Technical Analysis
November 2007
Jan Oplatek
Technical Analysis
Technicians (sometimes called chartists) are only
interested in the price movements in the market.
Despite all the fancy and exotic tools it employs,
technical analysis really just studies supply and demand
in a market in an attempt to determine what direction, or
trend, will continue in the future.
In other words, technical analysis attempts to understand
the emotions in the market by studying the market itself,
as opposed to its components.
Assumptions
The market discounts everything
Technical analysts believe that the company's fundamentals, along
with broader economic factors and market psychology, are all priced
into the stock, removing the need to actually consider these factors
separately. This only leaves the analysis of price movement, which
technical theory views as a product of the supply and demand for a
particular stock in the market.
Price moves in trends
This means that after a trend has been established, the future price
movement is more likely to be in the same direction as the trend
than to be against it.
History tends to repeat itself
The repetitive nature of price movements is attributed to market
psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical
analysis uses chart patterns to analyze market movements and
understand trends
Chart
A graphical representation of a series of prices
over a set time frame
Time Scale
Daily
Weekly
...
Price Scale
Linear
Logarithmic
Chart Types
Linear
Bar
Candle
Point & Figure
Linear Chart
Closing price
Bar Chart
Candlestick Chart
Point & Figure Chart
Xs represent upward price
trends
Os represent downward
price trends.
Each box on the chart
represents the price scale,
which adjusts depending on
the price of the stock: the
higher the stock's price the
more each box represents.
On most charts where the
price is between $20 and
$100, a box represents $1,
or 1 point for the stock.
Trend
The general direction in which a security
or market is headed
Trends
Uptrend
a series of higher highs and higher lows
Downtrend
A series of lower lows and lower highs
Sideways
lack of a well-defined trend in either direction
Trend Lengths
Long term, Intermediate & Short term
Channel
Support, Resistance
Forces: Supply & Demand
Rounded numbers
Support, Resistance ­ Role Reversal
Once broken, takes opposite role
Volume
Number of shares traded
The higher the volume, the more active the
security
It is used to confirm trends and chart
patterns.
Any price movement up or down with
relatively high volume is seen as a
stronger, more relevant move than a similar
move with weak volume.
If you are looking at a large price
movement, you should also examine the
volume to see whether it tells the same
story
Price is preceded by volume. If volume is
starting to decrease in an uptrend, it is
usually a sign that the upward run is about
to end.
Chart Patterns
Distinct formation on a stock chart that
creates a trading signal, or a sign of future
price movements.
Chartists use these patterns to identify
current trends and trend reversals and to
trigger buy and sell signals.
Head and Shoulders
Signals the security is likely to move against the previous trend.
Two versions of the head-and-shoulders pattern.
The head-and-shoulders top is a signal that a security's price is set to fall, once
the pattern is complete, and is usually formed at the peak of an upward trend.
The second version, the head-and-shoulders bottom (also known as inverse
head and shoulders), signals that a security's price is set to rise and usually
forms during a downward trend.
Cup and handle
Bullish continuation pattern
where the upward trend has
paused, and traded down,
but will continue in an
upward direction upon the
completion of the pattern.
This pattern can range from
several months to a year,
but its general form remains
the same.
Double Top
Is found at the peaks of an upward trend
and is a clear signal that the preceding
upward trend is weakening and that buyers
are losing interest.
The first stage of this pattern is the creation
of a new high during the upward trend,
which, after peaking, faces resistance and
sells off to a level of support. The next stage
of this pattern will see the price start to
move back towards the level of resistance
found in the previous run-up, which again
sells off back to the support level.
The pattern is completed when the security
falls below (or breaks down) the support
level that had backstopped each move the
security made, thus marking the beginnings
of a downward trend.
Double Bottom
Reversal to Double Top
Wait till resistance level is really broken
Symetrical Triangle
Signals a period of consolidation
in a trend followed by a
resumption of the prior trend. It is
formed by the convergence of a
descending resistance line and an
ascending support line.
The two trendlines in the formation
of this triangle should have a
similar slope converging at a point
known as the apex.
The price of the security will
bounce between these trendlines,
towards the apex, and typically
breakout in the direction of the
prior trend.
Ascending Triangle
Bullish pattern, which
gives an indication that
the price of the security is
headed higher upon
completion.
The pattern is formed by
two trendlines: a flat
trendline being a point of
resistance and an
ascending trendline
acting as a price support.
