|3 Basic Principles of Stock Technical Analysis for Beginners|
If you want to become a successful trader and investor, then your analysis must understand the 3 basic principles of stock technical analysis, namely: Market actions discount everything, Price moves in trends, and History repeats itself.
There are various reasons why traders and investors want to study stock technical analysis. And indeed, there are many uses and applications of technical analysis. Not only to analyze price movements on the Indonesia Stock Exchange.
But according to my experience, having spoken directly with thousands of traders and investors over the years. There is one of the most common reasons why traders and investors want to learn stock technical analysis, namely: to know when to buy, and when to sell.
But unfortunately, determining when to buy and when to sell is not as easy as most people think.
Because the science of stock technical analysis itself has a lot of methods and indicators. And usually, this is where the beginning of the confusion experienced by many novice traders and investors.
Because as time goes by, we will find lots of methods and stock technical analysis indicators, which often turn out to be "out of sync" and show conflicting signals.
For example, let's say, for example, we see that the MACD indicator issues a BUY signal. But strangely, at the same time, we also see the Stochastic indicator issuing a SELL signal. And later, if we look at the Moving Averages indicator, there is no signal at all.
Likewise, if we look at Candlesticks, Bollinger Bands, RSI, and so on. For the same price movement, on the same stock, at the same time, but all of these indicators give different results.
Then which one should we follow? Shouldn't the more indicators, the better it should be? Isn't it that the more indicators we master, the more accurate our analysis will be?
Believe it or not, I used to think like that. Whenever I do stock technical analysis, I always use at least 5-6 indicators simultaneously.
Even at my previous workplace (I was a Broker-Dealer), we had to use 4 monitors, just to monitor and analyze the movement of 1 stock.
But the problem is, those indicators are very rarely "one vote". More often it is out of sync and contradicts each other. And it's very confusing!
The more indicators, it turns out that instead of getting clearer, it makes us even more confusing. The more indicators, instead of being more accurate, the analysis is even more chaotic!
Well, this is the result, if we learn stock technical analysis, without understanding the basics and how each indicator works. When in fact, for all types of indicators, the way they work is similar. Because everything is made based on the same basic principles, namely: 3 Basic Principles of Technical Analysis.
If we already understand these 3 principles, reading indicators will be much easier. And finally, the results of our analysis are also sharper and more accurate. Because we already know how it works and the principles of all existing indicators.
So, now the question is: what are these three basic principles?
Fundamental Principle of Stock Technical Analysis #1: Market Action Discounts Everything
The first basic principle is: “Market Action Discounts Everything”. Which, loosely translated, means more or less: "Price movements reflect everything."
This is a basic principle that must be understood (and accepted) by us, as stock traders and investors. As long as we don't understand (and want to accept) this basic principle, then whenever the stock technical analysis that we do will not be effective.
Loh… why is that, Riz?
Because if we don't believe that price movements reflect everything, then we will always doubt the analysis we have made ourselves.
Every time we do a stock technical analysis, there will always be things that make us unsure of our own analysis. So that in the end we also don't feel confident (or even don't dare) to make decisions.
Okay… then, now the question is: what does this first basic principle actually mean? What do the words “price movements reflect everything” mean?
It's easy like this...
In all stock price movements, there must be a cause. The price of a stock can't go up or down without reason. Whether it's fundamental reasons, corporate action, economic reasons, political reasons, psychological reasons, or whatever it is.
Fundamental reasons, can make stock prices go up and down, for example, financial statement performance, new product launches, changes in production raw material prices, product price changes, and so on.
While the reasons for corporate action can make stock prices move up and down, for example, the entry of new investors, mergers and acquisitions, tender offers, rights issues (HMETD), go-private, dividend distribution, and others.
Economic reasons, also affect the rise and fall of stock prices, for example, changes in foreign exchange rates, interest rate policies, trade balance reports, inflation rates, and so on.
Then for political reasons, although it rarely happens, the influence is also quite large for stock price movements. For example sentiment towards the government, change of leadership, general election results, changes to laws and regulations, and so on.
