estick charts have grown in popularity recently because of the information aperson can easily glean from them at a glance. They are color coded to reveal the
Figure 9.1 DJIA One-Day Interval Candlestick Chart (Courtesy of QCharts(www.qcharts.com))
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relationship between a stock’s open and close while also revealing a stock’s pricerange. If a stock closed higher than it opened, the body of the candlestick is white indicating a bullish market. If the candlestick is dark, then the stock closed lower thanit opened indicating a bearish market. These colored areas are known as the body ofthe candlestick, while the line above and/or below is the shadow. (see Figure 9.2).There’s a great web site for learning more about candlestickcharts. Go to www.wick-ed.com to further your understanding.
A bar chart is another method used to chart prices and is composed of a verticalbar and two small horizontal ticks at 90-degree angles (see Figure 9.3). The verticalline itself represents the stock’s price range for the time period (15 minutes, hourly,daily, weekly). The horizontal tick to the left indicates the opening price; the one to
Figure 9.2
Candlestick Basics
Figure 9.3
Bar Chart Basics
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the right, the closing price. Bar charts work well to get a sense of a stock’s dailyprice range and for creating channel lines. They are most commonly used in newspapers and elsewhere, because of their simplicity. Figure 9.4 shows the Dow JonesIndustrial Average illustrated using a daily bar chart.The next style is called a line chart, shown in Figure 9.5. Line charts are the mostsimple of the three. They show a stock’s closing price from tick-to-tick, day-to-day,week-to-week, and month-to-month, like a child’s join-the-dots game. Many technicians (those people who use technical analysis as their sole or primary method fordetermining future price action) cite the closing price as the most important price ofthe day, and therefore a more valid measure of market activity. Line charts workwell when you are adding additional analysis techniques such as moving averagesor momentum indicators.The next style is more esoteric because it must be created—it is not just a graphof price versus time. Point-and-figure (P&F) charts use marks that are a series of Xsand Os, and a column on the left-hand side for price (see Figure 9.6). An X is usedto signify an increasing price and an O is used to signify a price decrease. P&Fcharts are created with alternating columns of Xs and Os that form patterns used toevaluate supply and demand. There is, however, no scale for time or volume, whichmakes P&F charts primarily sensitive to price movements.The first step in creating a P&F chart is to choose a scale. The choice is arbitrary,but is selected to signify what the analyst believes is a significant move for thestock. Thus, a volatile stock like SDL, Inc. (SDLI) might have a five-point scalewhile a more sedate stock like AT&T (T) might have a half-point or one-point scale.
Figure 9.4 DJIA One-Day-Interval Bar Chart (Courtesy of QCharts (www.qcharts.com))
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Figure 9.5 DJIA One-Day-Interval Line Chart (Courtesy of QCharts (www.qcharts.com))
Figure 9.6 shows an example of a one-point scale. Starting when the stock pricewas at $25, an X was placed on the chart. The stock then moved up to $26, and another X was placed above the first one. As the stock continued to move upward, Xswere placed one above another until the price reached $29. Then, before the stockcould touch the $30 mark, it dropped back down to $28 (or below) and the chartshifted over a column and a series of Os were inserted in the new column to signifythe decline. The stock continued downward until reaching $26 per share, whereupon it reversed and hit $27 and a new column was started and a new series of Xsintroduced. The example then ends with the stock at $32 on an upward run. Thenext mark on the chart would depend on where the stock price moves next. If theprice is $33, there will be another X placed above the last one. If it drops back to$31, a new column will be started with an O at the $31 level. Until one of thoseevents takes place, there will be no new additions to the chart—regardless ofwhether it takes a week or a month. In this case, time simply doesn’t matter.P&F charts were developed years before the advent of computerized charting.They were primarily a method of detailing trends in a format that was easy to track.Modern data suppliers and computer technology provide the means to look at pricedata across time and with various moving averages, volume data, and so on. Thishas, for all practical purposes, reduced the use of P&F charts to the ash heap of historical curiosities, as the amount of information a P&F chart conveys is severely
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Figure 9.6
Point-and-Figure Chart
limited. I include it so that when you do run across it, you are not fooled into thinking that it is some sort of complex chart that only a genius can understand.All the other charting techniques can be constructed to represent specific timeperspectives—intraday, daily, weekly, or monthly—that correspond to your tradingneeds. In most price charts, the vertical axis represents price fluctuation and the horizontal axis denotes time. As a beginner, you may want to start by looking at marketsover the longer term. You need to assess a market’s movement by reviewing its pricemovements throughout the past year, paying close attention to the most recent weeks.Online technical sites are geared to provide you with various charts thatshow price movement over different time spans. You can easily checkout a stock’s daily movement or the past year by one stroke on thekeyboard. Check out www.quote.com or www.bigcharts.com.
