Technical Analysis Basics
Flags and Pennants are countertrend consolidation formations. In the case of a flag the boundaries
are parallel, while a pennants boundaries are converging.
Rectangles are sometimes referred to as trading ranges or areas and can be
bounded top and bottom by horizontal lines. This type of consolidation
area represents a major conflict between supply and demand with no clue
to the outcome until the eventual, decisive breakout occurs. Rectangles
can be distinguished by diminishing volume similar to triangles.
Right Angle Triangles, Ascending and Descending Triangles are
bullish formations and descending triangles are bearish formations. If
the top line is horizontal and the bottom line is up-sloping the triangle
is the ascending variety and if the bottom line is horizontal and the
top line is down sloping the triangle is the descending variety. Prices
ascend when the break is from an ascending triangle and descend when the
break is from a descending triangle.
Trendlines and Channels
The most basic and useful skill any technician
can possess is the ability to draw and utilize basic trendlines. Prices
move in trends of varying durations and are simply drawn by fixing on
point at the last turn in prices and drawing a straight line under but
generally not intersecting prices in an up trend to the next logical point
that defines the price action. In a down trending market the line is drawn
connecting the tops rather than the bottoms. Frequently prices will rise
in a channel, moving predictably between the two parallel lines that define
it. A very useful trading situation.
An elementary but essential piece of a trader's
arsenal is the ability to establish basic areas of support and resistance.
Previous tops (former resistance) become support areas as prices decline
and previous bottoms (former support) become resistance as prices advance.
Support is simply an area where sufficient demand exists to stop prices
from falling and resistance is an area where selling pressure halts an
Breakaway Gaps almost always occur where prices break from an area of consolidation or break out over a major moving
average or trendline. Prices breakaway from the range they were trapped
in by major resistance. Continuation or Runaway Gap is a very useful gap
to trade. This gap is found when prices have made an advance and then
gap up to continue on a second leg of the advance, frequently proportional
to the first move, as prices accelerate. Exhaustion Gaps are found when
skyrocketing prices have exhausted themselves. This move is generally
found at the top of a wild run-up. Island Reversal is a rare formation
signaled by a gap up, a short trading range of a day or two and then a
gap down, usually not a major trend reversal, but an interesting phenomena.
Head and Shoulders Top is the most reliable and common of all the major reversal formations.
There are many variations on the formation including multiple shoulders
and heads. They seem to develop with amazing symmetry and are present
at most market tops.
Reverse Head and Shoulders presents itself at bottoms and is simply an inverted version of the head
and shoulders top.
Symmetrical Triangles are the most common form of triangles. A sideways formation with a top that can be more or
less defined by a down sloping boundary and whose bottom can be more or
less defined by an up sloping boundary. This pattern can also be referred
to as a coil.
Double and Triple Tops and Bottoms as reversal formations are quite rare
as a matter of fact and it is extremely difficult to decide if one is
observing a major reversal phenomena or a consolidation formation until
prices have moved significantly. Tops that are relatively close together
and quickly formed are generally not reversals. The true reversal takes
time, generally a month or more. Triple bottoms and tops are quite rare
but they do occur and they are very compelling formations. The quickest
test and one that most fail at first blush is diminishing volume on each
One Day Reversals are largely minor trend phenomena and are often referred
to as a selling climax.
Wedges are countertrend consolidation formations that appear at minor or intermediate
trend reversals. Wedges are characterized
by their converging or nearly converging countertrend boundaries.
Bollinger Bands are considered some of the most useful bands in technical analysis, for they vary in distance from
the moving average of a security's price based on the security's volatility.
During periods of increased fluctuation, the bands widen to take this into
account. When the fluctuation decreases, the bands are tapered for a narrower
focus to the price range. The upper band is the standard deviation multiplied
by a given factor above the simple moving average. The lower band is the
standard deviation multiplied by the same given factor below the simple
moving average. The standard interpretation is that Bollinger Bands do not
give absolute buy and sell signals, but instead indicate whether the price
is relatively high or low, allowing for more informed confirmation with
other technical indicators. Bollinger Bands are typically drawn two standard
deviations from a 20-day simple moving average for intermediate-term analysis,
10 days for short term with 1.5 standard deviations, and 50-day for long-term
studies with 2.5 standard deviations. According to John Bollinger, for the
most accurate average "choose one that provides support to the correction
of the first move up off a bottom. If the average is penetrated by the correction,
then the average is too short. If, in turn, the correction falls short of
the average, then the average is too long. An average that is correctly
chosen will provide support far more often than it is broken." Mr. Bollinger
also contends that: Sharp moves tend to occur after the bands tighten to
the average, when a stock is less volatile. The greater the period of less
volatility, the higher the propensity for a price breakout. When the price
hits the upper or lower bands, it is suggested to confirm with other indicators
whether that price movement shows strength or weakness, respectively, which
could indicate a continuation. If indicators do not confirm this movement,
it can suggest a reversal. Tops or bottoms made outside the bands, followed
by the same inside the bands, indicate a trend reversal. A move originating
at one band tends to go to the other band.