Psychological reasons, trigger price movements, for example, the perception of cheap or expensive shares, the comparison of the price of these shares when compared to other stocks in the same sector, changes in investor sentiment, and the like.
So actually there are lots of reasons why a stock can move up or down. In fact, there are too many to list one by one!
That's why, we as users of stock technical analysis, don't need to worry about it. In essence, if a stock's price goes up or down, it must be for one (or several) reasons that we mentioned earlier. I don't know which reason, the point is there and we don't have to bother!
Why don't we need to worry about the causes behind price movements? And why don't we need to think about the reasons why a stock goes up or down? Wouldn't it be better if we knew the reason? And our analysis will be more accurate?
To answer this question, it's a good idea to look at the illustration below...
The illustration above is a chart of the Flow and Cycle of Stock Price Movements. Which shows what's going on behind the price movement, and how the process of a stock price moves (or is moved) up and down.
Btw, we have discussed the Flow and Cycle of Price Movements in detail and depth in the TRANSIT Investing Masterclass (Basic). Therefore, in this article, we will only briefly discuss it.
As we have already mentioned. That stock prices move up and down, there must be a cause and reason. For ease of understanding, we call these reasons FACTOR-X.
Price Movement Flow #1: The X-FACTOR
This X-FACTOR can be in the form of fundamental reasons, corporate action, economics, politics, psychology, and so on. Anyway, this is the cause, what makes the stock go up or down.
Furthermore, this X-FACTOR is sought and then analyzed by Smart Money using Fundamental Analysis.
Price Movement Flow #2: Fundamental Analysis
Who exactly is this Smart Money? And why are they called Smart Money?
They are called Smart Money because they have large funds. And a large amount of funds is used to pay a team of analysts, whose specific task is to find out about the X-FACTOR in every share on the Indonesian Stock Exchange.
Btw, there are many things we need to straighten out regarding fundamental analysis. Things that people who teach Value Investing have never been told about, and kept tightly under wraps. The things that we will cover are all in the TRANSIT Investing Masterclass (Basic).
Because fundamental analysis is not only about financial ratios. And not just to see if the company is good or not. In fact, fundamental analysis is the science of looking for the X-FACTOR that occurs in every stock.
This is the true function of fundamental analysis. And this is how legendary investors use fundamental analysis. Including Warren Buffett, Lo Keng Hong, and several big names on the Stock Exchange.
With fundamental analysis, they will find which stocks have good X-FACTORS, and which stocks have bad X-FACTORS. This is the main basis of their decision to buy and sell shares. This is what is known as Big Money Action.
Price Movement Flow #3: Big Money Action
If the X-FACTOR in the stock is good, then they will buy (accumulate) the stock. Meanwhile, if the X-FACTOR in the stock is bad, then they will sell (distribute) the stock.
Because of the large and massive accumulation and distribution carried out by Big Money, this buying and selling will make the price move.
In the language of economics, the buying and selling made by the Big Money will cause the dynamics of Supply and Demand.
When Big Money buys (accumulates) shares, the demand for these shares increases. And according to the law of economics, an increase in demand will cause prices to rise.
Vice versa. When Big Money sells (distributes) shares, the supply of these shares increases. And an increase in supply will cause prices to fall.
Well, the movement and rise and fall of stock prices, which are caused by Big Money Action, are then "detected" using Technical Analysis.
Price Movement Flow #4: Technical Analysis
So actually technical analysis is not astrology, prediction, or fortune-telling!
Technical analysis is how we read price movements, to understand what Big Money is actually doing. Because they have done the fundamental analysis, and they know what X-FACTOR is in the stock.
So as traders and investors, all we need to do is just follow their movements. If they buy, yes we buy too. If they sell, we will sell too. It's that simple. Follow the Smart Money!
That is why, the first principle of technical analysis is: "Market Action Discounts Everything". Or the free translation is: "Price movements reflect everything".
When a stock moves, whether it goes up or down, we don't need to get dizzy and busy finding out what causes it. Because Big Money can't buy or sell a stock without a good reason!