VOLUMEPrice action over time is only part of the picture. Volume is the best measure of interest in a stock, and its importance cannot be overstated. Among traders there’s asaying: “Volume precedes price.” Let’s take a look at why volume is so important.Let’s say you’re a motion picture executive, and your new movie has just beenreleased to over 500 theaters nationwide. What good is it to know the number oftheaters, if you don’t know how many tickets have been sold? If no one is watchingthe show, it won’t be in the theaters for long! If everyone is buying a stock, but theprice hasn’t changed, it probably won’t stay unchanged for long. The law of supplyand demand is critical to determining the future course of a stock or index.Institutional money managers—the people making the investment decisions forlarge mutual funds, state retirement programs, and other pension funds—often
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catch wind of changing fundamentals in a stock or sector, good or bad. The chart inFigure 9.7 has an added feature along the bottom that indicates volume. You caneasily see the big spike in volume on the left side. Shortly thereafter, this stockmade a monster move, gaining over 600%! I wish I could say this happens everytime, but it doesn’t. However, if you’re hunting for a stock that has been overlookedand could triple in value, volume certainly bears watching.Volume patterns are extremely important, as they indicate at what levels and towhat degree most activity occurs. Look at the right side of Figure 9.7. After thestock peaked, it went into a very choppy style of price action. One thing is clearlyindicated here: There were lots of buyers on each dip. Institutions were stepping upto the plate and buying here consistently, which signals to you and me that thiswould be a relatively safe entry point if we were looking to own the stock, or put onan option position.What if the volume dropped off as the stock climbed higher? That would tell methere’s no conviction among buyers and that the stock was not strong enough for amajor up move. The chances of it returning to earth are pretty good. Figure 9.8shows clearly that, even though this stock is advancing, the volume is drying up oneach successive day. By drawing a trend line to the upside, the subsequent break tothe downside is easier to spot.
Figure 9.7
Price-Volume Chart of PMCS (Courtesy of QCharts (www.qcharts.com))
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Figure 9.8 Advancing Price and Declining Volume (Courtesy of QCharts(www.qcharts.com))
MOVING AVERAGESMoving averages are another useful technical tool that help traders to determinewhen a trend may be changing. It is usually calculated by using the closing prices,adding them together for the desired time period, then dividing by the number ofdays, as with any average. If you wished to know the five-day moving average, andtoday is Monday, simply add the closing prices for the previous week (Mondaythrough Friday) and divide by five. Easy. This is a simple moving average (SMA),named because all days are equally weighted.An exponential moving average (EMA) is a method by which the most recentdata points are more heavily weighted. The theory behind exponentially smoothedmoving averages asserts that the most recent data is the most important. Keep inmind that there any number of ways to weight the front data more heavily. For thisexample, let’s use a five-period moving average where the five most recent datapoints are averaged together. As a new period is added, the oldest one is droppedoff, and a new five-period average is calculated. The percentage weight attributed toeach data point (day, week, month, etc.) would be as follows:
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Data PointMost recent data pointOne period backTwo periods backThree periods backFour periods back
TECHNICAL ANALYSIS UNVEILEDPercentage Weight in CalculationSimple AverageExponential Average20%33%20%27%20%20%20%13%20%7%
Luckily, there’s an abundance of software programs that figure all this stuff outfor you, allowing you the leeway of plugging in your own parameters or using thedefaults. Don’t worry about how to do it; just remember that most technicians seemto favor the simple moving average.
