmative of these zones compared to RSI and is used more often by professional traders. The RSI does not look for a double confirmation before identifying overbought and oversold zones. The Stochastics goes one step ahead and also identifies %K line and the %D line and uses a crossover to identify the oversold levels with much greater conviction and empirical success rate.

Trading with Moving Average Convergence Divergence (MACD)
In many ways, the MACD is referred to as the king of technical indicators since it encompasses moving averages and also oscillators. MACD not only identifies the overbought and oversold zones in the chart but also identifies the right levels of entry and exit. MACD is highly flexible and can be used in range-bound markets as well as in trending markets. How do you identify signals using MACD? You first recognize the lines in relation to the zero line which identify an upward or downward bias in the stock price. Secondly, you try and identify the cross over or cross under of the red line and the blue line to get the appropriate trading signal.
Technical charts are the life line of a trader. Knowledge of some of the basic technical indicators can go a long way in helping you with better trading decisions.
 

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