Remember, as traders and investors, our focus is on taking advantage of the opportunities that exist and how we can profit from the Stock Exchange. This is what is called: Market Timing!
Price Movement Flow #5: Market Timing
We're not analysts, we're not stock commentators. So we don't need to look for reasons and causes, why this stock goes up or why it goes down.
After all, it's no longer a secret that News and Info are ALWAYS late. The stock has gone up a lot, and only then the good news came out. If the stock has fallen far, then there is bad news.
Because in the Flow and Cycle of Price Movements, News and Info are indeed the last links in the chain.
Price Movement Flow #6: News & Info
Back when I was still active as a Broker-dealer, there was a saying going around among us. It reads more or less like this: "New news will appear when the party is over".
Or in other words, traders and investors who buy stocks because of the news, are usually the ones who lose the most. Because the “party” was over when the news came out, and they only had to clean up and “do the dishes”.
So, once again, always remember this principle: Market Action Discounts Everything!
As traders and investors, we don't have to worry about the reasons behind stock price movements. Why is this stock going up, and why is it going down. When it's time to buy, we buy, when it's time to sell, we sell.
No need to look for info, or wait for news. Because if we wait for the news to appear, it means the “party” is over. And that means it's too late!
Now the next question is: if we really don't need to look for news, then what should we look for?
If indeed price movements reflect everything, then how do we analyze price movements? How do we know the direction of Big Money, as well as the dynamics of Supply and Demand?
For that, let's move on to the next principle…
Basic Principle of Stock Technical Analysis #2: Prices Move in Trends
The first step to conducting a stock technical analysis is determining the trend. Because prices don't move randomly. Price movements are not random. All stocks whose prices go up and down actually have a pattern.
This is the next basic principle. That prices move in a pattern, which we call a trend.
And all kinds of stock technical analysis indicators, are actually made to determine and detect this pattern (trend). Whether it's Stochastic, MACD, Moving Averages, RSI, Bollinger Bands, Candlesticks, and so on. Everything has the same purpose and function.
Well, if indeed all types of stock technical analysis indicators are made to detect trends, then why can different signal indicators be different? Why does one indicator give a Buy signal, but another indicator gives a Sell signal?
To answer these questions, we must understand that in technical stock analysis, there are actually 3 types of trends. And each stock technical analysis indicator is made to detect a different type of trend.
That is why we often find that between one indicator and another, they are often out of sync and contradict each other. Because these indicators are designed to look at the market from a different perspective.
To understand better, let's look at the illustration below...
According to stock technical analysis, there are 3 types of price movement trends. Namely: Long Term Trend, Medium Term Trend, and Short Term Trend.
Actually, we have discussed this trend thoroughly, in detail, and in-depth, in the TRANSIT Investing Masterclass (PRO and PRO+ versions).
Including what are the characteristics of each trend, how to determine which trend we are currently in, and how to anticipate trend changes. Therefore, in this article, we will only discuss trends briefly and casually.
Trend Type #1: Long-Term Trend
Long-Term Trend, sometimes also known as Long-term (Primary) Trend, is the major trend or main trend, which determines the main direction of the price movement of a stock.
In technical analysis of stocks, the definition of a Long Term Trend is a trend with a duration of more than 30 weeks. Or more specifically, more than 150 candles/bar.
Examples of stock technical analysis indicators, whose function is to detect long-term trends, are all types of moving averages indicators.
Yes, semua jenis indikator Moving Averages! Entah itu Simple Moving Averages, Exponential Moving Averages, Weighted Moving Averages, Smoothed Moving Averages.
Anyway any technical analysis indicator name that contains the words “Moving Averages”, is actually designed to detect Long Term Trends.
That is why, Moving Averages are known as lagging indicators. Moving Averages are also considered indicators that are "slow" in anticipating price movements. Because its function is to detect long-term trends.
If we use the Moving Averages indicator, we talk about the direction of the market and the movement of stock prices over the next 7-8 months. Not just daily and weekly price movements. Because that is not the function and purpose of creating Moving Averages.
