Investor Education Investment Knowledge Technical Analysis Primer
| Technical Analysis Primer |
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Table Of Contents
•1. Introduction
There are two main methods in analyzing securities to facilitate investment decisions making.
However, for this report we will focus our attention on Technical Analysis.
If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.
1.1 The Basic Assumptions
1.1.1 What Is Technical Analysis?
•1. The market discounts everything. •2. Price moves in trends. •3. History tends to repeat itself. 1.1.2 Three assumptions of technical analysis
1. The Market Discounts Everything Price movement chosen to be the core of technical analysis is because technical analysts believe that the price is already reflective of all the company's fundamentals, along with broader economic factors and market psychology. Thus there is no need to consider the other factors separately unlike that of fundamental analysis. Where price movement as seen as a product of the supply and demand for a particular stock in the market. Critics of technical analysis often criticize the exclusive analysis of price factors only, ignoring the fundamental factors of the company such as its future, its management, its brand value.
2. Price Moves in Trends Most technical trading strategies are based on the assumption that price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it.
3. History tends to repeat itself Another assumption is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, investors are likely to provide a consistent or similar response towards similar market stimuli over time. Chart patterns are used to analyze market movements and understand trends, where it illustrates patterns in price movement.
2. Fundamental Vs. Technical Analysis
Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. The following will look at the criticism against technical analyst, and discuss how they differ and how they can be utilized together.
2.1. Differences between Technical Analysis and Fundamental Analysis
2.2 The Critics
2.3 Can They Co-Exist?
3. The Use Of Trend Definition of trends: "A general direction in which something tends to move" (dictionary.com). In our application, trend would be reflective of the general direction of where a security is heading.
The following charts with provide a basic insight on what would a trend constitute:
Chart 1: Singapore Straits Times Index
Discussion: The frame on the upper half, is indicative of the stock's prices compiled over the years from 2003 to 2007. As seen in Chart 1, the overall trend is upwards going. The bottom frame reflects the frequency and intensity of the fluctuation in volume of the STI. Overall, the direction of this security is clear.
Chart 2: Singapore Straits Time Index
Discussion: This chart presents captures a shorter time frame (May - Aug 2007) of the stock price movements. As seen in the chart, there are numerous ups and downs within this short frame of time, making it a very unstable stock at present. Thus at present, there isn't a clear indication of which direction this security is headed.
3.1 A More Formal Definition Unfortunately, trends are not always easy to see. Defining a trend goes well beyond the obvious. In any given chart, prices tend not to move in a straight line in any direction, but rather in a series of highs and lows. In TA, it is the movement of the highs and lows that constitutes a trend. For example, an uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs.
Figure 1
Figure 1 is an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from this point. Point 3 is the low that is established as the price falls from the high. For this to remain an uptrend, each successive low must not fall below the previous lowest point or the trend is deemed a reversal.
There are three types of trend:
3.3 Trend Lengths Chart 3: Indication of various trend lengths
3.4 Trendlines A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock.
. Chart 4: United Overseas Bank Ltd
Discussion: The chart above indicates an upward trendline, which is drawn at the lows of an upward trend.
3.5 Channels An extended use of trendlines is the channel, or channel lines. Channel lines are the addition of two parallel trendlines. The channel lines acts as a guide to trade between the two levels of support and resistance until it breaks beyond one of the levels, in which case there is a likely chance to expect a sharp move in the direction of the break. The upper trendline connects a series of highs, while the lower trendline connects a series of lows. Like a trend, it can slope upward, downward or sideways.
Chart 5: United Overseas Bank Ltd
Discussion: Chart 5 above illustrates an ascending channel on a stock chart; the upper trendline has been placed on the highs and the lower trendline is on the lows. The price has veers off of these lines several times but with minimal significance, and has remained in the range for several months. Thus as long as the price does not fall significantly below the lower line or move beyond the upper resistance, the range-bound upwards trend is expected to continue.
4. Support And Resistance Another major concept is ‘support and resistance'. This is referred as the consistent battle between the bulls and the bears, which is the struggle between buyers (demand) and sellers (supply) of a market. As such, prices of a security seldom move above (resistance) or below (support).
Chart 6: Illustration of Resistance and Support
Discussion: As shown in the Chart above, the upperline indicates the Resistance level, where price level of the stock is not likely to surpass. While the lowerline indicates the Support level, at a level at which prices are not likely to fall below.
4.1 Why Does it Happen? These support and resistance levels are important as they reflect the market psychology, supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these trends are veers off, this likely indicates a change in the supply, demand and the market psychology. It will eventually lead to new levels of support and resistance being established.
