Chapter 4-2 Introduction to Technical Analysis

The methods used to analyze and predict the performance of a company’s stock fall into two broad categories:  fundamental and technical analysis.  Those who use technical analysis look for peaks, bottoms, trends, patterns and other factors affecting a stock’s price movement and then make buy/sell decisions based on those factors.  It is a technique many people attempt, but few are truly successful at it.

The world of technical analysis is expansive.  There are literally hundreds of different patterns and indicators that traders claim to have success with.  We have tried to keep this tutorial as short as possible.  Our goal in this lesson is to introduce you to the different types of stock charts and the various technical analysis tools available to traders.

 

What Is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, past prices and volume.  Technical analysts do not attempt to measure a security’s intrinsic value; instead they look at stock charts for patterns and indicators that will determine a stock’s future performance.

Technical analysis has become increasingly popular over the past several years, as more and more people believe that the historical performance of a stock is a strong indication of future performance.  The use of past performance should come as no surprise.  People using fundamental analysis have always looked at the past performance of companies by comparing fiscal data from previous quarters and years to determine future growth.  The difference lies in the technical analyst’s belief that securities move according to very predictable trends and patterns.  These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable.

There are many instances of traders successfully trading a security using only their knowledge of the security’s chart, without even understanding what the company does.  However, although technical analysis is a tremendously helpful tool, most agree it is much more effective when used in combination with fundamental analysis, especially when participating in longer-term trades. Let’s take a look at some of the major charts and indicators used by technical analysts.

 

Charts

 

The Bar Chart

 

 equities-content-image-4-2-3 The bar chart is one of the most popular types of charts used in technical analysis.  As illustrated on the left, the top of the vertical line indicates the highest price at which a security traded during a set timeframe (in this case, 1 minute), and the bottom represents the lowest price.  The closing price is displayed on the right side of the bar and the opening price is shown on the left side of the bar.  A single bar, like the one to the left, represents any desired timeframe, from as little as 1 minute of trading activity to as much as one day, one week, or even one month.

 

The chart below is an example of a bar chart for WellPoint Health Networks (WLP):

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The advantage of using a bar chart over a straight line graph (type most commonly displayed on Internet websites, television shows, and in newspapers) is that it shows the high, low, open and close for each interval for a set timeframe.  For instance, in the example above the 2-minute bar chart shows the high, low, open, and close for every 2 minute interval.  This type of chart is what we will be using to display various indicators throughout this lesson.

 

The Candlestick Chart

equities-content-image-4-2-5Candlestick charts have been around for hundreds of years.  They are often referred to as “Japanese candles” because the Japanese would use them to analyze the price of rice contracts. Similar to a bar chart, candlestick charts also display the open, close, high and low for any desired timeframe.  The difference is the use of color to show if the stock went up or down over that timeframe.

 

The chart below is an example of a candlestick chart for WellPoint Health Networks (WLP).  Green bars indicate the stock price rose, red indicates a decline:

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Traders seem to have a “love/hate” relationship with candlestick charts.  People either love them and use them frequently or they are completely turned off by them.  There are several patterns to look for with candlestick charts – here are a few of the popular ones and what they mean:

 equities-content-image-4-2-7 This is a bullish pattern – the stock opened at (or near) it’s low and closed near its high.
 equities-content-image-4-2-8 The opposite of the pattern above, this is a bearish pattern. It indicates that the stock opened at (or near) it’s high and dropped substantially to close near its low.
 equities-content-image-4-2-9 Known as “the hammer”, this is a bullish pattern only if it occurs after the stock price has dropped for several candles.  A hammer is identified by a small body along with a large range.  The theory is that this pattern can indicate that a reversal in the downtrend is in the works.
 equities-content-image-4-2-10 Known as a “star”, this pattern is used in other patterns such as the “doji star”. For the most part, stars typically indicate a reversal, and or indecision.  There is a possibility that after seeing a star there will be a reversal or change in the current trend.

