Section 5: Technical Analysis

There is enough discussion in Wall Street circles about technical analysis versus fundamental analysis to fill many volumes. The term technical analysis refers to the study of stock charts and their patterns. It differs from fundamental analysis, which is the study of company fundamentals (such as corporate earnings, growth prospects, management, etc.).

Generally, these two forms of analysis are the basis of two schools of thought to predict the behavior of stocks. People who believe almost exclusively in studying company fundamentals include most Wall Street analysts, financial advisors, and the mainstream media "stock pickers". Some of the more avid believers of fundamental analysis are not only critical of technical (chart) analysis, some of them equate the usage of chart patterns with reading tea leaves and fortune telling. The fundamentalist will insist that the only sure way to profit on stocks is to invest in companies with solid earnings potential, and that any kind of prediction using chart analysis is, at best, proven only in hindsight.

The technical analyst, on the other hand, believes that a properly interpreted stock chart contains everything you would ever need to know about a stock. They argue that the stock's price fluctuations and volume reflect the composite knowledge that all investors have about the company, that charts contain everything that can be known about the stock. They believe that the patterns will therefore contain more information about the company than a lone fundamental analyst could ever dream of obtaining.

Which one is right—Technician or Fundamentalist?

Both are right, or neither, depending on your point of view, and here's why. As we discussed in previous sections, stock prices fluctuate as a result of investor speculation. On one hand, there is no better way to assess what investors are speculating on than by examining charts—price and volume action will indicate what stocks are hot, or not. On the other hand, why are investors speculating in the first place? Because they perceive that the company fundamentals warrant buying or selling of the stock.

However, for the purposes of trading, we are only  interested in technical analysis, because chart patterns, when intepreted properly, reveal everything that could be known about the underlying company. Oddly enough, such information even reflects the opinion of fundamental anlysts, those who don't even believe in stock chart patterns in the fist place. Fundamental analysis should only be used to understand why a stock is behaving in a particular manner, never to determine a buy or sell for a stock.

For the purposes of trading, only technical analysis should be used, because a stock chart will reflect all conveivable knowledge about a stock, including company fundamentals and investor sentiment. Charts are the "window" into the composite mind of the market.

Much talk exists about technical analysis in various stock trading circles, with terms thrown around like "backing and filling," "head and shoulders," "basing," and other terms related to stock chart analysis. There are also many books on the subject of technical analysis, some of them being hundreds of pages of great complexity, and, frankly, not very useful.

Don't let any of this confuse you. While chart analysis is imperative for good stock trading, you only need to study four general components. These are:

• Price versus volume. The purpose of studying a chart is to recognize when traders are taking an active interest in a stock, either to the buy side or sell side. You will discover almost everything you need to know by watching the movement of a stock price in relationship to its volume.
• Trend versus time. Something as basic as a stock trend is often underestimated, even the by very best technicians, but it is one of the key components of stock analysis. A trend can simply be stated as the overall direction that a stock is taking in a defined period of time (such as an hour, a day, a week, a month, etc.). An uptrend is when a stock makes higher highs and higher lows as it advances across a certain unit of time; a downtrend is when the stock makes lower highs and lower lows.
• Channeling. All stocks tend to trade in a specific range, or a channel. A channel developes for a stock because it tends to form support and resistance levels (discussed in detail later on). Although some trading systems use channeling exclusively (which is not recommended), understanding this technology can be a valuable tool when screening for potential trades.
  
  

Stock technicians have devised many various methods of analyzing these four components, some of them are more complicated than others, but it all comes down to price vs. volume, trend vs. time, suport and resistance, and a stock's moving average(s). The fact that these four components can be shown in a myriad of different ways is why technical analysis seems complex. But if you understand these basic components, chart analysis is simple.

 

Candlestick Two-tone Charts

 

A candlestick chart is the format of choice for stock trading, mainly because it provides the maximum information at a glance. Candlestick charts, originating in Japan, are called by this name because the chart elements look similar to candles.

 

A typical candlestick chart. Each notation looks like a “candle,” hence its name.

 

Candle Interpretation

 

Each "candle" in a chart contains enough information to show the open, close, high and low point of the price during that interval. For instance, if the chart interval is a day, then each "candle" shows the opening price of the stock, its highest price, lowest price, and its close, as indicated below.