Simple moving average (SMA): An arithmetic mean calculated by taking n number of data points, summing the data points, and then dividing the sum by thenumber of data points. You can plot this single point on a chart, and by addingsuccessive points (created by dropping the oldest data item and including thenewest data item in the calculation), the series of points creates a simple movingaverage line in which all data points have equal value.Exponential moving average (EMA): A variant of the simple moving average inwhich more emphasis is placed on the most recent prices than the older ones.The EMA follows the actual price more closely than the SMA.
Traders use moving averages to identify trend shifts as well as the relative valueof a stock or index. Investor’s Business Daily shows the 200-day moving average(DMA) for the Dow, S&P 500, and Nasdaq Composite each day. The relative distance above or below is sometimes noted in newsletters and financial programs toindicate the relative value of the market.An extremely simple system for using moving averages is to sell when the trendturns down and to buy when the trend turns up. Okay, it’s too simple, but that’s thebasic concept. The shorter the time frame used, the more erratic the average becomes. If you were trading the OEX based on the 5 DMA moving up or down,you’d be making a lot of false-start trades, because a true picture would never beformed. At the same time, if your time frame is too long, a significant portion of anew trend has already occurred by the time you get in (or out).Many traders use a combination of different averages to generate buy and sellsignals. Some use two averages in what is termed a crossover method. Let’s say thetwo they use are the 5 and the 20 DMA. When the 5 passes over the 20, that’s a buysignal; when the 5 passes under the 20, a sell signal is generated. Other traders prefer to use three in a similar fashion, such as a 10, 50, and 200 DMA. When the 5passes above the 10, and then the 10 passes above the 200, that’s a buy signal. Theyuse the second crossover as a confirmation the trend has changed. While this is very
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reliable, it’s also a very cautious approach to trading. It really is up to the individualand his or her own personal style. If you’re aggressive, shorten up and use two. Ilike to use them in conjunction with other signals, but seldom by themselves. Myfavorites are the 50-day and 200-day moving averages that many institutionaltraders follow. If the 50-day drops below the 200-day, it’s a sell signal, and if itmoves above, it’s a buy signal.The next two graphs simply illustrate the sell and buy signals that followed themarket top in July 1998, the bottom in October, and its subsequent rally. Figure 9.9shows the timing for a two-averages signal and Figure 9.10 shows the timing for athree-averages signal.These two methods trigger two different sets of results. In Figure 9.10, the beartrap rally made for a better (higher) exit point, but I suspect the emotional trauma ofriding out that late August swoon was tough to endure. The system kept you in themarket longer and got you in later than the two-averages method shown in Figure9.9. Either method would have saved you from the bottom reached on October 8;and both methods certainly provided good entry points after that. As I said, it’s amatter of style, not to mention nerves.
Figure 9.9 Crossover Using 10 and 200 DMA Method (Courtesy of QCharts(www.qcharts.com))
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Figure 9.10 Crossover Using 10, 50, and 200 DMA (Courtesy of QCharts(www.qcharts.com))
ON-BALANCE VOLUMEOn-balance volume (OBV) is a tool that dissects trading volume into two categories: the amount bought and the amount sold. (Sounds good so far.) This is acomputer-generated statistic, as I could not begin to imagine doing this task manually. The purpose of course is to determine whether a stock is under accumulation ornot. By tracking OBV in a flat market, a trader can get a sense of future price action;OBV is closely linked to the “volume precedes price” axiom.On-balance volume (OBV): A technical indicator that signals the buying andselling momentum of a stock by comparing price to volume. OBV works on thetheory that when a stock closes up for the day, the volume of shares traded represents buying power; and when a stock closes down for the day, the volume ofshares denotes selling power. Since trend changes in OBV often precede trendchanges in price, on-balance volume can be used to forecast market reversals.
There are different ways to look at this. If a stock is channeling sideways on average volume, a trader would look at OBV to see if there’s a net accumulation occurring. If the stock is under accumulation, the law of supply and demand will
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eventually begin pushing the price up; to what degree depends on how aggressivethe buyers are.This works both ways. Let’s say that there’s a large amount of stock being fedinto the market. Institutions sell it off piecemeal to prevent killing a stock. OBV is agood way to detect this action. Why would you want to sell if a stock is under serious accumulation? Why would you want to buy if there’s an overall trend of distribution underway?Figure 9.11 features a daily bar chart with on-balance volume (the middle line)and volume (at the bottom). The left side of the OBV indicator is flatter than SouthDakota, giving no indication of any sentiment one way or the other. However,something happened of huge significance, as shown by the volume spike (1). Subsequent accumulation began (2) which led to a noticeable upturn in the trend line(3), which was trending up before, just not that much. Some technicians believe thatfor a trendline to be valid it should be at a 45°angle. Anything steeper is not sustainable; anything flatter isn’t a true trend.