 

Keep in mind that there are over 20 other patterns used by technical analysts for candlestick charting.  Should you choose to use candlesticks when charting, spend the appropriate time needed to truly understand the information being represented by the candlestick patterns and formations.

Indicators

Now that we’ve introduced you to the most common types of charts used by technical analysts, let’s take a look at various indicators.

 

Moving Averages

One of the easiest indicators to understand, the moving average, shows the average value of a security’s price over a period of time.  To find the 50-day moving average, you would add up the closing prices (but not always – we’ll explain later) from the past 50 days and divide them by 50.  Because prices are constantly changing, the moving average will move as well.  It should also be noted that moving averages are often used in comparison or in conjunction with other indicators, such as the Moving Average Convergence Divergence (MACD).

The most commonly used moving averages are of 15, 20, 50, 100 and 200 days.  Each moving average provides a different interpretation on what the stock will do – there is not one right timeframe.  The longer the time-span, the less sensitive the moving average will be to price changes.  Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations (or “noise”) that can confuse interpretation. Here is a visual example using the stock chart of US Steel Corp. (X):

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In the example above, the yellow line is the 20-period moving average, the orange is the 50, and the blue is the 200.  Notice that a longer timeframe, creates less, and thus more reliable, crosses (signals of reversals in trend).

 

Support and Resistance

Support and resistance are price levels at which movement should stop and reverse direction. Think of support/resistance (S/R) as levels that act as a floor or a ceiling to future price movements.

 

Support – A price level below the current market price, at which buying interest should be able to overcome selling pressure and thus keep the price from going any lower.

 

Resistance – A price level above the current market price, at which selling pressure should be strong enough to overcome buying pressure and thus keep the price from going any higher.

 

One of two things can happen when a stock price approaches a support/resistance level.  On the one hand, it can act as a reversal point:  in other words, when a stock price drops to a support level, it will go back up.  On the other hand, S/R levels may reverse roles once they are penetrated.  For example, when the market price falls below a support level, that former support level will then become a resistance level when the market later trades back up to that level.

Here is a visual example using the stock chart of US Steel Corp. (X):

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It is important to note that S/R levels vary in strength, leading to certain price levels being designated as major or minor S/R levels.  For example, a five-day high on a bar chart would be a much more significant and useful resistance level than an intra-day high resistance level.  Daily support and resistance levels are drawn the same for intraday charts as they are for daily charts.  Obviously, as discipline traders we do not give a stock too much room, so our levels have to be even more precise and we have to work much harder to find the appropriate level and entry.  Remember to always confirm your levels with the corresponding orders on the limit open book, tape, and/or ECNs to find a good entry/exit point.

 

The Relative Strength Index (RSI)

There are a few different tools that can be used to interpret the strength of a stock.  One of these is the Relative Strength Index (RSI), which is a comparison between the days that a stock finishes up and the days it finishes down.  This indicator is a big tool in momentum trading.

The RSI is a reasonably simple model that anyone can use.  It is calculated using the following formula.  (Don’t worry; you will probably never have to do this manually.)

 

RSI = 100 – [100 / (1 + RS)] where: RS = (Avg. of n-day up closes) / (Avg. of n-day down closes) n = days (most analysts use 9 to 15 day RSI)

 

The RSI ranges from 0 to 100. At around the 70 level, a stock is considered overbought and you should consider selling.  But this number is not written in stone:  in a bull market some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets.  Likewise, if the RSI approaches 30, a stock is considered oversold and you should consider buying.  Again, make the adjustment to 20 in a bear market.  The smaller the number of days used, the more volatile the RSI is and the more often it will hit extremes.  A longer term RSI is more rolling, fluctuating a lot less.  Different sectors and industries have varying threshold levels when it comes to the RSI.  Stocks in some industries will go as high as 75 to 80 before dropping back, while others have a tough time breaking past 70.  A good rule is to watch the RSI over the long-term (one year or more) to determine at what level the historical RSI has traded and how the stock reacted when it reached those levels.

