Technicians say that a market’s price reflects all relevant information, so their analysis looks at the history of a security’s trading pattern rather than external drivers such as economic, fundamental and news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians’ focus on identifiable trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what
investors think of that information, known and perceived; studies such as by Cutler, Poterba, and Summers titled “What Moves Stock Prices?” do not cover this aspect of investing.
Prices move in trends
Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by Dow Theory.
An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the
“zig-zag” movement in the price. The series of “lower highs” and “lower lows” is a tell tale sign of a stock in a down trend. In other words, each time the stock moved lower, it fell below its previous relative low price. Each time the
stock moved higher, it could not reach the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn’t pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. “Everyone wants in on the next Microsoft,” “If this stock ever gets to $50 again, I will buy it,” “This company’s technology will revolutionize its industry, therefore this stock will skyrocket” – these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.
Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse – the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.
Charting terms and indicators
• Resistance — a price level that may prompt a net increase of selling activity
• Support — a price level that may prompt a net increase of buying activity
• Breakout — the concept whereby prices forcefully penetrate an area of prior support or resistance, usually, but not always, accompanied by an increase in volume.
• Trending — the phenomenon by which price movement tends to persist in one direction for an extended period of time
• Average true range — averaged daily trading range, adjusted for price gaps
• Chart pattern — distinctive pattern created by the movement of security prices on a chart
• Dead cat bounce — the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
• Elliott wave principle and the golden ratio to calculate successive price movements and retracements
• Fibonacci ratios — used as a guide to determine support and resistance
• Momentum — the rate of price change
• Point and figure analysis — A priced-based analytical approach employing numerical filters which may incorporate time references, though ignores time entirely in its construction.
• Cycles – time targets for potential change in price action (price only moves up, down, or sideways)
Types of charts
• Open-high-low-close chart — OHLC charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.
• Candlestick chart — Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.
• Line chart — Connects the closing price values with line segments.
• Point and figure chart — a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.
Overlays are generally superimposed over the main price chart.
• Resistance — a price level that may act as a ceiling above price
• Support — a price level that may act as a floor below price
• Trend line — a sloping line described by at least two peaks or two troughs
• Channel — a pair of parallel trend lines
• Moving average — the last n-bars of price divided by “n” — where “n” is the number of bars specified by the length of the average. A moving average can be thought of as a kind of dynamic trend-line.
• Bollinger bands — a range of price volatility
• Parabolic SAR — Wilder’s trailing stop based on prices tending to stay within a parabolic curve during a strong trend
• Pivot point — derived by calculating the numerical average of a particular currency’s or stock’s high, low and closing prices
• Ichimoku kinko hyo — a moving average-based system that factors in time and the average point between a candle’s high and low
These indicators are generally shown below or above the main price chart.
• Advance decline line — a popular indicator of market breadth
• Average Directional Index — a widely used indicator of trend strength
• Commodity Channel Index — identifies cyclical trends
• MACD — moving average convergence/divergence
• Relative Strength Index (RSI) — oscillator showing price strength
• Stochastic oscillator — close position within recent trading range
• Trix — an oscillator showing the slope of a triple-smoothed exponential moving average
• Momentum — the rate of price change
• Accumulation/distribution index — based on the close within the day’s range
• Money Flow — the amount of stock traded on days the price went up
• On-balance volume — the momentum of buying and selling stocks
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