Descending Triangle
Bearish signal to chartists,
suggesting that the price
will trend downward upon
completion of the pattern.
The descending triangle is
constructed with a flat
support line and a
downward-sloping
resistance line.
Flag
The slope of the flag should move
in the opposite direction of the
initial sharp price movement; so if
the initial movement were up, the
flag should be downward sloping.
The buy or sell signal is formed
once the price breaks through the
support or resistance level, with the
trend continuing in the prior
direction.
This breakthrough should be on
heavier volume to improve the
signal of the chart pattern.
Pennant
looks like a symmetrical
triangle, where the support
and resistance trendlines
converge towards each
other.
Very similar to Flag
Wedge
Falling & Rising Wedge
Similar to triangles, but longterm
(3-6 months)
Gaps
Empty space between one trading period and the previous trading
period. They usually form because of an important and material
event that affects the security, such as an earnings surprise or a
merge agreement.
There are four main types of gaps:
Common,
Breakaway,
Runaway
Exhaustion.
Each are the same in structure, differing only in their location in the
trend and subsequent meaning for chartists.
Common Gap
occurs often in the price
movements of a security.
These types of gaps often occur
when a security is trading in a
range and will often be small in
terms of the gap's price movement.
They can be a result of commonly
occurring events, such as lowvolume
trading days or after an
announcement of a stock split.
These gaps often fill quickly,
moving back to the pre-gap price
range.
Breakaway Gap
Occurs at the beginning of a market
move - usually after the security has
traded in a consolidation pattern
It is referred to as a breakaway gap
as the gap moves the security out
of a non-trending pattern into a
trending pattern.
The strength of this gap (and the
accuracy of its signal) can be
confirmed by looking at that volume
during the gap.
The greater the volume out of the
gap, the more likely the security will
continue in the direction of the gap,
also reducing the chances of it
being filled.
Runaway gap
Is found around the middle
of a trend, usually after the
price has already made a
strong move.
It is a healthy sign that the
current trend will continue
as it indicates continued,
and even increasing,
interest in the security
Exhaustion gap
Forms at the end of a trend and is a
negative sign that the trend is about to
reverse.
This usually occurs at the last thrusts of
a trend (typically marked with panic or
hype), but can also be the point when
weaker market participants start to move
in or out of the security.
The exhaustion gap usually coincides
with an irrational market philosophy,
such as the security being touted as "a
can't-miss opportunity" or conversely as
something to "avoid at all costs".
The gap should be marked with a large
amount of volume.
Island Reversal
Formed by a gap
followed by flat trading
and then confirmed by
another gap in the
opposite direction.
This pattern is a
strong signal of a top
or bottom in a trend,
indicating a coming
shift in the trend.
Triple Top
This chart pattern represents
the markeťs attempt to move a
security in a certain direction.
After three failed attempts, the
buyers (in the case of a top) or
sellers (in the case of a bottom)
give up, and the opposing
group in the market takes a
hold of the security, sending it
downward (sellers) or upward
(buyers)
Bearish pattern
Difficult to spot in the early
stages as it will initially look like
a double-top pattern
Triple Bottom
Reversal to Triple Top
The price objective will
also initially be calculated
as the distance of the chart
pattern added to the price
breakout.
So if the chart pattern is
formed between $50 and
$30 at a price breakout of
$50 the price objective is
$70 ($50+$20)
Rounding Bottom
looks similar to a cup and
handle, but without the handle.
long-term reversal pattern that
signals a shift from a downtrend
to an uptrend.
This pattern is traditionally
thought to last anywhere from
several months to several years.
Due to the long-term look of
these patterns and their
components, the signal and
construct of these patterns are
more difficult to identify than
other reversal patterns.
Moving Averages
Among the most popular technical indicators, moving averages are
used to gauge the direction of the current trend.
Every type of moving average (commonly written MA) is a
mathematical result that is calculated by averaging a number of past
data points.
Once determined, the resulting average is then plotted onto a chart
in order to allow traders to look at smoothed data rather than
focusing on the day-to-day price fluctuations that are inherent in all
financial markets.
Types:
Simple
Exponential
Simple Moving Average
Problems:
Short-term averages respond
quickly to changes in the price of
the underlying, while long-term
averages are slow to react.
Exponentially Weighted Moving Average
The exponential moving average is a type
of moving average that gives more weight
to recent prices in an attempt to make it
more responsive to new information.
