Introduction to Technical Analysis
There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements.
Technical analysis is about analysis of supply and demand in the market to determine where the price trend is going. In other words, technical analysis attempts to understand the market sentiment behind price trends
What is Technical Analysis?
Technical analysis is a method of evaluating securities that involves a statistical analysis of market activity, such as price and volume. Technical uses charts and other tools to identify patterns that can be used as a basis for investment decisions.
There are many different forms of technical analysis: Some rely on chart patterns, others use technical indicators and oscillators, and most use a combination of techniques. In any case, technical analysts’ exclusive use of historical price and volume data
What is a chart?
Charts are simply graphical representations of a series of prices over time. For example, a chart might show a stock’s price movement over a one-year period where each point represents an individual day’s closing price. Or, a chart might show a commodity’s price movement over a period of just one hour with each point representing one second. The common denominator is that price is typically on the Y-axis and time is usually on the X-axis.Figure 0
Figure 0 shows an example of a basic stock chart for Alphabet Inc. (GOOGL). It’s a representation of the price movement of a stock over a roughly six-month period. The bottom of the chart, running horizontally (X-axis), is the date or time scale. On the right-hand side, running vertically (Y-axis), is the price of the security. This type of chart – known as a candlestick chart – shows the daily price range of a stock that’s represented by the length of each bar.
Type of Charts
There are four primary types of charts used by investors and traders depending on the type of information they’re seeking and their desired goals.
These chart types include line charts, bar charts, candlestick charts, and point and figure charts.
1. Line Charts
Line charts are the most basic type of chart because it represents only the closing prices over a set period. The line is formed by connecting the closing prices for each period over the timeframe.
2. Bar Charts
Bar charts expand upon the line chart by adding the open, high, low, and close – or the daily price range, in other words – to the mix. The chart is made up of a series of vertical lines that represent the price range for a given period with a horizontal dash on each side that represents the open and closing prices. The opening price is the horizontal dash on the left side of the horizontal line and the closing price is located on the right side of the line.
3. Candlestick Charts
Candlestick charts originated in Japan over 300 years ago, but have since become extremely popular among traders and investors. Like a bar chart, candlestick charts have a thin vertical line showing the price range for a given period that’s shaded different colors based on whether the stock ended higher or lower. The difference is a wider bar or rectangle that represents the difference between the opening and closing prices.
4. Point and Figure Charts
Point and figure charts are not very well known or used by the average investor, but they have a long history of use dating back to the first technical traders. The chart reflects price movements without time or volume concerns, which helps remove noise – or insignificant price movements – that can distort a trader’s view of the overall trend. These charts also try to eliminate the skewing effect that time has on chart analysis.
The idea of a trend is perhaps the most important concept in technical analysis. The meaning in finance isn’t all that different from the general definition of the term – a trend is really nothing more than the general direction in which a security or market is headed.Take a look at the following chart: Figure 1 – 5-Year S&P 500 SPDR (SPY) Chart
It isn’t difficult to see the trend higher in Figure 1. However, it’s not always that easy, as demonstrated in Figure 2 below. Figure 2 – 2-Month S&P 500 (SPY) Chart
There are a lot of ups and downs in this chart, but there isn’t a clear definition of which direction the stock is headed.
A Formal Definition
Trends aren’t always easy to spot because prices almost never move in straight lines. Rather, prices tend to move in a series of highs and lows over time. In technical analysis, it is the overall direction of these highs and lows that constitute a trend. An uptrend is classified as a series of higher highs and higher lows, while a downtrend consists of lower lows and lower highs.Figure 3 – Trend Diagram
Figure 3 is an example of an uptrend. Each of the high points of the trend – 2, 4, and 6 – are higher than the previous high, while each of the low points of the trend – 3 and 5 – are higher than the previous low. For the uptrend to continue, the next low point must be above 5 and the next high point must be above 6, else the trend will be deemed a reversal.
Types of TrendsThere are three types of trends:
- Sideways / Horizontal Trends
Sideways or horizontal trends occur when there is little movement up or down in the peaks and troughs of a trend
In addition to their direction, trends can be classified in terms of their length. Most traders consider trends short-term, intermediate-term, or long-term. Long-term trends occur over a timeframe of longer than one year; intermediate-term trends occur over one to three months; and, short-term trends occur over less than one month.
Here’s an example of how these trend lengths look in practiceFigure 4 – Trend Comparisons
When analyzing a trend, it’s important that the chart is constructed to best reflect the type of trend being analyzed. Daily or weekly charts are best for identifying long-term trends, while minute or hourly charts are best for short-term trends. It is also important to remember that long-term trends carry greater weight than short-term trends. For instance, a one-month trend isn’t as significant as a five-year trend.
A trendline is a simple charting technique whereby a line is added to a chart to represent the trend in a market or stock. Drawing a trendline is as simple as drawing a straight line that connects lower lows or higher highs to show the general trend direction. These lines are used to cut through the noise and show where the price is headed, as well as identify areas of support and resistance.Figure 5 – Trendline Examples
Figure 5 shows an example of a downtrend trendline where the stock price experiences resistance, as well as an uptrend trendline where the stock price experiences support.
A channel consists of two trendlines that act as strong areas of support and resistance with the price bouncing around between them. The upper trendline consists of a series of highs, while the lower trendline consists of a series of lows. A channel can slope upward, downward, or sidewaysFigure 6 – Price Channel
Figure 6 illustrates a sideways channel where the upper trendline connects a series of highs and the lower trendline connects a series of lows. When the price breaks out from the upper trendline, the upper trendline becomes a new support level as the stock moves higher.
Support and resistance
Support and resistance are the next major concept after understanding the concept of a trend. You’ll often hear technical analysts talk about the ongoing battle between bulls and bears, or the struggle between buyers (demand) and sellers (supply).
Support levels are where demand is perceived to be strong enough to prevent the price from falling further, while resistance levels are prices where selling is thought to be strong enough to prevent prices from rising higher.Figure 6 – Price Channel
As you can see in Figure 6, the price channel from the previous section, the bottom trendline represents a key support level while the upper trendline represents a key resistance level. The arrows near the top and bottom trendlines show the levels where the price seldom surpassed until it broke out higher. After the breakout, the upper trendline transitioned from a resistance level to a support level for the new trend.
Indicators represent a statistical approach to technical analysis by looking at trends, volatility, and momentum, they provide a secondary measure to actual price movements and help traders confirm the quality of chart patterns
Oscillators are the most common type of technical indicator and are generally bound within a range. For example, an oscillator may have a low of 0 and a high of 100 where zero represents oversold conditions and 100 represents overbought conditions.
The accumulation/distribution line is one of the most popular volume indicators that measures money flow in a security. The indicator attempts to measure the ratio of buying and selling by comparing the price movement of a period to the volume for that period.
The calculation is:
Acc/Dist = ((Close – Low) – (High – Close)) / (High – Low) * Period’s Volume
Average Directional Index
The average directional index (ADX) is a trend indicator that’s used to measure the strength of the current trend – although it has limited use identifying the direction of the current trend.
The ADX is comprised of the positive directional indicator (+DI) and the negative directional indicator (-DI). The +DI measures the strength of the uptrend while the –DI measures the strength of the downtrend. These two measures are also plotted along with the ADX line that measures on a scale between zero and 100.
Moving Average Convergence/Divergence
The moving average convergence-divergence (MACD) is one of the most powerful and well-known indicators in technical analysis. The indicator is comprised of two exponential moving averages that help measure momentum in a security. The MACD is simply the difference between these two moving averages plotted against a centerline, where the centerline is the point at which the two moving averages are equal.