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.
Support and Resistance
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 advance.
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 respective peak.
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 points.
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.