Technical analysis is used to evaluate stocks by analyzing trends and movements in the stock price. In other words, you're looking at the stock's price chart and not the company's financial statements.
Price trends are a key idea in technical analysis. You can set up a screener to show a stock's price relative to its high or low over a specified period of time. If the price is trending towards new highs, you may want to become a buyer. On the other hand, short sellers looking to profit from a stock's decline would look for stocks heading for new lows.
The moving average is another important number. If it is trending up, it means the stock price is also trending up.
News is another factor that can affect stock prices, especially earnings reports or legal news about stocks you own or want to buy. Keep an eye out for upcoming scheduled news events.
Technical analysis also attempts to value a company, but rather than analyzing a company's intrinsic value and prospects, it uses historical price and volume data to assess where the price of a security or a market will move in the future. This is all about looking at past patterns and trends to see if they are repeatable in the future.
The assumptions underlying the technical analysis are:
• The market discounts everything.
• Prices move in trends.
• History tends to repeat itself.
Technical analysis uses charts of price movements along with technical indicators and oscillators to identify patterns that may indicate future price movements. (Indicators are calculations used to confirm price movement and form buy and sell signals. Oscillators are another type of calculation that show whether a security is overbought or oversold.) It therefore doesn't matter if a security is overbought or oversold is undervalued and only deals with future price movements.
Therefore, one of the most important concepts in technical analysis is the trend. However, trends can be difficult to spot as prices do not move in a straight line and therefore technical analysis identifies a series of highs or lows that occur to determine the direction of movements. These are classified as up, down and sideways movements. The chart below attempts to explain this by describing a simple uptrend. Obviously, by following a trend (by others - buyers or sellers) - the end result can be self-fulfilling - leading to the herd mentality where everyone follows one another. Another word for following other buyers or sellers is momentum - momentum trading.
Point 1 on the chart reflects the first high, point 2 the subsequent low, and so on. For it to be an uptrend, each subsequent low must be higher than the previous low, otherwise it is called a reversal. The same principle applies to downtrends.
Besides direction, technical analysis will also classify trends by time.
Primary movements are long-term price trends that can last for several years. Primary movements in the broader market are known as bull and bear markets: a bull market is a rising market and a bear market is a falling market. Primary movements consist of a series of secondary movements, each lasting up to a few months, which in turn comprise a series of tertiary or everyday movements.
Technical analysis results are displayed in charts that graphically represent price movements. After drawing historical price movements, a trend line is added to clearly show the direction of the trend and indicate reversals.
The trend line can then be analyzed to provide further indicators of potential price movements. The chart below shows an uptrend line drawn at the lows of the uptrend, which represents the support line for a stock as it moves from progressive highs to lows.
This type of trendline helps traders anticipate the point at which a stock's price will move back up. Similarly, a downtrend line is drawn at the highs of the downtrend. This line represents the level of resistance a stock faces each time the price moves from a low to a high.
There are a variety of different charts that can be used to show price action and some of the main types of charts are:
Line charts – where the price of an asset or security over time is simply plotted as a single line. Each point on the line represents the security's closing price. However, to identify an underlying trend, chartists often use what are known as moving averages to smooth out extreme price movements. Instead of representing each closing price on the chart, each point on the chart instead represents the arithmetic mean of the security's price over a specified number of days. 10, 50, 100 and 200 daily moving averages are commonly used.
Point and Figure charts – these plot significant price movements in vertical columns, using a series of Xs to represent significant up moves and Os to represent significant down moves, without using a consistent timescale. Whenever the security's price direction changes, a new column is started.
Bar charts – these connect the highest and lowest price levels that a security has reached over a given period of time with a vertical line. This period can range from a single day to a few months. If the period selected is a trading day, a horizontal line representing the day's closing price intersects this vertical line.
Candlestick charts - these are closely related to bar charts. Again, they connect the security's high and low prices with a vertical line, but use horizontal lines to mark both the opening and closing prices for each trading day. If the closing price of the day exceeds the opening price, the candle body will be exposed, while in the opposite case it will be shaded.
Technical analysis charts also contain channel lines, where two parallel lines are added to show the areas of support and resistance, respectively connecting the series of lows and highs. Technical analysis users will expect a security to trade between these two levels until it breaks out, when a sharp move towards the break is expected. Subsequently, breaking a support level provides a sell signal, while breaking a resistance level as the asset's price gains momentum indicates a buying opportunity.
These are called outbreaks.
An example of such a breakout pattern is the triangle shown below. Here price action becomes progressively less volatile, but often breaks out in both directions in quite spectacular fashion.
Other continuation patterns include the rectangle and the flag.
Chartists typically use relative strength charts to confirm breakouts from continuation patterns. Relative strength charts simply show a security's price action relative to the broader market. If the security's relative performance versus the broader market improves, this may confirm that a suspected breakout to the upside has occurred or is imminent.
However, because prices don't always move in the same direction and trends eventually stop, technical analysts also look for what are known as reversal patterns, or sell signals. Probably the most well-known of these is the head and shoulders reversal pattern, as shown in the example overleaf.
A head and shoulders reversal pattern forms when price action causes the right shoulder to break the neckline, the support level, signaling the prospect of a sustained decline in the security's price.
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