Difference between SMA & EMA
Using MA ­ Confirm Trends
Lagging Indicator
Many traders will only
consider holding a long
position in an asset when
the price is trading above a
moving average.
This simple rule can help
ensure that the trend
works in the traders' favor.
Using MA - Momentum
Place three moving averages onto a
chart and then pay close attention to
how they stack up in relation to one
another
Using MA - Support
falling price of an
asset will often
stop and reverse
direction at the
same level as an
important average
Using MA - Resistance
Using MA ­ Stop loss
The ability of moving
averages to identify
strategic places to set
stop-loss orders
allows traders to cut
off losing positions
before they can grow
any larger.
Indicators & Oscillators
Indicators are calculations based on the price and the volume of a
security that measure such things as money flow, trends, volatility
and momentum.
Indicators are used as a secondary measure to the actual price
movements and add additional information to the analysis of
securities.
Indicators are used in two main ways: to confirm price movement
and the quality of chart patterns, and to form buy and sell signals.
Indicators which are bound within a range are called oscillators these
are the most common type of indicators.
Oscillator indicators have a range, for example between zero and
100, and signal periods where the security is overbought (near 100)
or oversold (near zero).
Non-bounded indicators still form buy and sell signals along with
displaying strength or weakness, but they vary in the way they do
this.
Momentum
A leading indicator
Rate of change
Momentum=price/price(n periods ago)X100
Cross-overs, divergences
Moving Average Convergence Divergence - MACD
Created by Gerald Appel in the 1960s
The MACD is calculated by subtracting
the 26-day exponential moving average
(EMA) from the 12-day EMA.
A nine-day EMA of the MACD, called the
"signal line", is then plotted on top of the
MACD, functioning as a trigger for buy
and sell signals.
Moving Average Convergence Divergence - MACD
The idea behind this momentum indicator is to measure
short-term momentum compared to longer term
momentum to help signal the current direction of
momentum.
When the MACD is positive, it signals that the shorter
term moving average is above the longer term moving
average and suggests upward momentum.
The opposite holds true when the MACD is negative this
signals that the shorter term is below the longer and
suggest downward momentum.
When the MACD line crosses over the centerline, it
signals a crossing in the moving averages.
www.wikipedia.org
Trading with MACD
1. Crossovers - when the MACD falls below the signal line,
it is a bearish signal, which indicates that it may be time to
sell. Conversely, when the MACD rises above the signal
line, the indicator gives a bullish signal, which suggests
that the price of the asset is likely to experience upward
momentum. Many traders wait for a confirmed cross above
the signal line before entering into a position to avoid
getting getting "faked out" or entering into a position too
early, as shown by the first arrow.
2. Divergence - When the security price diverges from the
MACD. It signals the end of the current trend.
3. Dramatic rise - When the MACD rises dramatically - that
is, the shorter moving average pulls away from the longerterm
moving average - it is a signal that the security is
overbought and will soon return to normal levels.
Traders also watch for a move above or below the zero
line because this signals the position of the short-term
average relative to the long-term average. When the
MACD is above zero, the short-term average is above the
long-term average, which signals upward momentum. The
opposite is true when the MACD is below zero. As you can
see from the chart above, the zero line often acts as an
area of support and resistance for the indicator.
MACD - DJI
Bigcharts.com
Relative Strength Index RSI
A technical momentum indicator that compares
the magnitude of recent gains to recent losses
in an attempt to determine overbought and
oversold conditions of an asset.
RSI = 100 - [100/(1 + RS)]
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 - a reason to consider selling. This
number is not written in stone, in a bull market
80 is a better level because stocks often trade
at higher valuations
Likewise, if the RSI approaches 30, a stock is
considered oversold - a cause consider buying
it. Again, make the adjustment to 20 in a bear
market.
Directional Movement Index DMI
Created in 1978 by J. Welles Wilder
DMI tells you when to be long or short
DMI is a moving average of range
expansion over a given period (default
14).
The positive directional movement
indicator (+DMI) measures how
strongly price moves upward;
The negative directional movement
indicator (-DMI) measures how strongly
price moves downward.
The two lines reflect the respective
strength of the bulls versus the bears.
Each DMI is represented by a separate
line
Top DMI ­ dominant one
Investopedia.com
Average Directional Index (ADX)
ADX ­ gauge the
strength
Below 20 ­ weak
Above 40 - strong
Thanks