Directional Movement Index is a unique filtered
momentum indicator. It is based on the assumption that markets exhibit strong
trends only about 30% of the time and provides entry only when markets exhibit
significant trending characteristics. Direction Movement is the largest
amount of daily movement a security has up or down. In other words, if the
rise of today's high relative to yesterdays high is larger than the drop
of today's low relative to yesterday's low then the Direction Movement is
said to be up and equal to the difference between today's high and yesterday's
high. Likewise, for the case where the drop in low prices is larger. +DI
and ~VDI are the sums of the up and down directional movements respectively
over the past days specified by the sum of the True Range for the specified
time range. The Directional Movement Index relates the +DI and the ~VDI
to give a measure of trend. The Average Directional Movement (ADX) is simply
a moving average variation of the Directional Movement Index (DX). The Average
Directional Movement Rating (ADXR) takes an average of todays current versus
a past ADX value. If you employ a trend-following technique a long is triggered
when +DI crosses over the ~VDI line and a sell when the -DI crosses over
the +DI line Welles Wilder originally defined directional Movement in 1978.
His book, New Concepts in Technical Trading Systems, offers a full explanation
of all the facets of using Directional Movement.
Moving Average Convergence Divergence (MACD)
is a price momentum indicator developed by Gerald Appel. The oscillator
is based on the price spread between two exponential moving averages of
the closing price. The two commonly used exponential moving averages are:
a 12 period exponential moving average and a 26 period exponential moving
average The difference between these two is then smoothed by a 9 period
exponential moving average. This is called the signal line. When MACD is
negative and below the signal line you should be poised for a buy signal.
This occurs when MACD rises above the signal line. You should be ready to
sell when MACD drops below the signal line.
Momentum is a relatively straightforward indicator
that measures the acceleration or deceleration of prices as opposed to price
itself. It is calculated by subtracting the price of x periods ago from
the price now. This indicator is constructed to measure the speed or rate
of change and can also be referred to as rate-of- change (ROC). One of the
benefits of this indicator is that it leads price action at market turning
The Money Flow Index is a volume-weighted version
of the Relative Strength Index. The Money Flow Index is calculated in the
same fashion except that the up and down averages are multiplied by volume
giving a picture based on activity and not simply price movements.
Moving Average (MA) is perhaps the oldest and
the most widely used technical indicator. It shows the average value of
a security's price over time. Moving averages can be calculated in a number
of ways. A simple moving average (SMA) is calculated by adding the prices
over a given number of periods, then dividing the sum by the number of periods.
For example, a nine-day simple moving average would add together the closing
prices for the last nine days, and then divide that number by nine. An exponential
moving average (EMA) gives more weight to recent prices, and is calculated
by applying a percentage of today's closing price to yesterday's moving
average. The longer the period of the exponential moving average, the less
total weight is applied to the most recent price. The advantage to an exponential
average is its ability to pick up on price changes more quickly. Moving
averages are also used to plot values other than price, for example, volume.
On Balance Volume
On Balance Volume (OBV), developed by Joe Granville,
is a volume trend that relates price to volume, and tries to capture the
buying and selling pressure in the market. The indicator's objective is
to show if volume is flowing into or out of a security. Money is flowing
into the security when the indicator is rising and out of the security when
the indicator is falling. Adding the volume to a cumulative total when prices
close higher and subtracting the volume from the total when prices close
lower calculate OBV.
Relative Strength Index (RSI) is a price momentum
indicator, which depends solely on closing prices. The RSI is based upon
the difference between the average of the closing price on up days and the
average closing price on down days over a given period, and is plotted on
a vertical scale of 0 to 100. RSI avoids the problems of erratic movement
by dropping off old data, the take away, number that weakens the Rate of
Change and Stochastics. RSI an oscillator introduced by J. Welles Wilder,
Jr., in 1978 is probably one of the most widely followed technical indicators
available. RSI uses thresholds of 30 and 70 as oversold/overbought readings.
Also, divergence with price seems to work well. A positive divergence is
when prices continue to drop while RSI fails to make new lows. Likewise,
a negative divergence is when prices continue to climb and RSI fails to
make new highs.
The Stochastic Oscillator shows closing price
relative to the range of prices over a user-determined number of periods.
The Stochastic Oscillator is based on the premise that during an upward
trading market, prices tend to close near their high, and during a downward
trading market, prices tend to close near their low. Stochastics measures
at what point the price of a security is within the entire price range of
the security over a given period. A popular and dynamic indicator developed
by Dr. George Lane, it is widely followed and is interpreted in a similar
manner to RSI. Signals can be given from the crossing of thresholds, crossing
of one or more of its own smoothings, and/or divergence with price. There
are many variations of Stochastics employed but the basic premise is that
%K is the primary indicator and either %D or %D Slow is the second indicator.
%D and %D Slow are merely smoothed values of the original %K. There are
also exponential, simple and weighted versions of the oscillator.