What is technical analysis?
Technical analysis is the practice of gauging a stock’s future price fluctuations by analyzing past activity. This method involves looking for specific chart patterns and examining other historical data related to price and volume.
To give you some perspective, let’s contrast this with fundamental analysis. As the name suggests, this approach examines companies in light of their fundamentals: their balance sheets, income statements, cash flow, quarterly earnings, price-to-earnings ratio and other quantitative measures of a firm’s financial health. Fundamental analysis also encompasses less tangible qualities: how competitive a company seems in its industry, the quality of its management team, and so forth. The premise is to buy stocks of companies that are currently undervalued by investors using these measures.
Technical analysts, by contrast, don’t necessarily believe fundamental analysis can help them find a diamond in the rough. Technical analysis assumes all pertinent information about a company is known and therefore priced in to a stock’s current value, including fundamental data. By using the price action and volume of a security, technicians draw conclusions as to the trends of supply and demand.
This article will cover some of the basics, such as trends and countertrends, support and resistance, the forces of buyers and sellers, trading ranges, swing highs and swing lows, volume and price charts. Moving averages (MA), the last item covered here, is the first technical study most chartists learn when diving deeper into this topic.
As an aside, even though we discuss estimating the behavior of a stock using technical analysis, anything can and often does happen when investing in the markets. Ally Invest does not recommend the use of technical analysis as a sole means of investment research. Additionally, technical analysis is geared toward short-term trading as opposed to longer-term investing. Using this method may result in increased frequency of trading and possibly higher transaction costs than a fundamental approach. Ally Invest does not recommend day trading.
Trends are an important piece of the trading puzzle for a technician. The trend is the overriding directional movement of a security’s price. Whether we’re talking about investing, economic or fashion trends, the assumption is the same — a trend is expected to continue for a certain length of time. Technical analysis is no different and many of its methods are derived from this premise. Bear in mind, there’s no guarantee that the trend will continue as planned.
Technical analysis focuses more on decoding the market’s psychology around a stock more than the company’s actual merits as a long-term investment.
The trend is the main direction of a stock’s price. There are three main trends: up, down and sideways. If a bullish chart is identified, also known as an uptrend, a trader expecting the trend to continue would look for opportunities to profit from the continued movement upward. Simplistically speaking, a trader could buy the stock — known as going long. If the trader instead finds a bearish pattern to work with, in this case a downtrend, then the trader would determine an area to enter a short sale — or go short.
A quick explanation of short selling
Selling short is the process of borrowing shares via your broker and selling them in the open market, with the intention of purchasing the shares back for less cost in the future. To be clear, you did not own the shares before selling them, which is why you had to borrow them via your broker. (The shares must be returned to your broker at some point in the future.) Unfortunately your intentions will not always be fulfilled and losses can result in a few different ways.
First, you may have to pay more to buy back the stock than you received when initially shorting it; this can result in unlimited losses. Not only that, if you are short the stock when the company declares a dividend, and the ex-dividend date occurs while your position is open, you will owe the dividend to the owner of your short stock. Finally, this type of trade is done in a margin account. Trading on margin carries additional risks, so please make sure you understand them before opening this kind of position.
Support and resistance
If the market was up on a given day, a common interpretation is there were more buyers than sellers, pushing prices higher. However, every buy has a matching sell and every sell has a matching buy. So how can we make sense of more buyers than sellers? It is not really the number of buyers or sellers, but rather their level of aggressiveness in reaching an acceptable price level. If buyers aggressively bid on stocks, the price will increase, even though the number of buyers and sellers are equal.
If buyers are willing to pay higher prices, prices go up. On the other hand, if sellers are more forceful in selling and will accept lower and lower prices as they sell, the forcefulness of the sellers will override the interest of the buyers, and prices will fall. Support and resistance are price areas of a stock chart (or other security chart) which may indicate where a stock’s price may hesitate and continue sideways or where a price reversal may occur. Let’s look at each of these in more detail.
