A stock's price is the result of many different factors, but fundamentally it is determined by supply and demand like any other good. Investors will buy when they think a stock is priced too low, and sell when they believe the price has hit a high point. By using support & resistance as well as moving averages we can understand how technical analysis helps us to trade in Future & Option market. The price levels similar to these points are known in technical analysis as support and resistance lines. Support and resistance lines provide valuable clues about the possible future price movement of a stock. Most of the traders in the market think of technical analysis as the unemotional application of lines, using past price movements to predict future ones. When we apply it to the price of a stock, the interpretation is that the price of a stock goes up due to increasing demand, and decreases because of increasing supply. When the two lines meet, the meeting point determines the current market price of the stock, and where the market reaches a (temporary) balance.
Support & Resistance:
In this paragraph, we will learn why support and resistance lines are developed. Generally, at support line it is expected that stock's price does not fall below, because at that price level there is sufficient demand for the stock to stop a downtrend. In other words, buyers for these stocks emerge as it reaches an attractive valuation level. Similarly, a resistance line is the level above which usually a stock's price will not rise, because at that price level a sufficient supply of stock is available to stop an uptrend. At this point, the owners of stock begin to sell and earn profit as it reaches a level where they believe it is fairly even or overvalued.
Horizontal lines are drawn on a chart to indicate areas of support and resistance. The lows from where the stock price has “bounced off” multiple times in the past are identified as support. This price is where buying pressure overtakes selling pressure, and the market moves higher. Resistance is the price on the chart where selling pressure overtakes buying pressure, and the market moves lower. A resistance level is identified by a previous price high on the chart. Red lines in the chart below illustrate support (lower) and resistance (upper) lines.
Notice that, where the support and resistance lines are located changes over time. Support was initially at about 31.50 and resistance is at 42.50. The longer that prices trade in a support or resistance area, along with how many "hits" it has taken, the more significant the area becomes.
Once it is decisively broken, resistance levels can transform into support levels and vice versa. Here’s a break through, a resistance line shows that the buyers have won out over sellers, and are determined to bid the price of the stock higher than the previous highs. Once the resistance line is broken, another resistance line is created at a higher level. In that case, the previous resistance line often becomes the new support level. At this point, momentum of the stock to move in a single direction increases. More is the distance between support and resistance lines, more favorable it is expected to be. The farther apart the two lines are, the stronger each line is.
This is why technical analysis is used to consistently reduce your risks and improve your profits. Thus, support and resistance levels are important tools for any technical analyst. Understanding whether a stock's price is near a support or resistance level allows you to be aware that a reversal may be likely. Support and Resistance lines provide you a trading edge that will help you to improve your odds of making profitable trades.
In technical analysis, concluding the trend of the stock is very important. A trend may be short term, long term or a medium term. The trend is always volatile. We can use moving averages to determine a trend. In a long term trend, there may be several short term trends. These trends may be a positive or a negative trend.
You must be in a dilemma as to which moving average to use, exponential or simple, 10 or 20 moving average. Here is the answer; Simple moving average (SMA) is the average of recently closed price of the stocks for the past few days. Exponential moving average (EMA) is a weighted moving average that gives more importance to recent price data than the simple moving average does. Therefore, it’s better to use exponential than simple moving average.
When the market moves sideways, a moving average won’t do you much good. You will find that moving averages spend a lot of time just above or just below the market, and you will see lot of crossovers. This could be a “whipsawed”. Once you close that trade (at a loss) and place another in the opposite direction, the market reverses again. In this situation, you would end up with lot of loss. You need to recognize when the market is in a sideways trend and avoid trading at that time.
The moving average, which reduces the number of trades you need to make, but still gets you in on all those big moves is the perfect time frame one should pick. To reduce the “whipsaw” problem, more than one moving average should be used. Try superimposing moving averages with two different time periods on a price chart. When they cross is your signal to trade. In the below mentioned example I have used 20EMA & 200SMA.
Notice that where the 20 EMA & 200 SMA crosses over the stock consolidates for a time being and makes a new high. So, when there is a positive cross-over, the stock is bullish and when there is a negative cross-over, the stock is bearish. In this case 20 EMA was above 200 SMA, so it’s a positive cross-over and vice versa.
Moving Averages are a useful tool for understanding the overall direction of the stock market that are also best used in conjunction with other methods of analysis. They are a lagging indicator, so they will not get you out at the very top, nor back in at the very bottom, but they do provide high quality trading signals and are useful as confirming indicators.
Stay Tuned! Happy Investing!