Technical Analysis

A fundamental principle of technical analysis is that a market's price reflects all relevant information, so their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior - hence technicians' focus on identifiable trends and conditions. This type of analysis is not foolproof, but in most cases can give a trader a relatively good idea of the future movement of an equity's price pattern.

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart. Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.

Tools of the Technical Analyst

There are dozens of tools available to the technician. One can spend virtually all of their time engaged in analysis, and never actually get to trading. While acknowledging that each tool has its own merits, we are going to focus on the basic tools employed by virtually every successful trader. They will be listed in order of importance. These tools can be applied in less than 10 minutes once you become familiar with their application. In addition, they are available through a variety of free charting websites such as stockcharts.com, bar charts.com, stockta.com, and by most online brokers.

1. Trend Lines

Technical analysis is built on the assumption that prices trend. Trend lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well.

An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.

A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be imminent.

Note; socks are only in an uptrend or downtrend approximately 30% of the time. The rest of the time they are what is known as rangebound, or trading between support and resistance levels. To determine the strength of the moment, look that the ADX on the underlying security. An ADX figure above 25 indicates a strong trend. A figure of below 20 indicates no trend at all. Between 20 and 25 is open to interpretation.

2. Support And Resistance

A support level is a price level where the price tends to find support as it is going down. This means the price is more likely to "bounce" off this level rather than break through it. Think of support as a temporary floor for the share price. This would be the area in which a trader would use a bullish strategy. However, once the price has passed this level, by an amount exceeding some noise, it is likely to continue dropping until it finds another support level.

A resistance level is the opposite of a support level. It is where the price tends to find resistance as it is going up. This means the price is more likely to "bounce" off this level rather than break through it. Think of resistance as a temporary ceiling for the share price. This is an area where a trader would use a bearish strategy. However, once the price has passed this level, by an amount exceeding some noise, it is likely that it will continue rising until it finds another resistance level.

Learning to draw support and resistance lines can be challenging for new traders. Fortunately, there are many free websites which will do it for you. Once such site is www.stockta.com.

3. Volume

When analyzing volume, there are guidelines we can use to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness - or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they are a good general aid in trading decisions.

A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume show lack of interest and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed. Conversely, when the price of a stock is dropping but the volume is getting weaker and weaker, a price reversal could be in the offing.

Another signal observed by smart traders is the difference of volume on up days vs. down trading days. Since no stock moves in one direction, check out whether the up or down days have greater associated volume. It is a likely omen of things to come. This is how the pros do it!

4. Moving Averages

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days’ price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex types of moving averages (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we’ll focus on the type just described, which are called ‘simple (a.k.a. arithmetic) moving averages’.

When deciding whether a particular security is bullish, bearish or stagnant, we normally look at two moving averages and two moving average crossovers (the crossover you choose will be based on your anticipated holding period).

The first is the 50 day moving average. This is an intermediate indicator which lets the trader know if the stock is trending up or down. If the equity price is above its 50 DMA, it is considered a bullish signal (never own a stock trading below this level), and below this line the stock is considered bearish. Equities priced at or near their 50 DMA are considered ambivalent and show no real strong propensity to move in one direction or the other. Crossing the 50 DMA line constitutes a potential change in direction.

Next, we have the 200 day moving average. This gives us a longer term view, but is otherwise used just like the 50 DMA. Investors are bullish or bearish depending on whether the security is trading above or below this price level.

Now let's talk about moving average crossovers using two different timeframes. Generally speaking, when using two moving averages, the shorter moving average will dictate whether a stock is bullish or bearish. A very popular pairing is the 50 and 200 DMAs. When the 50 DMA is above the 200 DMA, the stock is considered to be in an uptrend (validate by drawing trend lines on the chart). When the 50 DMA crosses below the 200 DMA, traders see this as a signal to move from a bullish to a bearish strategy. This indicator is so powerful that it is referred to as 'the golden cross'. When this cross is accompanied with strong volume, it is considered a very powerful indicator.

For traders looking for shorter term entry points (like most options traders), take a look at the relationship between the

5 DMA and the 20 DMA. When the 5 DMA crosses above the 20 DMA, this is a good time to enter a bullish trade (provided your other signals are in alignment). When the 5 DMA crosses below the 20 DMA, it could be a good time to enter a bearish trade (given a bearish trend and confirming signals).