Aggressiveness of buyers and sellers
If a stock’s price is declining, support is where the aggressiveness of buyers is estimated to increase, in theory preventing prices from declining below this price area. Because support is an indication of where buyers may have interest, this term is sometimes used interchangeably with buying, demand, bulls or price floor.
Bulls, who expect prices to increase, bring demand when a stock’s price has reached a desirable level or is undervalued by some measure. How aggressively the buyers act determines what happens next as a stock’s price declines. If buyers act very aggressively and demand seems very high, not only may a stock’s price stop decreasing, it may actually bounce and go higher, reversing direction quickly. If buying pressure is not as strong, the stock’s price may stabilize and then continue sideways. If demand is lackluster, it may not be strong enough to counteract selling pressure, and support fails, allowing the stock price to trade lower.
On the opposite side is resistance. If a stock’s price is going up, resistance is where the aggressiveness of sellers is thought to increase, with the assumption prices would not move above this price area. Selling, supply, bears or price ceiling are all common terms used to indicate resistance. Since bears expect markets to decline, they will provide a supply of shares at a price they feel is overvalued according to certain methods of valuation. This is what creates resistance.
Previous highs or lows help identify support and resistance. Either using a single point or stringing points together, both methods employ horizontal lines and extend the length of the chart before and after each price point. Take into consideration support and resistance are not exact prices; they are price areas. This fact makes technical analysis more of an art than you might have realized.
Support equals resistance?
Another tenet of technical analysis is support equals resistance. If price action is able to break the floor of support and trade lower, this area becomes future resistance. So the area where demand was readily available now becomes a price level where supply increases.
This is also true in reverse. As a stock price moves higher, it may encounter resistance, or an increase in selling pressure. If the forcefulness of buyers is able to overcome the increase in selling pressure, the stock price may break through resistance and trade higher. Going forward, the area of previous resistance now acts as new support.
A trading range is when the price action seems to Ping-Pong back and forth between known areas of support and resistance. There are two main schools of thought on how to approach trading ranges. Some believe the sideways price action will continue, so buyers will buy toward the support level and sellers will sell at the resistance levels. However, another approach is to wait to see if the trading ranges are broken. If the price action breaks above the resistance, buyers will enter at that point with the expectation higher prices will continue. A bearish trader would wait for support to fail and then sell into weakness expecting the prices to continue lower.
Trends and countertrends
The trend is the overall direction in which the stock is expected to go. Evaluating the trend’s direction, along with its strength and duration are often the first steps taken when performing technical analysis.
Trending stocks rarely move in a straight line, but instead in a step-like pattern. For example, a stock might go up for several days, followed by a few steps down (termed a pullback) during the next few days before heading north again. This behavior can camouflage the true trend to the untrained eye. If several of these zigzag patterns are strung together, the chart appears to be moving higher with some degree of estimation, characterized by higher highs and higher lows. The main trend is up, and the countertrend is slightly down. Each peak before the pullback is known as the local or swing high.
Although they’re usually not as orderly as uptrends, downtrends also move in a zigzag or step-like fashion. For example, a stock could decline over the course of many days. Then it may retrace upward (known as a bear rally) over part of the loss for the next few days before turning south once more. When this behavior is repeated over time, the downtrend of the chart becomes easier to see and a technician will notice the lower highs and lower lows. The move downward is the major trend, with the low of each movement noted as the swing or local low. The bear rally or retracement up is the countertrend in this case.
With price as the primary piece of information studied by technical analysts, volume is number two on the list. Volume is the number of shares or contracts traded over a specific duration of time. This window is usually one day, but can be as brief as minutes or hours.Volume is important because it is expected to confirm or deny any trends observed in price action. A comparison of current volume is usually made against average daily volume. If current volume is less than average, the implication is the existing price trend may be short-lived. If current volume is average or higher, it’s estimated the price trend may be sustainable or may actually increase in momentum.
You could say volume is an indication of how widespread current opinion is among the traders active in a certain stock. Price trends that appear to be backed by high volume may indicate the current consensus opinion, not just a few contrarians.
Trends can also be observed with volume. When looking for confirmation of a price trend, the volume trend should be increasing or about even with the average daily volume over the same time period. When looking for evidence of a trend losing steam, analysts want to see a trend in decreasing volume.