 

 

Don't worry if you can't remember the exact meaning of the “candle” format. The two important points to recognize are the price swing during the chart interval (the overall height of the “candle”), and whether or not the wide portion is hollow (a hollow candle indicates that the stock closed higher than it opened).

 

Two-Tone

 

A tow-tone chart is preferable for trading, because a two-tone chart will instantly reveal up action versus down action (that is, buying versus selling). Usually, two-tone charts are displayed in blue and red, blue for up action and red for down action.

 

 

If you haven't used candlestick charts before, they may take getting used to, but once you become comfortable with them, you will realize the importance of their value.

 

Also, don't get too hung up in the detailed notations of each mark on a "candle." When you analyze a stock, the most significant aspect is whether or not the action was up or down, and in some cases, the range of its price swing in the unit of time you are interested in.

 

The Price-Volume Relationship

 

The single most important aspect to interpreting a chart is to learn the relationship between price and volume. In fact, if you took all the literature ever written on technical analysis, almost all of it boils down to various methods of interpreting this relationship.

 

Reading the Tape

 

In the fictionalized autobiography of the legendary Jesse Livermore, much reference is made to "reading the tape." The "tape," in his day, was the paper ticker tape that printed all the trades at the New York Stock Exchange. It was said that Livermore would be able to watch the ticker tape, sometimes for hours on end, then suddenly know the precise moment that a stock would rise or fall. He often referred to it as a "sixth sense," an art that has to be acquired, and difficult to teach.

 

All that Jesse Livermore ever did, really, was observe the price fluctuations in relationship to volume. The "sixth sense" was the same sense that a trained musician has for playing "by ear", or the same sense that a major league baseball manager has when he notices a pitcher may be running out of steam. It is the simple art of observation and to read what is there.

 

To the degree that you can "read the tape" is the degree that you will spot good trades, and it is one of several goals in this book to teach you how to acquire this skill. (Fortunately, we don't have to rely on a paper tape in the 21st century, as we have streaming, real time charts to reveal the price/volume relationship).

 

Price versus volume is the portal, or "looking glass" that shows you what other traders (speculators) are up to.

 

The Simplest Example

Example of price versus volume. Stock “A” and “B” both have a noticeable increase in
volume on day 2, except stock “A” is going up, while stock “B” is going down.

The two charts above show price and volume action for the last couple of hours of a trading day and the first couple of hours of the next trading day. Notice that each stock shows a sharp rise in volume on day 2 versus day one. However, stock "A" is rising in price, while stock "B" is falling in price. This illustrates why a mere increase in volume is meaningless without also assessing the price direction.

In the case of stock "A", the volume is said to be up volume—there are more buyers than sellers (which is evident by the rise in price, if nothing else). For stock "B", the action is down volume, as there are more sellers than buyers (which is evident by the fall in price). It is important to note that a rise or fall in volume is relative, i.e., that an increase in volume simply means that it is larger than recent, previous volume---for the same stock.

 

A More Common Example

 

In the previous illustration, all that we know is that stock "A" has strong buying interest, while stock "B" has strong selling interest. While this would be helpful to know which one to buy (or which one to sell short), most stocks are not as straightforward with their price and volume action. More often, the action can shift midday, and can shift several times—presenting buying opportunities throughout the day.

 

An example of shifting momentum of price and volume. This is a more typical trading
pattern, and illustrates how you can use price and volume action to locate good buying opportunities.

The intra-day chart shown for CYMI (above) illustrates a more typical pattern of price and volume action. After the opening bell (1), heavy buying interest drives the stock up, but then the price begins to fall (2), which indicates that the early up volume has now turned into down volume (you know this by direction of the price). Then, the stock drifts only modestly to the upside as volume slows to a crawl (3). During this stretch, you would not trade the stock, even though it is rising slightly in price, because volume is light, indicating low interest. However, around 10:15, volume begins to increase sharply (4), and with a rising price. This indicates strong buying interest, which is a perfect time to buy the stock and enter the trade. Following price versus volume for the remainder of the day would indicate when and if you should exit. In this case, big selling occurs in the last several minutes (5), which you can determine by the fall in price with an increase in volume. You successfully exit the trade for about 4% gain—not bad for a two-hour hold!