4.2 Role Reversal Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.
Image 2: Illustration of role reversal
Discussion: The dotted line above represents a level of resistance that prevented two occasions from exceeding it (point 1 and 2). However, once the resistance is broken, it becomes a level of support (shown by Points 3 and 4) by acting as the lowest price level which prevents it from heading lower again.
Chart 7: Illustration of the phenomena of role reversal
Discussion: In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. This is most often seen when a stock is trading in a generally sideways manner, if you draw the trendlines, as the price moves through successive peaks and troughs, testing resistance and support.
4.3 The Importance of Support and Resistance Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if an important level of resistance has overtime prove to be stable and strong and never broken, one would take advantage of the situation to take profit when the security is moving up and exits before it climbs down. A break beyond a level of support or resistance does not always have to be a reversal. For example, if prices moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price increase is expected to be faster than it was in the channel. As such, support and resistance points influence the way people buy stocks. For e.g. avoid placing orders at major points, as the area around them is usually marked by a lot of volatility. Do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number.
5. The Importance Of Volume While price is the primary item of concern in technical analysis, volume is also extremely important.
5.1 What is Volume? Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume exchanged hands, the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do.
Chart 8: Chart of the STI from Nov 2006 to Sept 2007
5.2 Why Volume is Important Volume is an important aspect of TA, used to double confirm trends and chart patterns, indicated by prices. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. For example, if a stock jumps 5% in one trading day after being in a long downtrend. To confirm if this is the trend reversal, traders analyze the volume. If the day's trading of stocks remains around the average daily volume, then it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal. Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the link between volume and price movement is poor, it is often indicative of weakness in the trend. When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward trend on declining volume.
6. What Is A Chart? A chart is a graphical representation of a series of prices over a period of time. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded.
6.1 Chart Properties There are several considerations when attempting to understand a chart. Such as time scale, the price scale and the price point properties used.
Chart 9: Linear Scale Chart and Logarithmic Scale Chart
Linear Scale Logarithmic Scale
7. Chart Types There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. They are the line chart, the bar chart, the candlestick chart and the point and figure chart. Each of the following charts is created based on the S&P 500 Index during the period of January 2006 through May 2006. Note that despite the same information, but the way the data is plotted and shown in the charts is different. Charts are one of the most fundamental aspects of technical analysis. It is important to have a clear understanding of what is being shown on a chart and the information that it provides.
8. Chart Patterns •v Distinct formation on a stock chart that creates a trading signal, or a sign of future price movements that are used to identify current trends and trend reversals and to trigger buy and sell signals. •v Theory behind chart patterns is that history repeats itself, and that certain patterns are seen many times, signaling a certain high probability move in a stock •v Chartists look for these patterns to identify trading opportunities, though there are no chart patterns that will tell you with 100% certainty where a security is headed. •v There are two types of patterns within this area of technical analysis, reversal and continuation. •v A reversal pattern signals that a prior trend will reverse upon completion of the pattern. •v A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe.
8.1 Head and Shoulders •v One of the most popular and reliable chart patterns in technical analysis. •v A reversal chart pattern that when formed, signals that the security is likely to move against the previous trend. •v Head and shoulders top is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end. •v Head and shoulders bottom, also known as inverse head and shoulders, is the lesser known of the two, but is used to signal a reversal in a downtrend.
Charting Test - Identify the inverse Head and Shoulders found below:
The head and shoulders chart pattern illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.
8.2 Cup and Handle •v A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.
•v As you can see above, this price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price. •v Once price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year.
8.3 Double Tops and Bottoms •v This chart pattern signals a trend reversal •v It is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.
Charting Test - Identify the double bottom and double top below:
Chart 11: Double top and double bottom
•v In the case of the double top pattern, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom, the price movement has tried to go lower twice, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward.
8.4 Triangles
There are 3 types of triangles, which vary in construct and implication, the symmetrical triangle, ascending and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.
Charting Test - Identify the triangle
Chart 12: Triangle
•v The symmetrical triangle in chart 12 is a pattern in which two trendlines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. •v In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. •v In a descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout.
8.5 Flag and Pennant •v These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. •v It is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks.
Charting Test - Identify the flags
Chart 13: Flags
•v In a pennant, the middle section is characterized by converging trendlines, much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a channel pattern, with no convergence between the trendlines. In both cases, the trend is expected to continue when the price moves above the upper trendline.
8.6 Wedge •v Can be either a continuation or reversal pattern. Similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and six months.
Chart 14: Wedge
The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish.
8.7 Gaps •v A gap in a chart is an empty space between a trading period and the following trading period. •v Occurs when there is a large difference in prices between two sequential trading periods. For example, if the trading range in one period is between $25 and $30 and the next trading period opens at $40, there will be a large gap on the chart between these two periods. •v | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
3.2 Types of Trend 