Price charts, or simply charts, are a graphical means to display numerical data. As they say, a picture is worth more than a thousand words, or in this case, data points. Technicians use many different ways to display price data, ranging from basic to advanced styles. The basic components of a price chart are the time frame (which typically runs along the x-axis) and the price range (which runs along the y-axis). Depending on how the data are displayed, it is these axes which can have a profound effect on the appearance of the trend — making it appear significantly more or less dramatic by changing the axes’ scale. In evaluating a potential trend, make sure you understand how it’s being visualized on your chart.
Most charts default to a daily time frame setting, but in practice this setting can be quite short or very long. A tick is the smallest increment by which a security can change in price. For most stocks a tick is one penny. Although uncommon, a tick is also the smallest increment available as the x-axis of a price chart. Other durations include minutes, hours, weeks, months or years. If there is only one data point shown for the selected time frame, it is usually the closing price.
Oftentimes, there are four data points per time frame — the open, close, high and low. The price scale runs along the y-axis, usually on the right side of the chart. How wide or narrow the increments between the prices are in the vertical axis has a significant impact on the appearance of the data. If the spacing is wide, the strength of the trend can seem stronger than it may be. If the distance is narrow, a strong trend may be mistaken as slow-moving. To add to the mix, this axis can be constructed using two main methods — linear or logarithmic.
Price scale and time scale
A linear price scale shows equal spacing between the different values, no matter the price. The distance between 50 and 60 is the same as the distance between 100 and 110 or 200 and 210. However, logarithmic charts or log charts for short, keeps spacing between values with respect to a percentage change. In the examples above, the differences were all 10 points, but the percentage moves varied. From 50 to 60 the percent change is 20%; for 100 to 110 the change is 10%, and for 200 to 210 it is 5%. Visually, a stock would have to move the same amount on a percentage-basis to appear having moved as the same distance on the chart. So an increase from 50 to 60 representing a 20% move would be the same distance if the stock traveled from 100 to 120, or from 200 to 240.
The smaller the time scale, the more data are displayed in the chart. Depending on the chartist, some feel more is less; for others more is more. The argument is if there is too much data, the chart contains a lot of noise which can detract from focusing on the critical information. If there is too little data, a vital signal could be omitted. When comparing the steepness of inclines or declines of different charts, be sure the charts are constructed with similar scales. Otherwise you could be making misinformed investment or trading decisions.
Different types of price charts
The closing price at the end of each daily regular trading session can be used to create a simple line chart. These data points are then connected with a line. If you’d like to add some color contrast to the area under the line chart, this is termed a mountain chart. Although simple and easy to understand, the line and mountain charts leave out important pieces of information like the opening price, the high of the day, or the low of the day. All four of these data points are included in both bar charts and Japanese candlestick charts.
Bar charts use a vertical line to denote the trading range between the high and low of the day. The open and close prices are added as horizontal dashes. In reading left to right, the open is a hyphen on the left side and the close is a hyphen on the right. An elongated vertical line shows an extended range for that trading day. Bar charts may also be termed OHLC charts, since they denote the open, high, low and close of each time period. In other words, you get four price data points packed into each bar — information many technicians find crucial to evaluate a possibly emerging trend.
Japanese candlestick charts, or candles for short, also record the open, high, low, and close of a trading session. However the visual representation is different from that of a bar chart. Here instead of a horizontal line, a rectangular shape is drawn known as a real body. Extensions indicate the high and low of the trading session, known as upper and lower shadows. The real body reflects the open and close over a given timeframe. The resulting chart looks like a string of candlesticks, each with an upper or lower wick, burnt to varying lengths from a tall taper to a stubby nub.
If the real body is black (or red, in some charting software packages), the stock closed the timeframe lower than it opened. On the flip side, if the real body is white, clear or green, the stock’s price closed higher than it opened the timeframe. However, this does not indicate whether the stock was up or down for a particular time period, only where the open and closed occurred in relation to each other.
