What is a technical analysis?
Everyone of us dreamed about wealth and happiness - even once. It's quite natural, because we were born to live well, to eat well, to dwell in nicely appointed, solid house or apartment and to have fabulous vacation, at least once a year. Reading this, above mentioned goals seemed to be quite obvious and realistic and not overreaching, but Our hard work becomes profitable, only when many terms and causes are fulfilled. Somebody have to had a demand for our skills and knowledge, have to appreciate our effort, and reward it with honest value. Is that always a case? Unfortunately - not always.
If you work for large corporation, monthly pay of your dreams seems to be just a drop in the bucket, comparing with capital gathered, but...
We can deprive themselves of many small pleasures, like dining out, latest film, or evening in the pub with friends, to save enough for a new car. Finally, we got one. Its brand new, shiny, as we wanted. We still deprive ourselves, to realize another dream. Meanwhile, our car depreciating, loosing value every month. It will be fulfilled to, but...
Just like bad dream - we chase something, almost reaching, but we can't grab it.
Lets say we opened an investment account in prestigious broker house, and buying some stock. Its price go down and we loose money or otherwise its increasing, and we gain. Why this happened?
Stocks & bonds prices go up when there are more buyers than sellers and fell down in opposite situation. Why this happened?
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There are four types of technical analyses concerning price fluctuations:
First: Fundamental one. In a case of actions, it evaluating company finances, estimating future income and capital gain perspectives. In a case of bonds, given country prime rate tendencies. In a case of commodities future contracts, accessibility and world wide production development possibilities are evaluated. In cases of currencies, general economic condition and socio - political circumstances in the country of origin are taken into consideration.
Second: Psychological one, evaluating general market moods and investors strategies, judging from central banks behavior, like prime rate trends. Another important clue is how those trends are spreading around, and to what extend. Sheep flock - like trends are usually dangerous, causing great instability, both in good and bad times.
Third: Astrological one, looking to the stars and heavenly bodies for human behavior explanations. Halley/Bop comet, clearly visible on the sky in 1997/98 break, caused quite unexpected stir I in agricultural crops future contracts in New York CSCE exchange. Example: Arabica coffee green beans futures went up 125% in three months!
Fourth: Technical one, based solely on mathematical interpretations of various price trend graphs. Such an analysis, supported by oscillations detecting formulas, can help to find optimum moment for financial instruments purchase or sale, after detecting certain price levels.
Technical Analysis: Introduction
There are two major types of analysis for predicting the performance of a company's stock - fundamental and technical. The latter looks for peaks, bottoms, trends, patterns, and other factors affecting a stock's price movement and then making a buy/sell decision based on those factors. It is a technique many people attempt, though very few are truly successful.
Today, the world of technical analysis is huge. There are literally hundreds of different patterns and indicators investors claim to be successful. Trying to keep this tutorial short was not an easy task, but we will try our best to scratch the surface and introduce you to the different types of stock charts and the various technical analysis tools.
If you are new to the market and don't have a solid understanding of the various securities, we'd recommend you check out our tutorials on stock basics, bond basics and mutual funds.
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 for patterns and indicators on stock charts that will determine a stocks future performance.
Technical analysis has become 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 not come as a big surprise. People using fundamental analysis have always looked at the past performance 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 with very predictable trends and patterns. These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable.
Some technical analysts claim they can be extremely accurate a majority of the time. There are many instances of investors successfully trading securities with only the knowledge of its chart and without even understanding what the company does. Technical analysis is a terrific tool, but most agree that it is much more effective when combined with fundamental analysis.
Let's now look at some of the major indicators technical analysts use.
Technical Analysis: What is Technical Analysis?
Bar charts are some of the most popular type of charts used in technical analysis. As illustrated on the left, the top of the vertical line indicates the highest price a security traded at during the day, 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 one day of trading.
Candlestick 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, daily high, and daily low. The difference is the use of color to show if the stock was up or down over the day.
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Technical Analysis: The Point & Figure Chart
This type of chart is somewhat rare, in fact most charting services do not even offer the point and figure chart. This is a chart that plots day-to-day increases and declines in price. Increases are represented by a rising stack of X's while decreases are represented by a declining stack of O's. These types of charts were traditionally used for intraday charting (a stock chart for just one day), mainly because it can be long and tedious to create P&F charts over a longer period of time manually.
The idea behind P&F charts is that they help you to filter out less-significant price movements and let you focus more on the most important trends. Below is an example of a Point and Figure chart for AT&T (T):
Technical Analysis: Using the Moving Average
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 most often used when compared or used in conjunction with other indicators such as MACD and EMA.
