How to use technical analysis to shortlist stocks to trade and invest

One of the biggest problems in the stock market is identifying which stock to buy. This becomes more of a problem when you have to choose from a sector. Your attention gets drawn to a sector because of some event or news flow or simply because stocks from the sector are doing well. So, you decide to focus your investment into stock(s) from that sector.

Now comes the tricky part. Every sector has many stocks as a part of it (at least, a good sector as far as the market is concerned, should have candidates for every kind of market player). If the news flow is positive for a sector, it is not going to be so across-the-board within the sector.

Moreover, stocks have uneven performances and, therefore, their pricing will happen basis their individual performances. Unfortunately, almost no small investor has much capability to analyse the performance of the company.

How does one then solve the problem of stock selection?

Here is where technical analysis comes to your rescue. It operates on a simple premise – that the market knows best! The market is composed of all kinds of people, many of whom possess skills to analyse or are either privy to information. Collectively, their action of buying and selling creates the price of the day.

Thus, all relevant information is already in the price. When these prices are taken and studied over a period of time, a trend emerges. The trend, as the saying goes, is the ultimate friend of the technical analyst. He uses the trend element of the stock to separate out different stocks from the sector. The ones showing the strongest trends are the ones being preferred by the market currently.

Therefore, it all comes down to just one thing: Is there a trend visible on the chart? If yes, then the stock can be shortlisted for trading and investing. Note here, that the trends can be up or down.

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A trader can go both ways while an investor would be interested in uptrends only. To gauge the trend accurately, we would need to see all the charts. But that has practical difficulties.

After all, there are more than 2,000 stocks that trade every day. So first thing to do is to create a shortlist where we can then look at charts. We can do this very efficiently by using various technical indicators. The beauty is that technical analysis shall allow you to create the kind of list you wish to create. The whole idea here is to reduce the 2,000+ traded stocks down to a more manageable list of say 20 and then take a look at their charts for more details.

Technical analysts use price and volume. From these we can also derive market breadth data as well as create indicator data. All these are available in any standard software. We can use them separately or in combination. We can also look at prices using patterns such as Candlesticks and Ichimoku and Heiken Aashi. Again, these are also available in standard software.

With a little bit of common sense, one can string together any combination of all the above. Many software offer pre-designed scanning strings. I have created my own software called NeoTrader that takes scanning to a totally different level, producing trades and creating high level processed data ready for analysis.

Prices can be looked at through different time frames. Thus, you can create price bars that range from, say, 5 minutes all the way to monthly or quarterly. Traders can look at shorter timeframes while investors can look for longer timeframes.

The simplest way to create a list is to use a moving average. Conceptually, a moving average (MA) acts as a divider of price trends – if prices are trading above the MA level, then it is on an uptrend and if below, then it is on a downtrend. Since MA can be computed for different time lengths, this also allows one to create multiple lists. Almost every software has some capabilities to run a scan for price levels vis-à-vis the MA level. So, a trader, for example can choose to look for stocks that are above the 10-DMA or where the 8-DMA crosses above the 21-DMA. Price status and crossover status are the two main signals that one checks here.

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Aggressive traders can look for the signals using, say, 15-min charts. In that case, they will get a list for intraday trades. Momentum players can use the same scan on daily data to get plays for the following day. Positional traders can use the same scan on weekly data to get multi-day or multi-week playlists. Long-term investors often look at whether prices are above or below the 200 DMA, as this is taken as a reliable indicator of the long-term trend. One can experiment with different time lengths of the MA. The study of data indicator over different time frames is a massive area in TA and we can create many lists using those. But it does require some knowledge about the indicator so that one knows what type of list one is producing.

Each indicator has its own logic and, therefore, shall produce a different list. As an example, one of the most popular indicators is the Relative Strength Index (RSI). One can run a scan asking for a list of stocks, where the RSI moves up or where its level is already above 60-70 (indicating strong uptrend) or below 40-30 (indicating strong downtrend).

Pattern studies are direct price action studies (MAs and indicators are derivatives of price) and give us a different list. Candlestick is all about different types of patterns and these can be looked at in any time frame chart. One needs to have an understanding of the important patterns and can easily scan for those patterns to create a list.

Ichimoku and Heiken Ashi are also Japanese candle technics that have specific settings that tell us about the trend status. These can be queried specifically.

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Standard software can scan candlesticks but only some specialised software will be able to do Ichimoku and Heiken Ashi. There are also more complex patterns like Elliot Wave, but they require specialised software.

Each of these will give you a list. One should not go overboard creating lists. One can try to finetune the list by looking for signal overlaps. So one can combine, for example, an MA scan with a candlestick scan. We can look for an upward crossing of a 21-DMA along with a Long Body Bull Candle Pattern as a bullish signal. And so on.

Once you have a list, you have the probable candidates that can be expected to be in action in the immediate future. This allows you to focus on a few stocks and raises your chances to profit from the market. Please note that it is entirely possible that the market may choose to ignore your list! But if you do this diligently every day, you will end up on the right side of the market a good chunk of the time. Moreover, you will avoid the pitfalls of trading or investing in the wrong set of stocks. That is a bigger gain than it seems. Money not lost is almost as important as money made!

For small investors and traders, technical analysis and market scanners are invaluable tools to ensure that they stay in the game and can create a sharp focus on what needs to be done.



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