Technical analysis:::::
Technical Analysis is the forecasting of future financial price
movements based on an examination of past price movements. Like weather
forecasting, technical analysis does not result in absolute predictions
about the future. Instead, technical analysis can help investors
anticipate what is "likely" to happen to prices over time. Technical
analysis uses a wide variety of charts that show price over time.
Technical analysis is applicable to stocks, indices, commodities,
futures or any tradable instrument where the price is influenced by the
forces of supply and demand. Price refers to any combination of the
open, high, low, or close for a given security over a specific time
frame. The time frame can be based on intraday (1-minute, 5-minutes,
10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly
price data and last a few hours or many years. In addition, some
technical analysts include volume or open interest figures with their
study of price action.
At the turn of the century, the
Dow Theory
laid the foundations for what was later to become modern technical
analysis. Dow Theory was not presented as one complete amalgamation, but
rather pieced together from the writings of Charles Dow over several
years. Of the many theorems put forth by Dow, three stand out:
Price Discounts Everything
Price Movements Are Not Totally Random
"What" Is More Important than "Why"
This theorem is similar to the strong and semi-strong forms of market
efficiency. Technical analysts believe that the current price fully
reflects all information. Because all information is already reflected
in the price, it represents the fair value, and should form the basis
for analysis. After all, the market price reflects the sum knowledge of
all participants, including traders, investors, portfolio managers,
buy-side analysts, sell-side analysts, market strategist, technical
analysts, fundamental analysts and many others. It would be folly to
disagree with the price set by such an impressive array of people with
impeccable credentials. Technical analysis utilizes the
information captured by the price to interpret what the market is saying
with the purpose of forming a view on the future.
Most technicians agree that prices trend. However, most technicians
also acknowledge that there are periods when prices do not trend. If
prices were always random, it would be extremely difficult to make money
using technical analysis. In his book,
Schwager on Futures: Technical Analysis, Jack Schwager states:
"One way of viewing it is that markets may witness extended periods
of random fluctuation, interspersed with shorter periods of nonrandom
behavior. The goal of the chartist is to identify those periods (i.e.
major trends)."
A technician believes that it is possible to identify a trend, invest or
trade based on the trend and make money as the trend unfolds. Because
technical analysis can be applied to many different time frames, it is
possible to spot both short-term and long-term trends. The IBM chart
illustrates Schwager's view on the nature of the trend. The broad trend
is up, but it is also interspersed with trading ranges. In between the
trading ranges are smaller uptrends within the larger uptrend. The
uptrend is renewed when the stock breaks above the trading range. A
downtrend begins when the stock breaks below the low of the previous
trading range.
In his book,
The Psychology of Technical Analysis,
Tony Plummer paraphrases Oscar Wilde by stating, "A technical analyst
knows the price of everything, but the value of nothing". Technicians,
as technical analysts are called, are only concerned with two things:
What is the current price?
What is the history of the price movement?
The price is the end result of the battle between the forces of supply
and demand for the company's stock. The objective of analysis is to
forecast the direction of the future price. By focusing on price and
only price, technical analysis represents a direct approach.
Fundamentalists are concerned with why the price is what it is. For
technicians, the why portion of the equation is too broad and many times
the fundamental reasons given are highly suspect. Technicians believe
it is best to concentrate on what and never mind why. Why did the price
go up? It is simple, more buyers (demand) than sellers (supply). After
all, the value of any asset is only what someone is willing to pay for
it. Who needs to know why?
Many technicians employ a top-down approach that begins with
broad-based macro analysis. The larger parts are then broken down to
base the final step on a more focused/micro perspective. Such an
analysis might involve three steps:
Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
Sector analysis to identify the strongest and weakest groups within the broader market.
Individual stock analysis to identify the strongest and weakest stocks within select groups.
The beauty of technical analysis lies in its versatility. Because the
principles of technical analysis are universally applicable, each of the
analysis steps above can be performed using the same theoretical
background. You don't need an economics degree to analyze a market index
chart. You don't need to be a CPA to analyze a stock chart. Charts are
charts. It does not matter if the time frame is 2 days or 2 years. It
does not matter if it is a stock, market index or commodity. The
technical principles of support, resistance, trend, trading range and
other aspects can be applied to any chart. While this may sound easy,
technical analysis is by no means easy. Success requires serious study,
dedication and an open mind.