The shadows extend vertically from the real body displaying the high and low of the timeframe. Sometimes shadows are elongated, revealing an intense tug of war between buyers and sellers. Other times they are short or nonexistent. If they are absent, then the open or close was equal with either the high or low of the session. If the open and close are equal, or near equal, the real body is displayed as a dash, known as a doji. This shape indicates the stock closed more or less where it opened.
Another style of chart, the Point and Figure chart, also records price, but without reference to a specific time frame. Point & Figure charts involve columns of X’s and O’s which appear drastically different from bar or candle price charts. Technicians suggest that since this style of chart tracks only significant price movements and reversals and because time is removed, much of the noise encountered with traditional price charts is reduced. This may also make it easier to recognize trends and support and resistance levels
Moving averages and technical studies
Moving averages are likely the most commonly used technical tool. Some sources group MAs with technical indicators, while others classify it as an oscillator. The label is unimportant. What matters is knowing how to use this technical study properly and under the right conditions. A moving average provides the best signals when a trend is firmly in place and it is moving in the same direction as the stock’s price action.
Because the overall trend is not always easy to determine, traders will often use a moving average to help smooth out the price action of a chart. This is the average closing price of a stock for a certain period of time, such as the last 20 days, last 50 days, or any other parameter you choose. The average moves in that, every day, a new set of data points is averaged in, while the oldest data points are dropped from the calculation. Price is what is happening now. Although they can provide a helpful perspective, moving averages show what happened in the past. So naturally, this will lag price action. This is not necessarily a bad thing, but don’t expect MAs to give you signals for entering at the top or bottom, but rather after the trend has already begun.
There are two main methods for calculating moving averages: simple or exponential. Simple is a straight-line average. For example, a five-day simple moving average (SMA) would take the closing price of the last five days, add them together and divide by five. Each day’s closing price influences the outcome equally. An exponential moving average (EMA) favors more recent data over older data. Instead of each of the five days having equal weight in the calculation, the most recent day will have a greatest impact on the average than the days before it.
Moving averages are used to identify overriding trends, and possibly highlight lagging signals. If crossing the price action, moving averages may provide signals depending on the direction in which they occurred. In other analyses, the price action and the moving average run together in a type of dance, indicating support or resistance depending on the location. If using multiple moving averages, they can cross each other, providing additional buy or sell signals.
If the current price action is above the moving average, the stock may be in an uptrend. If the price line is below, the stock may be in a downtrend. This sounds simple enough, but remember when you examine a chart with a moving average, you will see two things happening simultaneously. Depending on the time frame studied, you could see the stock price going up, while it is below the moving average — providing conflicting information.
Since shorter moving averages contain less data points, they will move more in tandem with the price action than a longer moving average would. Think of a short-term moving average having the agility of a speed boat, with the longer-term moving average similar to a cruise ship. Certainly the speed boat, or shorter MA, is easier to turn.
It is common to use two or more MAs with differing lengths simultaneously. When the MAs cross each other they produce additional signals. If the shorter time frame crosses over the longer time frame, the indication is the price action will go up. If it crosses under, the indication is the opposite. The closer the moving averages are in time duration to each other, the more crossing or “whip-saw” action will be observed. The crosses above and below will be frequent, making the signals more frequent, but also less sustainable and shorter-lived.
If the moving average tends to run along with the price action it can behave as a type of support or resistance. It is common to observe bouncing where the price action will either bounce up or down after touching the moving average. If it bounces down, the moving average acts as resistance. If it bounces up, it acts as support.
The length of the moving average should be similar to the trade’s duration. A short-term trader will tend to use shorter-term MAs than a longer-term trader or investor. The most common length is the 200-day MA, which is thought to be long-term. Considering there are about 250 trading days in one calendar year, a 200-day MA contains a data set that is almost one year in duration. Medium-range data sets include the 50- and 100-day MAs; shorter-term traders tend to use time periods shorter than 50, with the 20-day MA being quite common.
Technical analysis is a popular method which aims to help traders and investors better estimate stock prices. The basics of this technique include trends and countertrends, support and resistance, swing highs and lows, volume, price charts and moving averages.