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Depending on which investor you are talking to, technical analysis can be considered either a very useful tool or voodoo magic. Since we have begun to add a sample of this type of equity analysis to our site, and some questions have arisen, we thought an explanation of some of the basics could prove useful to those with an interest.
The objective of technical analysis is not to replace fundament research. Instead, it's best put to use once you have completed your due diligence. This type of analysis can increase your confidence by confirming your fundamental opinion of a stock and help you enter and exit your position.
The first step is to determine the overall trend. While this sounds simple, it could depend on your time-frame. There is the long-term investor (holding for years); a position trader (for several weeks or months); and a short-term trader (day trader looking for quick hits). Basic methods for determining the underlying trend include the MACD (Moving Average Convergence Divergence), trendlines/channels and moving averages. We will spare you the detailed explanation of calculating the indicators as technical packages are readily available.
There are simple and exponential moving averages with the latter helping to smooth the particular average. Trends are established when your short, intermediate and longer term averages are moving in the same direction. The 10, 50, 100 and 200 day averages are often used. MACD is the interaction between two moving averages and can vacillate above or below its zero line. A bullish signal occurs when the shorter averages crosses above the longer while both are above the zero line and headed higher together. Trendlines are drawn off a series of highs or lows (usually 3 to be considered valid) that contains all the action. A channel is formed by merely taking a line parallel to the trendline so that all the highs or lows are within.
Once you're comfortable with your trend, indicators such as a stochastic, RSI (relative strength indicator) or ROC (rate of change) can be used to help determine if the current trend is running out of steam. The first two compare the current price of a stock to its past prices over a specific period of time. The indicators move between 0 and 100 with overbought typically marked by a reading above 70 or 80, depending on your personal preference while oversold is considered below 30 or 20.
These indicators can give early warning that the longer term trend is in trouble. The best signals are generated when a divergence develops. This occurs when the stock price moves to a higher high while the indicator establishes a lower high while in overbought territory (or the opposite in a downtrend) and it then moves below the overbought level. As long as the underlying trend is still intact (trendlines not broken, MACD still headed in the same direction) the indicators can be used to time your trade in the direction of the trend once they would reach the opposite extreme reading (oversold on an uptrend). Penetration of your trendline or a bear signal from the MACD suggests that patience and further research are needed to determine if the underlying trend will resume.
ROC studies are a way to measure the strength of the move. A slowing or a decline in the rate of change of the moves from day to day implies that the move is weakening. While a stock may be in a firm uptrend, an overbought stochastic and a weakening ROC suggests that a shorter term top may be nearing which could present a better buying opportunity while your trend indications are intact.
These are simply levels that the stock or index may have trouble penetrating. In an uptrend it would be where the demand for a stock overcomes supply. Supports can be found at a rising trendline, moving average or a previous low before the advance resumed. Retracements are also popular and represent a percentage reversal of a specific move. Some prefer using 66%, 50% and 33%; others use Fibonacci retracements which are 62%, 50% and 38%. The best levels are typically a combination of several of the above. An ideal situation in an uptrend would see a stock stymied by a support level while the stochastic or RSI indicators begin to rotate higher out of oversold territory.
This represents merely a very small sample of technical analysis and ways that it can potentially be used. Clearly this type of research/analysis is not for all with many preferring a purely fundamental approach. However, as with technical analysis itself, research that encompasses a broader body of complementary work will raise the probability that the investment decision is the correct one.