Technical analysis can be as complex or as simple as you want it. The
example below represents a simplified version. Since we are interested
in buying stocks, the focus will be on spotting bullish situations.
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines,
moving averages
or peak/trough analysis. As long as the price remains above its uptrend
line, selected moving averages or previous lows, the trend will be
considered bullish.
Support:
Areas of congestion or previous lows below the current price mark
support levels. A break below support would be considered bearish.
Resistance:
Areas of congestion and previous highs above the current price mark the
resistance levels. A break above resistance would be considered
bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential
moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with
volume figures available, an indicator that uses volume is used to
measure buying or selling pressure. When
Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The
price relative
is a line formed by dividing the security by a benchmark. For stocks it
is usually the price of the stock divided by the S&P 500. The plot
of this line over a period of time will tell us if the stock is
outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Strength of the current trend.
Maturity or stage of current trend.
Reward to risk ratio of a new position.
Potential entry levels for new long position.
For each segment (market, sector and stock), an investor would analyze
long-term and short-term charts to find those that meet specific
criteria. Analysis will first consider the market in general, perhaps
the S&P 500. If the broader market were considered to be in bullish
mode, analysis would proceed to a selection of sector charts. Those
sectors that show the most promise would be singled out for individual
stock analysis. Once the sector list is narrowed to 3-4 industry groups,
individual stock selection can begin. With a selection of 10-20 stock
charts from each industry, a selection of 3-4 of the most promising
stocks in each group can be made. How many stocks or industry groups
make the final cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which
to choose. These stocks could even be broken down further to find the
3-4 of the strongest of the strong.
If the objective is to predict the future price, then it makes sense to
focus on price movements. Price movements usually precede fundamental
developments. By focusing on price action, technicians are automatically
focusing on the future. The market is thought of as a leading indicator
and generally leads the economy by 6 to 9 months. To keep pace with the
market, it makes sense to look directly at the price movements. More
often than not, change is a subtle beast. Even though the market is
prone to sudden knee-jerk reactions, hints usually develop before
significant moves. A technician will refer to periods of
accumulation as evidence of an impending advance and periods of
distribution as evidence of an impending decline.
Many technicians use the open, high, low and close when analyzing the
price action of a security. There is information to be gleaned from each
bit of information. Separately, these will not be able to tell much.
However, taken together, the open, high, low and close reflect forces of
supply and demand.
The annotated example above shows a stock that opened with a gap up.
Before the open, the number of buy orders exceeded the number of sell
orders and the price was raised to attract more sellers. Demand was
brisk from the start. The intraday high reflects the strength of demand
(buyers). The intraday low reflects the availability of supply
(sellers). The close represents the final price agreed upon by the
buyers and the sellers. In this case, the close is well below the high
and much closer to the low. This tells us that even though demand
(buyers) was strong during the day, supply (sellers) ultimately
prevailed and forced the price back down. Even after this selling
pressure, the close remained above the open. By looking at price action
over an extended period of time, we can see the battle between supply
and demand unfold.
In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
Simple chart analysis can help identify support and resistance levels.
These are usually marked by periods of congestion (trading range) where
the prices move within a confined range for an extended period, telling
us that the forces of supply and demand are deadlocked. When prices move
out of the trading range, it signals that either supply or demand has
started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Even if you are a tried and true fundamental analyst, a price chart can
offer plenty of valuable information. The price chart is an easy to
read historical account of a security's price movement over a period of
time. Charts are much easier to read than a table of numbers. On most
stock charts, volume bars are displayed at the bottom. With this
historical picture, it is easy to identify the following:
Reactions prior to and after important events.
Past and present volatility.
Historical volume or trading levels.
Relative strength of a stock versus the overall market.
Technical analysis can help with timing a proper entry point. Some
analysts use fundamental analysis to decide what to buy and technical
analysis to decide when to buy. It is no secret that timing can play an
important role in performance. Technical analysis can help spot demand
(support) and supply (resistance) levels as well as breakouts. Simply
waiting for a breakout above resistance or buying near support levels
can improve returns.