PRICE ENVELOPESA price or percentage envelope is an enhancement of a simple moving average. Traderswill surround a moving average with percentage bands that indicate a certain
Figure 9.11 On Balance Volume with Daily Bar Chart (Courtesy of QCharts(www.qcharts.com))
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percentage above and below the moving average (see Figure 9.12). This strategymakes it easier to spot when a stock or index has strayed too far from the moving average. This would indicate the stock is overextended in one direction or the other. A typical percentage might be 10% (10% above and below the moving average). Ashort-term trader might use a 3% envelope on a short moving average such as a 10DMA or a 21 DMA.This is another tool used to spot extreme price swings that would identify a goodopportunity to employ a contrarian viewpoint as the stock returns to a more normalrange. (See Bollinger bands later in this chapter for further variations.)
A WORD ABOUT TIME INTERVALSThe computer has done wonders for technical analysis because it has permittedevaluations to be performed faster than ever before. One mistake that many new(and some seasoned) traders and investors make is noting every single wiggle astock will go through by looking at graphs with a one-minute time interval. Unlessyou’re an emotionless being like Mr. Spock, this will lead to shattered nerves andulcers. I like to look close-up from time to time; but I get a better perspective when
Figure 9.12 Price Envelopes with Moving Average for SUNW (Courtesy of QCharts(www.qcharts.com))
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I step back to look at things using a broader time horizon. Some savvy traders canscalp the smaller price fluctuations and make a good living doing it. You’re betteroff leaving that game to someone else and focusing on bigger, longer-lasting trends.You’ll preserve your trading capital as well as keep your sanity (or what’s left of it).
TOPS AND BOTTOMS AND VOLUMELet’s face it: institutions move markets; the retail investor does not. If you want agood leading indicator of stock direction, volume is a great place to start. Investor’sBusiness Daily goes into great depth identifying stocks with the greatest percentagegain in volume. It’s easy to find the most actively traded stocks and options on anygiven day; but percentage-wise, the biggest gainers can be a good signal of bigmoves (up or down) to come.
CapitulationCapitulation is a word used to describe an extreme display of a market bottom(most often) and occasionally a market top. The words top and bottom are thosepoints where buyers and sellers, respectively, exhaust themselves. The guns they’reusing begin to click-click instead of fire. (The reason this happens is explained further, in Chapter 10, on sentiment analysis.) Basically, the crowd is wrong at rangeextremes. If everybody is in who wants in, who’s left to buy? If everyone’s out
Capitulation: A point in time when investors, en masse, finally give in during amarket decline. That is, some investors will hold fully to their bullish views on themarket during a bear market until a certain point. At the height of selling, however, the few remaining bullish investors will finally yield (sell their stocks); wheneveryone seems to have given up hope, the market has experienced capitulation.
who’s going to be out, who’s left to sell?An increase in volume is typically a good sign of reversals in the trend or the beginning of a new trend (especially when the volume increases dramatically from theprevious day’s trading). If the volume triples, that’s a healthy sign that the market isabout to turn around.The identification of capitulation is critical because it is the technical equivalentof an all-clear siren following a tornado. The odd thing about capitulation is that itseems to catch almost everyone off-guard. Figure 9.13 features a good example of achart that looks like it’s going down the drain, but instead goes on to rally big time!Remember back in the summer and fall of 1998? There was a tremendous amountof concern about Russia being insolvent, Brazil defaulting on about 600 trillionmillion dollars of debt, and interest rates had been going up ad nauseum. There wasa dramatic sell-off in September, followed by a rally some would refer to as a bear
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Figure 9.13
Dow Industrials 1998 Bottom (Courtesy of QCharts (www.qcharts.com))
trap. A bear trap is a rally attempt in a bear market that typically fools many traders,and significantly contributes to the overall cynical attitude of investors. Many willargue that this extreme pessimism/cynicism is a requirement for a true market bottom. In the case of capitulation, and trend reversals in general, the technicianssometimes will grudgingly seek out some other indicator (gasp!) from a differentanalysis technique—most often sentiment analysis.Some technical analysts feel that capitulation has to occur in orderfor the market to move from a bear market back to a bull market.