So don't use Moving Averages for Day Trading or Swing Trading! Especially if you are still a beginner, who doesn't understand the right way to combine different types of technical analysis indicators (multiple time-frame trading).
Now let's return to the discussion of Trends.
In stock technical analysis, a larger trend is formed by a set of smaller trends. In other words: there is a Trend within a Trend.
So, within a Long Term Trend, there are several Medium Term Trends.
Trend Type #2: Mid-Term Trend
The Medium-Term Trend, sometimes referred to as the Intermediate-term (Secondary) Trend, is the mid-term trend, which rises and falls in line with the main direction of a stock's price movement.
In technical analysis of stocks, the definition of a Medium-Term Trend is a trend whose duration is between 3 weeks and 30 weeks. Or more specifically, between 15 candles/bar to 150 candles/bar.
An example of a stock technical analysis indicator whose function is to detect medium-term trends is the Moving Averages Convergence-Divergence indicator. Or more popularly called MACD.
The MACD indicator is actually a derivative indicator (modification) of the Moving Averages indicator. And the MACD indicator was actually created to cover the shortcomings of the Moving Averages indicator. Or in other words: MACD is actually a “more responsive” Moving Averages indicator.
Because it is more responsive to price movements, that is why the MACD indicator is very suitable for us to use to detect and recognize Medium-Term Trends.
So if we use the MACD indicator, our time frame (holding period) is between 3 weeks and 30 weeks. That is, if we buy the shares today, then we will only do Profit Taking 3-6 months later.
This investment strategy is perfect for those of you who are busy, or who don't have time to monitor price movements and your portfolio every day. Because we buy these shares for 3-6 months later. Not for us to sell tomorrow or next week!
Because even though the MACD indicator is indeed much more responsive than the Moving Averages indicator, due to its nature which is classified as a lagging indicator (trend following), the MACD indicator will still not be as fast and responsive as an indicator designed to identify Short Term Trends.
Because the Short Term Trend is a Trend that is inside the Medium Term Trend.
Trend Type #3: Short-Term Trends
Short-Term Trend, sometimes also known as Short-term (Minor) Trend, is a small trend, which rises and falls in line with the Medium-Term Trend of the price movement of a stock.
In technical analysis of stocks, the definition of a Short Term Trend is a trend with a duration of less than 3 weeks. Or more specifically, less than 15 candles/bar.
Examples of stock technical analysis indicators, whose function is to detect Short Term Trends are all types of momentum indicators.
Examples of momentum indicators include Stochastic, Relative Strength Index (RSI), Rate of Change (ROC), Average Directional Index (ADX), William Percentage R (William %R), and so on.
Simply put, most (though not all) indicators that are oscillators are momentum indicators. Its main function is to recognize and detect Short Term Trends.
So if you want to do short-term trading, whether it's Day Trading or Swing Trading, then use momentum-type technical analysis indicators. Because these types of indicators are included in the leading indicator type.
A leading Indicator is an indicator that is very responsive to price movements, and very fast in detecting trend changes in Short Term Trends.
So, back to our previous question. Why do different stock technical analysis indicators also give different signals? Why does one indicator give a Buy signal, but another indicator gives a Sell signal?
Yes, because each indicator is different, designed to detect and see trends from a different perspective.
So if you want the results of your analysis to be accurate and your profits to be consistent, then you have to determine first which trend you want to "play" on. Because different indicators see, detect, and generate signals on different trends.
However, now the question is: if indeed the price moves in the form of a trend, then how exactly do we determine when to buy and when to sell? Then how accurate is an indicator in determining when to buy and when to sell?
To answer this question, let's go straight to the third principle, namely...
Basic Principle of Stock Technical Analysis #3: History Repeats Itself
This third basic principle also explains the previous basic principles: How do we know that prices move in a groove and cycle? How do we know that prices move and form trends?
The answer: Because history repeats itself!
What happened in the past, will happen again in the present, and will likely continue to happen again in the future. History repeats itself!