5. MACD

A lot of traders do not know how to use the MACD correctly. The MACD is a trend-following momentum indicator developed by Gerald Appel that shows the relationship between two moving averages of price (normally the close). The MACD line is calculated by taking the difference between a longer-period and shorter-period exponential moving average. It is the interaction of these two moving averages that gives the indicator its name. Over time, the two moving averages are constantly converging and diverging. Exponential averages are used because they respond more quickly to changes in price, since more weight is placed on the most recent price compared to the earlier prices.

Crossovers are probably the most popular use of MACDs: a sell signal is generated when the MACD crosses below the signal line, and a buy signal is generated when the MACD crosses above the signal line. In addition, the locations of these crossovers in relation to the zero line are helpful in determining buy and sell points. Bullish signals are more significant when the crossing of the MACD line over the signal line takes place below the zero line. Confirmation takes place when both lines cross above the zero line. Using the MACD in this way makes it a lagging indicator. Just like moving averages-which are also lagging indicators-the MACD works best in strong trending markets. Both the MACD and moving averages are intended to keep you on the “right” side of the market (on the long side during uptrends and on the short side or out of the market altogether during downtrends), meaning you buy and sell late.

6. RSI

The Relative Strength Index (RSI) is another momentum indicator. It indicates the current and historical strength or weakness of a market based on the closing prices of completed trading periods. It assumes that prices close higher in strong market periods and lower in weaker periods. It then computes this as a ratio of the number of incrementally higher closes to the incrementally lower closes. It then compares the magnitude of recent price gains to recent price losses in to determine overbought and oversold conditions of a market.

It is important to understand that the RSI is a "running" calculation and the accuracy of the calculation depends on how long ago the calculations started (timeframe). The first RSI value is an estimate - subsequent values improve on that estimate. Thus, calculating at a minimum of 14 days, and going up from there, provides more accurate RSI values.

The RSI is plotted on a scale that ranges from 0 to 100. A market is deemed overbought as the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the market may be getting oversold and, therefore, likely to become undervalued. Both instances could mark a trend reversal. When the numbers get above 80 or below 20, they really catch our attention as that level of strength or weakness is typically not sustainable. The centerline for RSI is 50. Readings slightly above or slightly below can give the indicator a bullish or bearish tilt.

Anytime we find a fundamentally strong equity moving out of an oversold position, we are likely to take a bullish trade. Conversely, weak stocks driven to the point of being over purchased are great candidates for bearish strategies. The RSI can also be used as a confirming tool working in conjunction with your other indicators.

7. Bollinger Bands

Bollinger Bands are a technical trading tool created by John Bollinger in the early 1980s. They arose from the need for adaptive trading bands and the observation that volatility was dynamic, not static as was widely believed a the time.

The purpose of Bollinger Bands is to provide a relative definition of high and low (much like the RSI). By definition prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.

Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.

As the price of a security approaches the lower band, it may be oversold and ready to rebound. The opposite is true when the price of the equity nears the upper band. The wider the bands, the greater the recent historical price movement of the security in question. When the bands form a narrow channel, this should alert traders that there is a good change the stock will break out substantially to the upside or the downside (normally the direction of the previous long term trend).

Putting It All Together

As a technical analyst (or fundamental analyst using technical indicators for the purposes of timing entry and exit points) you are simply employing certain tools to help predict the future behavior of any investment instrument. Independently, each of these indicators offer only limited reliability in making predictions of future pricing. But when used in concert with one another, they are a very powerful and predictive set of instruments. They help to answer the following important questions:

  • What is the overall trend of the market, and the particular security on your radar screen?
  • Might this movement be impeded by either support or resistance levels in the near future?
  • Does the volume indicate that the investors are gaining or losing interest in the direction?
  • Is the security trading at, above, or below its moving averages?
  • What kind of message is the MACD sending?
  • Could this equity be overbought or oversold, indicating a strong possibility for a reversal?
  • Is the security trading near the top, bottom, or middle of its range and how large is the trading range?

Once you have the answers to these questions, you should be able to place profitable trades on a fairly consistent basis.

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