TRENDSA trend is the general direction in which a stock or index is headed. In a bull marketthe trend is up; in a bear market, it’s down. Going back to Figure 9.7 for a moment,the trend for PMCS was definitely up before it peaked around $255 a share. It wasat this peak that the trend reversed. Wall Street is plastered with clichés, so here’sanother one: “The trend is your friend until the trend ends.” That’s true. Physicsteaches us that an object in motion will continue in motion until an outside force affects it. A stock going up will continue to go up until it stops, just like a stock going
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down will continue going down until it stops. To the technical analysts’ way ofthinking, it’s that last part about the outside force affecting it that they’re interestedin. It’s these points in a chart where directions (trends) change that everyone gets allexcited about; and you should, too.
Trend: A constant movement of a variable over the course of time. Dependingon the time frame, it can be considered a short-term or a long-term trend. Forexample, the movement upward in a stock price over the course of a few daysor weeks is considered a short-term uptrend. A constant, upward move in theprice of a security over months or years is considered a long-term uptrend.
When a stock goes up, at a certain point the buyers evaporate, stalling the upmove. That point is called the resistance level. A stock or index is said to hit resistance when the sellers (bears) outnumber the buyers (bulls), sending the stock backdown. The flip side of the equation is when the stock or index is going down: Thepoint at which the buyers overpower the sellers and the stock begins heading backup is called the support level (see Figure 9.14)Technical analysis revolves around these two terms: support and resistance.Understanding these concepts will be of tremendous value as we move forward.Let’s look at a real chart and see if we can determine support and resistancelevels.Figure 9.15 shows a bar chart that reveals the recent trading action of Microsoft(MSFT). It’s easy to see when buyers stepped in, although they couldn’t seem to getthe stock to rise. Up top, the bulls just couldn’t seem to overcome the bears, as thesupply was greater than demand. You’ll notice in the center of the resistance linethere was an attempted breakout of the stock, but it couldn’t follow through and collapsed. This chart has examples of several different things occurring, such as consolidation, trend reversals, and a failed rally.
Figure 9.14
Support and Resistance (Courtesy of QCharts (www.qcharts.com))
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Figure 9.15 MSFT Bar Chart with Support and Resistance Levels (Courtesy ofQCharts (www.qcharts.com))
Breakout: When a stock rises above a resistance level or falls below a supportlevel. A resistance level is a price that a stock has risen to on multiple occasionsbut has failed to exceed, or penetrate. When a stock breaks through that resistance level, especially when volume is high, the stock is likely to make a majoradvance, according to technical analysts. A breakout on the downside occurswhen a stock falls through a support level. A support level is the inverse of a resistance level. It represents a price that a stock has dropped to on more than oneoccasion, but hasn’t been able to penetrate.Consolidation: The behavior of a stock price after a major advance or decline.Specifically, it is a period of time that sees a stock price trading within a narrowrange. Some technical analysts argue that intermittent consolidation periods arenecessary for a sustained advance in a stock price.Trend reversal: Trends are sustained periods of rising or falling prices. When astock price is moving up, it is an uptrend. If a security’s price is moving lower, itis considered a downtrend. Reversals occur when stock prices go from uptrendsto downtrends or downtrends to uptrends.Failed rally: A short-term rise in a stock’s price during a predominant downtrendthat is quickly met with selling pressure.
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Using Figure 9.15, in the center of the resistance line, do you notice the bar thatpoked its way through but didn’t hold? Microsoft tried to break out of its tradingrange, but couldn’t. This is known as a failed rally attempt. Traders look for thesesituations constantly, since, if it had been able to continue upward, it would havebeen making new highs. This would have been great news because it would havemeant that everyone was making money. In other words, every single person longthe stock up to this point had a profit in it. But then the supply of stock dried up because, after all, who wants to sell a winner? However, this was not the case here,and down it came. Traders saw this as a failed rally, and either dumped the stockthey owned, taking a profit on the nice run it had just had, or began shorting thestock. Either way, supply began to flood the market and there wasn’t enough buyingpower to keep the price up. In this instance, the bears won the battle.“Cut your losses, and let your winners run” is yetanother popular axiom in the investment world.
