Learning Center

Depending on whom you are talking to, technical analysis can be considered either a very useful tool or voodoo magic. 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 results in profitable returns.

Trends

The objective of technical analysis is not to replace fundamental research. Instead, it is best applied after 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 refine the entry and exit your position.

The first step is always to determine the overall trend of price itself. While this sounds simple, it relies heavily on your timeframe for holding a position. There is the long-term investor (holding for years); a position trader (for several weeks or months); and a short-term trader (focusing on a few days down to intraday). You should focus on the chart lengths that best fit your time horizon and outlook.

Basic methods for determining the underlying trend include drawing simple trendlines and tracking moving averages.

Trendlines are the most basic form of charting and should not be dismissed for their simplicity. A trendline is drawn by either connecting a series of Lower Highs for identifying downtrends or a series of Higher Lows for uptrends.

Short-term traders will want to focus on Daily and intraday prices to stay on the correct side of the trend. Intermediate term traders and long-term investors should benefit following Weekly and Monthly trends.

An alternative to drawing your own trendlines would be applying a moving average to your chart. This indicator provides a visual line of the average price over a specified number of periods. The most popular moving averages used are the 20-, 50-, and 200-day periods. They represent the short, intermediate, and long-term timeframes.

Again, depending on your time horizon to stay in a position, if price is above the moving average, it is considered bullish (going higher). If price is below the moving average, it is deemed bearish (going lower). The shorter the timeframe used, the more signals will be generated, so be sure to choose a length that fits your timeframe to ensure success.

Support and Resistance

These are simply price levels or zones that a stock or index may have trouble penetrating. “Support” is created where the demand overcomes supply for a stock. Or more simply stated, where buyers prove to be more aggressive than sellers around a particular price. Support is usually found along a rising trendline (higher lows), an upsloping moving average, or near a previous low where an advance occurred thereafter.

“Resistance” develops where supply overwhelms demand or when sellers are more aggressive than buyers at a particular price level. It often happens against a falling trendline (lower highs), a down sloping moving average, or near a prior high before prices turned lower.

Breakouts & Breakdowns

In the case of wanting to participate in short-term momentum as price rapidly moves higher or lower, traders will focus on entering orders where buyers overcome a resistance zone or where sellers push through a support zone. These key inflection points that represent a shift in the supply-demand relationship can lead to what is referred to as a “breakout” or “breakdown” of price. Imagine it as price breaking out through a ceiling or breaking down through a floor. It will continue that momentum until it reaches a prior ceiling (resistance) or prior floor (support) on the chart. Or in some cases, the momentum will just start to wane on its own upon extending too far from the breakout/breakdown point.

Pullbacks

When momentum fades, price will often “pull back” into a range where new support and resistance levels are created in context of the prevailing trend. A general rule of thumb is once a breakout over a resistance zone (or ceiling) occurred, then it will now act as a new support (or floor) when prices pullback to it. The logic is that price level is where demand overcame supply and therefore if price trades at that level again, demand will re-enter the market to support it.

It is the opposite when breakdowns occur through a support zone (or floor). That price level should act as new resistance (or ceiling) when price pulls back or rallies into it. This time the assumption is sellers will reappear at that price level where supply had previously surpassed demand.

Technical Indicators and Pattern Analysis

It is highly recommended that anyone using technical analysis in their research and trading first become comfortable with defining the trend and identifying key support and resistance zones. Price itself is what determines whether you have a profit or loss and therefore any indicator or pattern derived from price should be deemed as secondary.

Over time, dedicated “tape readers” began to recognize recurring patterns and shapes appearing on price charts, often before significant moves occurred. There have been numerous books written about these patterns with various names, some more popular and frequent than others. While we cannot go into all of them, understand that you always can categorize them all into three categories - bullish, bearish, and neutral. If this is a path you wish to pursue, realize that trading bullish patterns in uptrends and bearish patterns in downtrends will yield the most success.

With the advent of computers, the ability to produce mathematical lines on price charts became easier than ever. This allowed for programmers to create “indicators” or various plots on a chart that “indicate” how prices are behaving in relation to their past. The indicators can be considered bullish, bearish, or neutral, just how patterns can be categorized. There have been hundreds of indicators developed over the years trying to predict price movement, but the reality is they all remain dependent, and therefore secondary, to interpreting price action itself.

Indicators and pattern analysis can be excellent tools to assist traders in quickly identifying certain market conditions, however, without a solid foundation in analyzing trends and key price levels, one can find themselves getting into trouble frequently. A good comparison to relying too much on indicators is like flying a plane using just the instruments. It can be done, but you probably want to learn to fly without them first.

Money Management

Management of your money can be the difference between long-term success and being forced out of the market. The following are not hard and fast rules, as individuals should tailor to their own needs and preferences, but some consideration needs to be given to these aspects.

The first is the tradable percentage of your total capital. The general guideline here is to invest a maximum of 50% of your capital.

The next question is the size of each individual trade. A range of only 5% to 15% of the total is often given as typical to prevent a situation where one blow up wipes you out.

As far as how much to risk, 5% or less of capital is considered the norm.

Position size and risk tolerance will vary for everyone regardless of capital, so it is critical to have it planned out ahead of time to remain disciplined to it. Most traders and investors start out taking on much bigger size and risk than they should because they focus on the reward instead of the risk. Always keep risk management first to ensure long-term success.

The Big Picture

On the surface, Technical Analysis can seem too simplistic to hold any water against fundamental or economic analysis, however, when it comes time to place your orders at a price you perceive to be over- or under- valued, you are now participating in the supply and demand mechanics of an auction market. Buyers and sellers are constantly leaving footprints behind them on the charts that can be interpreted through various techniques in the field of technical analysis.

Those traders and investors that incorporate price trends along with other forms of analysis can gain a significant edge so long as they remain disciplined to a sound risk management plan that meets their objectives.