Trends

 

Working with trends is one of the most important aspects to chart analysis, second only to price versus volume. There is an old saying on Wall Street, "The trend is your friend." Although overly simplified, this saying describes a key component to successful trading—the ability to spot a trend.

 

A trend can be described as the general direction of a stock. As a rule, an uptrend is a price movement that makes higher highs and higher lows, while a downtrend produces lower lows and lower highs (see below).

 

The above chart shows an uptrend, with each high point a little higher than the previous high, and each low point higher than the previous low. Interpreting a trend is useful, mainly because a stock that is locked into a particular trend will probably continue in that direction, at least for a while.

 

The chart below shows a downtrend, with each high and low point progressively lower.

 

Technically, the trend can be determined by drawing a line across the stock's high and low points, and it is the direction of the "slant" that indicates the trend. In practice, you don't need to literally draw lines, as you should train your eye to spot any trend, in any unit of time.

 

The Time Factor

 

In reality, a trend has no real meaning unless it is plotted against a known unit of time.

 

Consider the top chart (above) showing an uptrend, and notice that the uptrend is only true when plotted against the entire time frame shown (about 4 1/2 months). However, if we take a slice of time anywhere in the chart, we could see an entirely different trend. Hence, a trend should only be interpreted with relationship to your time horizon.

 

Notice that in the same chart for BVF (above), the 4-month trend is up, but the trend from late August to early October is decisively down. As you can see, a trend is only relative to a unit of time. If you were only interested in 3 or 4-month time horizons, then BVF has shifted trends several times during the 6-month period. For longer time horizons, the stock is simply on an uptrend.

 

Intra-day Trends

 

For short-term trading, trends are more important in the short run than they are for longer periods of time. In fact, a trend can be a predominate factor in very small time periods, even during the same trading day.

 

In the above chart for VRTS, notice that the stock is on a steep downtrend for nearly the first hour of trading. Then, the stock not only halts its decline, it locks into a firm uptrend for the remainder of the session. To say that this stock was on one particular trend or another during the day is not entirely accurate, because it shows two distinct trends—again, depending in your unit of time. If you are looking at the stock hour to hour, has has two distinctly different trends. If you looked at the whole unit of time (the entire day), then the trend is simply down (it is lower at the close than it was at the open).

Trend Reversals

 

A very powerful trading technique is to spot a trend reversal. This is when a particular trend reverses direction and goes the other way.

 

There are those on Wall Street that claim you can't really know for sure when a stock or the market will reverse its trend, but I beg to differ—it is easier to spot a trend reversal than many investors may think.

First, remember what a trend actually is: it is the making of higher highs and higher lows (uptrend), or lower lows and lower highs (downtrend). If that is the case, then a trend can be said to be broken, or reversing, when it deviates from its expected pattern.

 

For instance, suppose a stock, on a downtrend, continues to make lower lows and lower highs. Suddenly, it makes a higher high on an upswing. By the very definition of a trend, it has deviated from the downtrend, and is probably reversing.

 

 

The above Intra-day chart of the Dow Jones index illustrates a classic trend reversal. Notice that the index downtrends for the first half of the trading session, making progressively lower highs and lows. Then, shortly after 10:00, it moves above its previous high point. This is a clear indicator that the Dow could be reversing its trend. Later, around 11:30, the trend reversal is confirmed, as the index reaches a much higher level. Notice how the trend is then decisively up for the remainder of the trading session. The stock has reversed its trend.

 

 

The chart above shows another trend reversal, only this time the uptrend turns into a downtrend. Note how the Dow index ramps up nicely for the first hour of trading, levels out, but then flashes a trend reversal sign—achieving a lower low and a lower high. Shortly thereafter, it hits a new lower low and high, which is a confirmed reversal. The index promptly goes on a free fall, sliding all the way back to where it started. Had you bought any stock during the uptrend, you could have used these indicators as sell-signals.

 

Probabilities

 

One of the reasons that many investors don't think you can predict a trend is because it doesn't always work out. In some cases, the stock may momentary deviate from its trend, reaching, say, a higher high on a downtrend, but only to falter, and continue its downward direction. Just like life itself, nothing is an absolute certainty in the world of trading, almost anything can happen. But what you are calculating from chart interpretation is what a stock or market index will probably do.