An interesting thing happens when a stock breaks out: What used to be a resistance line now becomes support! Figure 9.16 demonstrates these dynamics. Oncethe breakout is confirmed, sometimes there’s a new round of buyers at the breakoutprice with follow-through the next day. Then, if later on the stock sells off and returns to this new support level, traders will first look to see if this support holds,then start buying again! Think of it as climbing the stairs—what was once the ceiling (resistance) now becomes the floor (support).The opposite is true heading south, as shown in Figure 9.17. The floor now becomes the ceiling. Traders look at this very carefully, too, because if a stock breaksthrough support, everyone starts looking for the next support level. The chances arepretty good the next stop in a falling price will be there. The art of determiningwhen this fall is over (i.e., something happens to make it stop going down) is sometimes called “picking a bottom,” or my favorite, “catching a falling knife.” I like the
Figure 9.16
Old Resistance Becomes New Support
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Figure 9.17
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Old Support Becomes New Resistance
“falling knife” term because it illustrates how you can get hurt, big time, trying topredict with cash when the exact reversal will occur. Bears do the same thing on abreakout. If they begin shorting too soon, they get what’s known as a short squeeze:when they begin to cover, it will often push a stock still higher. That’s why tradersoften prefer to wait until a stock or index hits the next support level and holds. Thisis one reason it’s so easy to lose money: you seldom see panic buying, only panicselling. So watch those support and resistance levels carefully!Figure 9.18 is a good example of a stock that first broke out above a stubborn resistance level. This particular move looks more like a Roman candle, though, because it soon came tumbling down. The left-hand arrow under “Break Down”shows the first breach of the new support level (old resistance level). The bullsmade a valiant attempt to save this stock, but in the end they got butchered as thestock went on to take out even the lower support level—not a good sign.
TREND LINESA trend line is simply the support and resistance lines turned at an angle. A stock orindex will follow this trend line as in the previous examples, but this time the lineswill not be horizontal. Figure 9.19 shows a stock in an upward or bullish trend line.It’s trading in a channel (as did previous examples), but the support line (lows) keepgetting higher, as does the resistance line. A technician would look at this and seehigher lows and higher highs—hallmarks of an upward trend.Trend lines: A term used in technical analysis to indicate the direction of a stockprice over a period of time. On a stock chart, it can be seen as a straight linealong the bottom of an upward-moving stock (market) price or along the top ofa downward-trending stock (market) price. Technical analysts believe that thelonger the trend line, the more likely it is the stock price will continue in that direction. A break in the trend line indicates a change in trend.
TREND LINES
Figure 9.18
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Breakout and Break Down (Courtesy of QCharts (www.qcharts.com))
To draw these lines, just take a ruler and pencil, then place the ruler on the lowestpoints on the zigzag price points. If it is a good example of a trend line, these pointswill line up. The length of it will vary. Some trend up (or down) for long periods, as inweeks or even months. Others will trend for a few hours. What the technical analystlooks for is this trend to be broken, up or down. Remember that axiom, “The trend isyour friend until the trend ends”? In the case of Figure 9.19, the trend went from friendto best buddy when it broke out to the upside, signaling a major breakout. If the supportline had been broken, it would have meant a reversal had occurred—a bearish indicatorsignaling a trader to either close out the position or go short. The Wall Street Journal,Investor’s Business Daily, and Barron’s are ideal sources to look for trend lines.When charting a stock or index, sometimes all you’ll get is a support or resistanceline, as in Figure 9.20. This stock was trending up very nicely, thank you, until it (obviously) fell way out of favor with Wall Street. Figure 9.20 is one ugly scene. Eachunit in the bar chart above represents one day, so you can see that this particular stockwas doing pretty well. Over the course of three trading days, however, it dropped likea rock, sending a very strong sell signal. You’ll notice a gap in the bar figures just below the support trend line. If the