It is also important to know a stock's price history. If a stock you
thought was great for the last 2 years has traded flat for those two
years, it would appear that Wall Street has a different opinion. If a
stock has already advanced significantly, it may be prudent to wait for a
pullback. Or, if the stock is trending lower, it might pay to wait for
buying interest and a trend reversal.
Just as with fundamental analysis, technical analysis is subjective and
our personal biases can be reflected in the analysis. It is important
to be aware of these biases when analyzing a chart. If the analyst is a
perpetual bull, then a bullish bias will overshadow the analysis. On the
other hand, if the analyst is a disgruntled eternal bear, then the
analysis will probably have a bearish tilt.
Furthering the bias argument is the fact that technical analysis is
open to interpretation. Even though there are standards, many times two
technicians will look at the same chart and paint two different
scenarios or see different patterns. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify
their position. While this can be frustrating, it should be pointed out
that technical analysis is more like an art than a science, somewhat
like economics. Is the cup half-empty or half-full? It is in the eye of
the beholder.
Technical analysis has been criticized for being too late. By the time
the trend is identified, a substantial portion of the move has already
taken place. After such a large move, the reward to risk ratio is not
great. Lateness is a particular criticism of
Dow Theory.
Even after a new trend has been identified, there is always another
"important" level close at hand. Technicians have been accused of
sitting on the fence and never taking an unqualified stance. Even if
they are bullish, there is always some indicator or some level that will
qualify their opinion.
Not all technical signals and patterns work. When you begin to study
technical analysis, you will come across an array of patterns and
indicators with rules to match. For instance: A sell signal is given
when the neckline of a head and shoulders pattern is broken. Even though
this is a rule, it is not steadfast and can be subject to other factors
such as volume and momentum. In that same vein, what works for one
particular stock may not work for another. A 50-day moving average may
work great to identify support and resistance for IBM, but a 70-day
moving average may work better for Yahoo. Even though many principles of
technical analysis are universal, each security will have its own
idiosyncrasies.
Technical analysts consider the market to be 80% psychological and 20%
logical. Fundamental analysts consider the market to be 20%
psychological and 80% logical. Psychological or logical may be open for
debate, but there is no questioning the current price of a security.
After all, it is available for all to see and nobody doubts its
legitimacy. The price set by the market reflects the sum knowledge of
all participants, and we are not dealing with lightweights here. These
participants have considered (discounted) everything under the sun and
settled on a price to buy or sell. These are the forces of supply and
demand at work. By examining price action to determine which force is
prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be
applied, it must be remembered that technical analysis is more an art
form than a science. As an art form, it is subject to interpretation.
However, it is also flexible in its approach and each investor should
use only that which suits his or her style. Developing a style takes
time, effort and dedication, but the rewards can be significant.
A rare reversal pattern characterized by a gap followed by a Doji,
which is then followed by another gap in the opposite direction. The
shadows on the Doji must completely gap below or above the shadows of
the first and third day. 
A bearish reversal pattern that continues the uptrend with a long
white body. The next day opens at a new high then closes below the
midpoint of the body of the first day. 
Doji form when a security's open and close are virtually equal. The
length of the upper and lower shadows can vary, and the resulting
candlestick looks like, either, a cross, inverted cross, or plus sign.
Doji convey a sense of indecision or tug-of-war between buyers and
sellers. Prices move above and below the opening level during the
session, but close at or near the opening level. 
A continuation pattern with a long, black body followed by another
black body that has gapped below the first one. The third day is white
and opens within the body of the second day, then closes in the gap
between the first two days, but does not close the gap. 
A Doji where the open and close price are at the high of the day. Like
other Doji days, this one normally appears at market turning points. 
A reversal pattern that can be bearish or bullish, depending upon
whether it appears at the end of an uptrend (bearish engulfing pattern)
or a downtrend (bullish engulfing pattern). The first day is
characterized by a small body, followed by a day whose body completely
engulfs the previous day's body. 