Flow and Cycle Price movement, which we have discussed in the first basic principle, is a pattern that has occurred since 130 years ago. So this is not new, and this is not new science.
Likewise, the second basic principle is regarding the tendency of price movements that form a trend. This is a pattern that has been observed since 1889, by a legendary investor named Charles Dow (The first theorist of Technical Analysis).
Charles Dow is the co-founder of The Wall Street Journal. A daily newspaper about the stock exchange is still being published today.
For decades, he documented price movements on the stock exchange. And the results of these observations, he wrote in the articles he wrote in The Wall Street Journal.
Well, it was a collection of his writings that was used as a template for The Dow Theory, the first theory of technical analysis.
The patterns contained in the theory of stock technical analysis are the result of observations and have occurred for more than 100 years. Again, this is nothing new!
Since prices on the Stock Exchange were still written using chalk and blackboard, until now when everything is completely computerized and connected to the internet.
Since 1889, when the theory of technical analysis was first coined, the whole world has experienced various kinds of economic crises, financial crises, to humanitarian crises.
Starting from World War 1 (1914), World War 2 (1939), Spanish Flu Pandemic (1918), Great Depression (1932), Suez Canal Crisis (1956), Global Debt Crisis (1982), Asian Monetary Crisis (1998), Sub-prime Mortgage Crisis (2008), European Debt Crisis (2010).
After experiencing so many crises and "trials", the theory of technical analysis has always been proven. The same patterns keep happening again, again, and again. For hundreds of years!
Why? Again, because history repeats itself. History repeats itself!
What happened in the past, will happen again in the present, and will likely happen again in the future. And so on.
Now the question: why can it be like that? Why does the same pattern always happen again and again? Even been repeated for 100 years more?
The simple answer: because human nature does not change!
Times have changed. Because technology is constantly evolving. So that in the end the situation and conditions of the world also change. This is a fact!
But what hasn't changed for hundreds (or maybe even thousands of years), is this: human nature!
When you see prices going up, greed will dominate. When you see the price drop, fear will take over. Euphoria and hysteria alternated. This is what makes the price move up and down.
This euphoria and hysteria have also made the Bullish-Bearish cycle repeat itself for hundreds of years. And it will likely continue like this for hundreds of years to come.
By using this third principle, we come to know. That the best way to "predict" future price movements, is to study price movements in the past (with the help of charts and technical analysis charts ).
All kinds of technical analysis methods and indicators are designed by applying this principle. This includes Fibonacci methods, Elliot Wave, Support/Resistance, and even candlestick patterns.
When a stock price movement forms (for example) pattern A, then usually the stock will go up. Because in the past, whenever stock price movements formed this pattern, the price did go up.
Likewise, if the price forms (for example) pattern B, then there is a possibility that the stock price will decrease. Because historically, as has happened before, every time this pattern appears, the price does go down.
That is why, as we said earlier, the best way to know when to buy and when to sell, is to pay attention to price movement patterns.
What happened before the price went up? What pattern appeared before the price went down? What is the flow and cycle? By knowing and paying attention to this, we will be able to carry out the analysis with accurate accuracy.
Application and Application of the Basic Principles of Stock Technical Analysis for Consistent Profits
Although in this paper, we have discussed at length the 3 Basic Principles of Stock Technical Analysis. But in fact, we have only come to the surface. We haven't really dived into the topic yet.
We still haven't discussed too deeply the X-FACTOR, the "dark" secrets behind the science of Fundamental Analysis, the "behind the scenes" intrigues carried out by Big Money, and so on.
There are still many, many things that we have not had the chance to discuss in this article. Including how to make consistent profits using Technical Analysis, how to design a complete Trading Plan, how to anticipate price changes, and so on.
If you are interested in knowing more and learning more, I have prepared a special class for you. And the good news, this class is FREE!
Yes. For a limited time and quota, access to join the TRANSIT Investing Masterclass (Basic) is FREE! And you will not be charged a penny.
You only need to enter your email (the email that is opened most often), then our system will send a link for you to access the video tutorials that we have prepared. After that, all you have to do is click the link, and you can start learning right away!