 

Furthermore, you can increase your odds of success by waiting for a confirmation. (A confirmation is simply another movement in the direction that you already believe is probable). Notice in the trend reversal above that the new uptrend is confirmed, because it reaches a higher high, convincingly above its previous high point.

 

Essentially, your odds increase with each confirmation of a trend reversal.

 

Market Trends

 

A market trend is the trend of a major index such as the Dow, NASDAQ and S&P-500. Not only are market trends important, they are senior to stock trends, because most stocks follow the market's lead. In other words, whichever direction the Dow is trending, there is a tendency for the majority of all other stocks to follow suit.

 

Market trends work just like stock trends, i.e. you can view the Dow, NASDAQ, etc. on a chart, just like a stock, and you can view a daily trend, or an intra day trend in small intervals.

 

 

The above illustration shows a 1-minute interval of the Dow Jones Industrial average for a single trading day. The superimposed blue lines show the trend that the index took for the day, which was initially a downtrend, then the market reversed to go on an uptrend.

 

Tides and Boats

 

The trend of the market is senior to all other trends, because the market trend is the tide that floats (or sinks) all other boats. Although one may argue that it is actually the other way around (that the market index merely reflects what the majority of stocks are doing), the truth is that most stocks trade in tandem. Remember, the market operates on "mob" psychology. If stock "A" is selling off, there is a tendency for people to sell stock “B,” even if they had no logical reason to do so. If three industry groups are falling, so will two other groups. Rightly or wrongly, most stocks tend to travel side-by-side.

 

Part of the reason this occurs is because the heavy players—the big institutions such as mutual and pension funds—often trade whole "baskets" of stocks. With literally billions of dollars at their disposal, a single move can make or break whole groups of stocks simultaneously.

 

Whatever the reason, however, if you see a major index on a downtrend, you can reasonably assume that most stocks will follow suit, and if you see the index rally, it will soon become the tide that lifts many boats.

An Example

 

To illustrate the fact that most stocks follow the market's lead, consider the following Intra-day of the Dow when it reversed course midday.

 

 

After trending downward for half of the day, the illustration above shows a confirmed trend reversal late in the day. The following charts show what happened to four individual stocks, chosen at random, during the same trading day.

Notice that each of these stocks went on a strong run up, precisely at the same time that the Dow reversed its trend. These four were chosen at random, but there were literally hundreds of other similar examples during the day. Who ever said that you don't know what a stock will do, or when it will rally? Watch the market, and you will discover one of the most powerful trading tools at your disposal.

 

One other point to note is that each of these four stocks are on a slow uptrend during the day, prior to the Dow's trend reversal, which makes them even stronger candidates for a rally. To reiterate an earlier point, a trend indicates what direction a stock will probably go in the near future, and in each of these examples, the Dow's reversal helped them along.

 

Chart Analysis Summary

 

Chart analysis has been made too complex by some stock technicians, while ignored by fundamental analysts, yet it doesn't have to be complex, nor should it be ignored. A stock chart is the "looking glass" into what speculators have been up to, and what they are likely to do in the near future.

Proper interpretation of charts is the modern version of "reading the ticker tape." The rules are simple:

• The relationship between price and volume is the single most important aspect to chart analysis. A stock moving higher on increasing volume indicates strong, positive speculation on a stock, whereas moving lower on higher volume indicates a strong, negative speculation.
• A stock's trend indicates the direction the stock will probably go in the near future. This single fact, in relationship to volume, is a very powerful trading tool.
• By definition, a stock is said to have reversed its trend if it begins to make higher highs and higher lows after downtrending, or lower highs and lower lows after uptrending. Such a trend reversal is more certain when the stock confirms this change by making one more step in the new direction.
• A trend has more meaning when it is associated to volume. For instance, an uptrend or downtrend is more significant the more volume it has behind its movement.
• A market trend is more important, and senior to a stock trend, because most stocks follow the market's lead.
• Channeling is a method of spotting the support and resustance levels of a sock, or recent trading range of a stock, which can help determine the likely level that a stock will rise of fall. However, a more powerful use of channeling is to spot when a stock breaks out of a trading range, which is a very significant indicator.
• Channeling, by itself, is not a workable strategy, and must therefore be used in conjunction with other indicators such as price versus volume, trend, and moving averages. Used in this way, channeling can help you narrow the field to a handful of good trading candidates.
   

Winning Patterns