CLASS II – Technical Analysis
The primary basis of technical analysis is that the market is a forward looking mechanism and automatically discounts everything that is known about a given company. This same concept applies to equities, commodities and currencies. If the information exists, then it has been previously disseminated by the markets and reflected in the current price.
When it comes to fundamental analysis of any given stock, regardless of where you obtained your information, you must assume you are the last to know and the data is already “priced into” the stock.
In technical analysis the chart formation is simply a visual snapshot of all the current and future prospects for the stock. The technical analyst is able to profit by identifying key turning points in the direction of the stock price. The price patterns depicted in the charts is a window into the future direction of the price.
Selecting The Right Stock
In this chapter you will learn how to analyze a stock in order to identify profitable trading opportunities. Any trading strategy is only as good as one’s ability to correctly analyze a stocks direction. It is important to have a thorough understanding of the methods used to identify stocks trend to apply the appropriate options strategy. After a complete discusion of the various technical indicators that can be used, we will present several strategies that take advantage of each type of market condition. With each trader’s risk tolerance and trading objectives being different, several differentconservative and speculative strategies will be covered.
Technical indicators are used to determine the most probable future direction of a stock regarding the overall trend and reversal points. Even though technical analysis is the primary method used to predict stock price movement, it is always a good idea to be aware of the “fundamental” analysis that could affect the price direction of a stock. This is not to say that a trade should not be entered into if there is an upcoming event, such as an earnings announcement, but it should be used as a way to confirm the enrty signal that was given by the technical analysis. Most previously known or publicly announced events that would affect a stocks price movement will already be “priced in” to the stock price. You must assume that any time you hear stock information in the public media that you are the last to know and the news should not be used to determine whether or not to trade a given security.
BY DEFINITION
Technical Analysis is the study of the price and volume of the equity, commodity and forex markets, through the use of chart formations. The sole purpose of which is to forcast future price trends. Technical analysis is based upon three primary assumptions. They are:
- Market movement is a forward-looking mechanism and discounts all known information.
- Prices do move in reliable trends.
- History repeats itself.
In applying technical analysis to forecast stock price movement, the analyst works under the assumption that anything that can affect the price, be it fundamental, economical, political, trader psychology or anything else that is a known event has already been factored into the stock or market price. Therefore, one only needs to analyze price and volume according to the chart patterns.
The price action will reflect changes in supply and demand and investors sentiment in regards to market reactions of fear or greed. If demand exceeds supply, prices should rise. If supply exceeds demand, the price should fall. Any fundamental event that has or could affect a security’s price will already be reflected in the price chart formations.
Secondly, technical analysis asserts that prices move in trends. The plotting of price targets on a chart attempts to identify a trend that is reversing direction or to spot the early part of a starting trend to trade with it.
Third, “those that know nothing of history are destined to repeat it.” They say that even geologists study historical events as a means of predicting future cataclysmic events. Technical analysis is also based on the premise that history repeats itself and if you were to examine historical charts of the markets for any period you choose this fact will become quite apparent. It is a logical conclusion since a chart pattern is a market snapshot of a psychological profile of the emotions of the market participants at a clearly defined point in time. Emotions cause investors to overeact and chart patterns are a visual representation of how investors have reacted to a specific set of circumstances in the past. Given a similar set of circumstances they will react the same way in the future. The price movement as shown on the chart formations give a clear indication of what the expected outcome will be. Technical analysis has stood the test of time and overwhelmingly proven it’s accuracy.
TRENDS & TRADING RANGES
Substantial amounts of money can be made on stocks that are trading in a trend, reversing trends or trading in a rangebound pattern. In order to implement the best strategy you need to determine what the stock is doing to enable you to predict future price movement.
When a stock is in a trading range the price will move up to a previous high point or down to a previous low point, but it will not trade outside of this range. A trading range pattern can take several forms but many times will resemble a “flag,” “pendant” or a “narrow sideways channel.”
The “flag” pattern shows a directional spike up (can also be an upside down flag pattern) with an extended trading range attached at the top that is a square shape resembling a flag.
The “Pendant” will also have a price spike (again, can also be an upside down pendant) with a triangular trading range in the form of a pointed flag attached at the end (much like a baseball pendant).
A “narrow sideways channel” is exactly what it sounds like. A closely defined sideways pattern that snakes along in a very narrow pattern for an extended peiod of time which can be weeks or months and is easily identifiable.
A trend is not confined to previous highs or lows. An uptrend is defined by a series of higher highs and higher lows and a downtrend by a series of lower lows and lower highs.
SUPPORT & RESISTANCE
Higher lows in an uptrend and lower lows in a downtrend are “Support” lines. The higher highs in an uptrend and the higher lows in a downtrend are the “Resistance” lines. Within a trading range, the highest point (top of range) is considered “resistance” while the lowest point (bottom of range) is the “support” line.
“Support” (bottom line) is the point at which selling has become exhausted and the buyers come back into the market while the “resistance” (top line) is the opposite reaction. This is the point in which the buyers have exhausted themselves and selling begins. The most important point regarding “support/resistance” is that when a major resistance level is broken through it usually becomes the new support level. In the same respect, when a major support level is broken it usually becomes the new resistance.
TREND LINES
To construct a trend line you will need at least two points to connect to. The trend line will only become valid after it tests the support price for a third time and holds at both support/resistance points. One basic concept of a trend line follows a basic law of physics. That is, that a trend in motion is more likely to continue it’s direction than to reverse until it is met with an equal or greater force than what had originally set the trend in motion. In addition, the trend tends to take on a certain slope as witnessed in the original line and will usually maintain the same form of slope. This will present certain clues as to the length and duration of the trend you are following. The trend line not only helps determine buy and sell points but is extremely helpful in signaling a change in direction when either support or resistance is broken.
An uptrend is a straight line drawn from the bottom left, upward to the right under successive lows. The downtrend is a stright line downward from the top left to the bottom right of chart.
In Class III we will take an in depth look at one of the most reliable technical trading systems… “Pattern Trading.”