A three day bearish reversal pattern similar to the Evening Star. The
uptrend continues with a large white body. The next day opens higher,
trades in a small range, then closes at its open (Doji). The next day
closes below the midpoint of the body of the first day. 
A bearish reversal pattern that continues an uptrend with a long white
body day followed by a gapped up small body day, then a down close with
the close below the midpoint of the first day. 
A bearish continuation pattern. A long black body is followed by three
small body days, each fully contained within the range of the high and
low of the first day. The fifth day closes at a new low. 
A doji line that develops when the Doji is at, or very near, the low of the day. 
Hammer candlesticks form when a security moves significantly lower
after the open, but rallies to close well above the intraday low. The
resulting candlestick looks like a square lollipop with a long stick. If
this candlestick forms during a decline, then it is called a Hammer. 
Hanging Man candlesticks form when a security moves significantly
lower after the open, but rallies to close well above the intraday low.
The resulting candlestick looks like a square lollipop with a long
stick. If this candlestick forms during an advance, then it is called a
Hanging Man. 
A two day pattern that has a small body day completely contained
within the range of the previous body, and is the opposite color. 
A two day pattern similar to the Harami. The difference is that the last day is a Doji. 
A one day bullish reversal pattern. In a downtrend, the open is lower,
then it trades higher, but closes near its open, therefore looking like
an inverted lollipop. 
A long day represents a large price move from open to close, where the length of the candle body is long. 
This candlestick has long upper and lower shadows with the Doji in the
middle of the day's trading range, clearly reflecting the indecision of
traders. 
Candlesticks with a long upper shadow and short lower shadow indicate
that buyers dominated during the first part of the session, bidding
prices higher. Conversely, candlesticks with long lower shadows and
short upper shadows indicate that sellers dominated during the first
part of the session, driving prices lower. 
A candlestick with no shadow extending from the body at either the
open, the close or at both. The name means close-cropped or close-cut in
Japanese, though other interpretations refer to it as Bald or Shaven
Head. 
A three day bullish reversal pattern that is very similar to the
Morning Star. The first day is in a downtrend with a long black body.
The next day opens lower with a Doji that has a small trading range. The
last day closes above the midpoint of the first day. 
A three day bullish reversal pattern consisting of three candlesticks -
a long-bodied black candle extending the current downtrend, a short
middle candle that gapped down on the open, and a long-bodied white
candle that gapped up on the open and closed above the midpoint of the
body of the first day. 
A bullish two day reversal pattern. The first day, in a downtrend, is a
long black day. The next day opens at a new low, then closes above the
midpoint of the body of the first day. 
A bullish continuation pattern in which a long white body is followed
by three small body days, each fully contained within the range of the
high and low of the first day. The fifth day closes at a new high. 
A single day pattern that can appear in an uptrend. It opens higher,
trades much higher, then closes near its open. It looks just like the
Inverted Hammer except that it is bearish. 
A short day represents a small price move from open to close, where the length of the candle body is short.
Candlestick lines that have small bodies with upper and lower shadows
that exceed the length of the body. Spinning tops signal indecision. 
A candlestick that gaps away from the previous candlestick is said to
be in star position. Depending on the previous candlestick, the star
position candlestick gaps up or down and appears isolated from previous
price action. 
A bullish reversal pattern with two black bodies surrounding a white
body. The closing prices of the two black bodies must be equal. A
support price is apparent and the opportunity for prices to reverse is
quite good. 
A bearish reversal pattern consisting of three consecutive long black
bodies where each day closes at or near its low and opens within the
body of the previous day. 
A bullish reversal pattern consisting of three consecutive long white
bodies. Each should open within the previous body and the close should
be near the high of the day. 
A three day bearish pattern that only happens in an uptrend. The first
day is a long white body followed by a gapped open with the small black
body remaining gapped above the first day. The third day is also a black
day whose body is larger than the second day and engulfs it. The close
of the last day is still above the first long white day. 
A continuation pattern with a long white body followed by another
white body that has gapped above the first one. The third day is black
and opens within the body of the second day, then closes in the gap
between the first two days, but does not close the gap. 
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