Week 10: Technical Analysis

Dive into the world of chart patterns and price movements to understand how technical indicators help predict future stock trends.

Let’s start with what is Technical Analysis?

Technical analysis is a method used to evaluate investments by analyzing price trends and market patterns, rather than digging into a company’s financial statements like fundamental analysis does.

While fundamental analysis focuses on sales, earnings, and company value, technical analysis is all about what the market is doing—based on price movements and trading volume.

You might be wondering, how do technical analysts evaluate investments?

Rather than asking “What is this company worth?”, they ask:

“What are the price charts and volume trends telling us about investor behavior?”

They look for:

  • Price trends

  • Chart patterns

  • Volume and momentum indicators

  • Oscillators (which show overbought or oversold conditions)

  • Moving averages

These tools help them identify patterns that can suggest whether to buy or sell a security.

Let’s explore some of these key technical tools…

These tools are called technical indicators, and traders use them to confirm trends, detect reversals, or time their entries and exits. Let’s break down a few:

  1. Moving Averages

Moving averages smooth out price data to help spot trends. There are two types you should know:

Simple Moving Average (SMA):
This is just the average of a set of closing prices over a given number of days.

Example: A 15-day SMA = the sum of the last 15 closing prices ÷ 15

Exponential Moving Average (EMA):
This is a bit more advanced. It gives more weight to recent prices, making it more responsive to new data.

Before you calculate the EMA, you need the weighting multiplier:

Formula:

Weighting Multiplier = 2 / (Time Period + 1)
Example: 2 / (15 + 1) = 0.125 = 12.5%

The actual EMA formula is:

EMA = [Price(t) × K] + [EMA(y) × (1 – K)]
Where:

  • t = today

  • y = yesterday

  • K = weighting multiplier

  • N = number of days in EMA

So, while the SMA is just a straightforward average, the EMA is smarter—it adjusts quicker to changes because it prioritizes newer data.

2. Relative strength index

What is RSI?
RSI (Relative Strength Index) is a momentum oscillator that measures the speed and change of price movements. It tells you whether a stock is being overbought or oversold.

  • RSI values range from 0 to 100

  • Above 70 = potentially overbought (price may drop soon)

  • Below 30 = potentially oversold (price may rise soon)

Formula:

RSI = 100 − [100 / (1 + RS)]
Where RS = Average Gain over X days / Average Loss over X days
(Default period = 14 days)

Let’s break it down:

  1. Track the closing price change each day for 14 days.

  2. Separate those into gains and losses.

  3. Average the gains and losses.

  4. Divide them to get RS.

  5. Plug RS into the formula.

Example:
If the average gain over 14 days is 1.5, and the average loss is 0.5, then:
RS = 1.5 / 0.5 = 3
RSI = 100 - [100 / (1 + 3)] = 75

That would suggest the stock is overbought

3. Moving Average Convergence Divergence

What is MACD?
MACD is both a trend-following and momentum indicator. It shows the relationship between two EMAs (Exponential Moving Averages)—typically a 12-day and a 26-day EMA.

Key components of MACD:

  1. MACD Line = 12-day EMA − 26-day EMA

  2. Signal Line = 9-day EMA of the MACD Line

  3. MACD Histogram = MACD Line − Signal Line
    (shows the strength of the trend)

How to decipher MACD:

  • Bullish Crossover: MACD line crosses above the Signal line → Buy signal

  • Bearish Crossover: MACD line crosses below the Signal line → Sell signal

  • Histogram bars growing = increasing momentum

  • Histogram bars shrinking = momentum weakening

EX:
Suppose the 12-day EMA is at $52, and the 26-day EMA is at $50
MACD Line = 52 − 50 = +2
If the Signal Line is +1.5, then Histogram = 2 − 1.5 = +0.5
Positive value = Bullish trend gaining strength

There are plenty more indicators traders use—the one you choose fully depends on your style and goals!

Now, what makes technical analysis different from fundamental analysis?

How did technical Analysis form?

This method is built on a few key assumptions (originally outlined by Charles Dow):

  1. The market discounts everything: All information—earnings, news, sentiment—is already reflected in the price.

  2. Price moves in trends: Prices tend to follow identifiable patterns, whether upward, downward, or sideways.

  3. History repeats itself: Human behavior creates recurring trends that can be predicted by studying past price movements.