Here is a visual example using the stock chart of US Steel Corp. (X):

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Using moving averages, trendlines, and support and resistance lines along with the RSI chart can be very useful.  Rising bottoms on the RSI chart can produce the same positive trend results as they would on the stock chart. Should the general trend of the stock price tangent from the RSI, it might spark a warning that the stock is either over or under bought.

The RSI is a great indicator that can help you make some serious money.  Be aware that big surges and drops in stocks will dramatically affect the RSI, resulting in false buy or sell signals.  Most traders agree that the RSI is most effective in “backing up” or confirming a decision.  Never make a trading or investing decision simply based on the RSI numbers.

 

Bollinger Bands

The Bollinger band indicator uses three lines:  the upper, the lower, and the simple moving average (SMA) that is between the two.  The upper/lower bands are plotted two standard deviations away from a SMA.  Standard deviation is a measure of volatility; therefore, Bollinger bands adjust themselves to market conditions.  When the markets become more volatile, the bands widen, and they contract during less volatile periods.  The closer the prices move to the upper band, the more overbought the stock is.  The closer the prices move to the lower band, the more oversold the stock is.

Below is an example using US Steel Corp. (X), which have the Bollinger bands in blue and the simple moving average in yellow:

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Bollinger bands are a good tool to use, but as we’ve been stating throughout this lesson, you should never trade or invest based solely on what just one indicator says.  Notice that there were instances when the stock touched the upper or lower band and did not react.  Rather than basing decisions on Bollinger bands, most traders use this indicator to confirm a decision.

 

Charting Patterns

Many people believe that history repeats itself.  Technical analysts often use proven, successful price patterns from stocks as tools to find new profitable moves in other stocks.  Let’s look at a few examples:

 

Cup and Handle

This is a slow developing pattern on a bar chart that can be as short as intra-day, but most commonly takes between 7 weeks to 65 weeks to form.  The cup is in the shape of a “U”.  The handle has a slight downward drift.  The right-hand side of the pattern has low trading volume.  As the stock comes up to test the old highs, the stock will incur selling pressure by the people who bought at or near the old high.  This selling pressure will make the stock price trade sideways with a tendency towards a downtrend for anywhere from four days to four weeks, then it will take off.

This popular pattern looks like a pot with a handle. It is one of the easier patterns to detect.

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Head and Shoulders

This is a chart formation resembling an “M” in which a stock’s price:  rises to a peak and then declines, then rises above the former peak and again declines, and then rises again but not to the second peak and again declines.

The first and third peaks are shoulders, and the second peak forms the head.  This pattern is considered a very bearish indicator.

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Double Bottom

This pattern resembles a “W” and occurs when a stock price drops to a similar price level twice within a short period of time. Look to buy when the price passes the highest point in the handle.  In a perfect double bottom, the second decline should normally go slightly lower than the first decline to create a shakeout of jittery traders.  The middle point of the “W” should not go into new high ground.  This is a very bullish indicator.

The belief is that, after two drops in the stock price, the jittery traders will be out and the long-term traders and investors will still be holding on.

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Conclusion Here are some points to remember about technical analysis:

 

  • Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, past prices, and volume.
  • The advantage of using a bar chart over a straight line graph is that it shows the high, low, open and close for each particular time interval.
  • One of the most basic and easy to use technical analysis indicators is the moving average, which shows the average value of a security’s price over a period of time.  The most commonly used moving averages are 15, 20, 50, 100 and 200 day.
  • Support and resistance levels are price levels at which movement should stop and reverse direction.  Think of support/resistance (S/R) as levels that act as a floor or a ceiling to future price movements.

There are literally hundreds of different price patterns and indicators out there.  While no one indicator is enough to justify an entry or an exit in a position, an indicator can be used to help confirm a decision.  Moreover, make sure you familiarize yourself with as many price patterns and formations as possible.  By doing so, your ability to identify high probability setups will improve dramatically, thus making your stock selection process much easier.

Questions