Technical Analysis (TA) like all market indicators are not solid buy or sell signals, they are indicators that must be used in conjunction with other forms of analysis. When done right, TA is a powerful tool. To start, lets break some myths.

Myth #1: TA is Bullshit

TA is a self-fulfilling prophecy. Trading is done by humans, trading psychology in itself is an entire methodology. Charts, regardless of what they track, display similar patterns. A Japanese rice trader by the name of Munehisa Homma understood this, and in 1755 wrote San-en Kinsen Hiroku, The Fountain of Gold; the first book on market psychology. He is also the inventor of the candlestick chart. This is why a lot of TA has Japanese names, Doji, Ichimoku Clouds, etc. Homma was the first to say “when all are bearish, there is cause for prices to rise”.

Myth #2: TA is all you need

TA is a tool, in the same way Fundamental Analysis (FA; real world events) is a tool for trading. Using TA in conjunction with FA is the best way to formulate a trading strategy.

Myth #3: More is Better

If your charts are loaded with 3+ indicators, your doing it wrong. More is not better. In the same way watching charts all day will give you an understanding of price action, you should watch the same indicators and learn how they react to price action. Learn and master no more than 2–3 indicators. Overstepping this rule will lead to analysis paralysis.

The Holy Trinity: On Balance Volume (OBV), Rate of Change (ROC), Relative Strength Index (RSI)

OBV: Relates price and cumulative total volume. Meaning when price goes up, OBV should go up, and vice versa. The idea is volume is higher on days when the price is moving in the predominant direction. OBV typically does not show divergences, however when it does its a powerful signal. When this indicator does not agree with price action, that is called a divergence.

ROC: Shows the difference between todays closing price and the close N days ago. This indicator should also agree with price action, as price moves up, ROC moves up and vice versa. When assets find a bottom there is generally a large ROC move. When this indicator does not agree with price action, that is called a divergence.

RSI: The RSI is classified as a momentum oscillator, measuring the velocity and magnitude of directional price movements. Momentum is the rate of the rise or fall in price. The RSI computes momentum as the ratio of higher closes to lower closes: stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes. When this indicator does not agree with price action, that is called a divergence.

Theory to Reality

Notice how RSI and OBV are making upwards moves while the stock is trading sideways. This sideways movement would normally mean nothing, however due to the bullish divergences from OBV and RSI it shows this sideways movement is ACCUMULATION. Traders are accumulating (buying) the stock at these levels.

CAG in 2008. Notice the significantly higher highs from the indicators and a double bottom from the price action. Notice how ROC and RSI begin to show bullish divs around 2 weeks before a significant rebound. OBV begins to show a bullish div on the second touch to the resistance line.

Altria (MO). HUGE bullish divergences across RSI and ROC. Notice how OBV made a higher high before the price action, which soon followed suit.

Huge bullish divergences for Kellog. Still waiting for this one to really pop. Notice how large the OBV divergence is. When you see this, its great.

Considerations

1. Check Market Health

Your asset may show divergences across multiple indicators, but if the market as a whole tanks these are meaningless. Check market health, don’t trade into heavy resistance/support.

2. Backtest, Backtest, Backtest

Stocks may show divergences, and it may be meaningless. Always backtest, generally using 2007–2008/other crashes. If the backtest shows 4/5 times bullish divergences lead to price gains, your good to go. If the backtest shows divergences are meaningless with this particular stock, there is no reason to believe times are different now, move on.

3. Look for Large Downward Moves to Find Large Upward Moves

AKA buy very low, sell a little higher. Knife catching isn’t difficult if your using indicators to help find bottoms. Use FinViz to find stocks that are trading well below All Time Highs (ATH), then use indicators to see if its near a bottom.

4. Use Daily and Weekly Timeframes

If divergences are showing across one time frame, thats good but not great. If divergences are showing across multiple time frames, thats great. Ignore monthly charts as generally they aren’t helpful. Daily and Weekly should be your bread and butter.

5. TA is a Self-Fulfilling Prophecy

The more people that use TA, the more powerful it is. Cryptocurrency is a great example of this. There is essentially no FA. No earnings, no disclosure, nada. The only methodology of trading is technicals. Bitcoin plays resistance/support levels like someone dipping their toes in hot water.