The most commonly used moving averages are of 20, 30, 50, 100, and 200 days. Each moving average provides a different interpretation on what the stock will do, there is not one right time frame. The longer the time span, the less sensitive the moving average will be to daily 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.
Technical Analysis: Using the Relative Strength Index
When talking about the strength of a stock there are a few different interpretations, one of which is the Relative Strength Index (RSI). The RSI is a comparison between the days that a stock finishes up against 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 with the following formula. (Don't worry, most likely, you will 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 - 15 day RSI)
The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level and you should consider selling. 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 shorter 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 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (1 year or more) to determine what level the historical RSI has traded at and how the stock reacted when it reached those levels.
Technical Analysis: The Money Flow Index
Now that we've taken a look at the Relative Strength Index (RSI), let's take a look at a more stringent momentum indicator. The Money Flow Index measures the strength of money flowing into and out of a stock. The difference between the RSI and Money Flow is that where RSI only looks at prices, the Money Flow Index also takes volume into account.
Calculating Money Flow is a bit more difficult than the RSI:
First we need the average price for the day:
Average Price = (Day High + Day Low + Close) / 3
Now we need the Money Flow:
Money Flow = Average Price x Day's Volume
Now, to calculate the money flow ratio you need to separate the money flows for a period into positive and negative. If the price was up in a particular day this is considered to be "Positive Money Flow". If the price closed down it is considered to be "Negative Money Flow".
Money Flow Ratio = Positive Money Flow / Negative Money Flow
It is the Money Flow Ratio that is used to calculate the Money Flow Index.
The Money Flow ranges from 0 to 100. Just like the RSI, a stock is considered overbought in the 70- 80 range and oversold in the 20-30 range.
The shorter number of days you use, the more volatile the Money Flow is. For the example below we will use a 14 day average.
Technical Analysis: Using Bollinger Bands
There are three lines used for the Bollinger band indicator: the upper, lower, and the simple moving average that is between the two. These upper/lower bands are plotted two standard deviations away from a simple moving average. Standard deviation is a measure of volatility, therefore Bollinger Bands adjust themselves to the 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 General Electric (GE). Bollinger bands are blue for the lower, green for the average, and red for the upper band:
We have circled three key points on this chart. The blue circle is where the stock price started to create a "base" on the lower band, it appeared that the stock was over sold. Buying at this point would have been a wise choice, as the stock proceeded to jump 20% or more in the next few weeks.
The two red circles are areas where the stock price was touching or breaking through the upper red band. This is usually an indication that the stock is over bought. In both instances, the stock dropped substantially in following weeks.
The Bollinger bands are a good tool to use, but as we've been preaching all along, never invest solely based on what just one indicator says. Notice there were instances when the stock touched the upper or lower band and did not react. Rather than basing their investment decisions on Bollinger, many investors use this indicator mainly to solidify a decision they are about to make.
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 - is 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 - is 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. The first is, it can act as a reversal point, in other words, when a stock price drops to a support level, it will go back up. The other possibility is that S/R levels 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.
The chart above shows an excellent example of support and resistance levels for General Electric (GE). Notice that once the stock price penetrated below the support level in December, it became the resistance level.
Another characteristic you should understand is that S/R levels vary in strength, leading to certain price levels being designated as major or minor S/R levels. For example, a 5 year high on a bar chart would be a much more significant and useful resistance level than a 1 month resistance level.
Many believe that history repeats itself. Using successful and proven price patterns from great stocks is a widely used method by technical analysts. Let's take a look at a few examples:
* Cup and Handle - This is a pattern on a bar chart that can be as short as 7 weeks and as long as 65 weeks. 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 4 days to 4 weeks, then it takes off.
It looks like a pot with handle. Investors have made a lot of money using this pattern, which is one of the easier to detect.
* Head and Shoulders - A chart formation that resembles 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.
* Double Bottom - Occurs when a stock price drops to a similar price level twice within a few weeks or months, the double-bottom pattern resembles a ?W". You should 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 investors. 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 investors are out and long-term investors are still holding on.
There have been entire volumes of textbooks written on technical analysis, this tutorial just scratches the surface. Technical analysis is one of those fields where everyone has a different theory on what works and what doesn\'t. If we can leave you with one last tip, it is to back test whatever strategy you decide to pursue. Back testing means looking back at several years\' worth of charts to see how a particular stock reacts. Different stocks do different things, so be sure to do your homework first.
Here are a couple 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 day.
- * One of the most basic and easy to use TA 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 the 20, 30, 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 100s of different price patterns and indicators out there.
- * In our humble opinion, technical analysis is a terrific tool, but much more effective when combined with fundamental analysis.
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