What is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, past prices, and volume. Technical analysts do not attempt to measure a security's intrinsic value; instead they look for patterns and indicators on stock charts that will determine a stocks future performance. Technical analysis has become popular over the past several years, as more and more people believe that the historical performance of a stock is a strong indic action of future performance. The use of past performance should not come as a big surprise. People using fundamental analysis have always looked at the past performance by comparing fiscal data from previous quarters and years to determine future growth. The difference lies in the technical analyst’s belief that securities move with very predictable trends and patterns. These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable. Some technical analysts claim they can be extremely accurate a majority of the time. There are many instances of investors successfully trading securities with only the knowledge of its chart and without even understanding what the company does. Technical analysis is a terrific tool, but most agree that it is much more effective when combined with fundamental analysis. Let's now look at some of the major indicators technical analysts use.

The Bar Chart

           Bar charts are some of the most popular type of charts used in technical analysis. As illustrated on the left, the top of the vertical line indicates the highest price a security traded at during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar and the opening price is shown on the left side of the bar. A single bar like the one to the left represents one day of trading.
                  The advantage of using a bar chart over a straight-line graph is that it shows the high, low, open and close for each particular day. This is the type of chart we will be using to display various indicators throughout this tutorial. There are two more types of charts that are also frequently used for technical analysis that are similar to the bar chart. The first we will look at is called "Candlestick Charting".

Candle Stick Charting

Candlestick charts have been around for hundreds of years. They are often referred to as "Japanese Candles" because the Japanese would use them to analyze the price of rice contracts. Similar to a bar chart, candlestick charts also display the open, close, daily high, and daily low. A difference is the use of color to show if the stock was up or down over the Candlestick charts have a "love or leave" relationship with investors. People either love candlesticks and use them frequently, or are completely turned off by them. There are several patterns people look for with candlestick charts, here are a few of the popular ones and what they mean:

This is a bullish pattern, the stock opened at (or near) its low and closed near its high.

The opposite of the pattern above, this is a bearish pattern. This indicates that the stock opened at (or near) its high and dropped substantially to close near its low.

Called "The Hammer", this is a bullish pattern only if it occurs after the stock price has dropped for several days. A Hammer is identified by a small body along with a large range. The theory is that this pattern can indicate a reversal in the downtrend is in the works.

Called a "star". This pattern is used in others such as the "doji star".For the most part, stars typically indicate a reversal and or indecision. There is the possibility that after seeing a star there will be a reversal or change in the current trend.

Using the Moving Average

One of the easiest indicators to understand, the moving average shows the average value of a security's price over a period of time. To find the 50-day moving average, you would add up the closing prices (but not always, we'll explain later) from the past 50 days and divide them by 50. Because prices are constantly changing, the moving average will move as well. It should also be noted that moving averages are most often used when compared or used in conjunction with other indicators such as MACD and EMA.

    The most commonly used moving averages are of 20, 30, 50, 100, and 200 days. Each moving average provides a different interpretation on what the stock will do, there is not one right time frame. The longer the time span, the less sensitive the moving average will be to daily price changes. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations (or "noise") that can confuse interpretation.

Here is a visual example using the stock price of AT&T:

Notice back in September when the stock price dropped well below its 50-day average (the green line). There has been a steady downward trend since then and no real strong divergence, until the end of December where it rose above its 50-day average and continued to rise for several weeks.
Typically, when a stock price moves below its moving average it is a bad sign because the stock is moving on a negative trend. The opposite is true for stocks that protrude their moving average - in this case, hold on for the ride.

Using the Relative Strength Index

When talking about the strength of a stock there are a few different interpretations, one of which is the Relative Strength Index (RSI). The RSI is a comparison between the days that a stock finishes up against the days it finishes down. This indicator is a big tool in momentum trading. The RSI is a reasonably simple model that anyone can use. It is calculated with the following formula. (Don't worry, most likely, you will never have to do this manually).

RSI = 100 - [100/(1 + RS)]
where:
RS = (Avg. of n-day up closes)/(Avg. of n-day down closes)
n= days (most analysts use 9 - 15 day RSI)

The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level and you should consider selling. This number is not written in stone, in a bull market some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30 a stock is considered oversold and you should consider buying. Again, make the adjustment to 20 in a bear market.
The shorter number of days used, the more volatile the RSI is and the more often it will hit extremes. A longer term RSI is more rolling, fluctuating a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks in some industries will go as high as 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (1 year or more) to determine what level the historical RSI has traded at and how the stock reacted when it reached those levels.

Here, we have an RSI chart for AT&T. The RSI is the green line, its scale is the numbers on the right hand side that go from 0 to 100. Notice the RSI was approaching the 60-70 levels in December and January and then the stock (blue line)
sold off. Also, notice around October when the RSI dropped to 25 the stock climbed up nearly 30% in just a couple weeks.
Using the moving averages, trend lines, divergence, support, and resistance lines along with the RSI chart can be very useful. Rising bottoms on the RSI chart can produce the same positive trend results as it would on the stock chart. Should the general trend of the stock price tangent from the RSI, it might spark a warning, the stock is either over/under bought. The RSI is a great little indicator that can help you make some serious money. Beware that big surges and drops in stocks will dramatically affect the RSI, resulting in false buy or sell signals. Most investors agree that the RSI is most effective in "backing up" or increasing confidence before making an investment decision, don't invest simply based on the RSI numbers.

Using Bollinger Bands

There are three lines used for the Bollinger band indicator: the upper, lower, and the simple moving average that is between the two. These upper/lower bands are plotted two standard deviations away from a simple moving average. Standard deviation is a measure of volatility; therefore Bollinger Bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen and they contract during less volatile periods.

   The closer the prices move to the upper band, the more overbought the stock is. The closer the prices move to the lower band, the more oversold the stock is. Below is an example using General Electric (GE). Bollinger bands are blue for the lower, green for the average, and red for the upper band:

We have circled three key points on this chart. The blue circle is where the stock price started to create a "base" on the lower band, it appeared that the stock was over sold. Buying at this point would have been a wise choice, as the stock
proceeded to jump 20% or more in the next few weeks.
The two red circles are areas where the stock price was touching or breaking through the upper red band. This is usually an indication that the stock is over bought. In both instances, the stock dropped substantially in following weeks.
The Bollinger bands are a good tool to use, but as we've been preaching all along, never invest solely based on what just one indicator says. Notice there were instances when the stock touched the upper or lower band and did not react. Rather
than basing their investment decisions on Bollinger, many investors use this indicator mainly to solidify a decision they are about to make.

Resistance and Support
Support and resistance are price levels at which movement should stop and reverse direction. Think of Support/Resistance (S/R) as levels that act as a floor or a ceiling to future price movements.

Support - is a price level below the current market price, at which buying interest should be able to overcome selling pressure and thus keep the price from going any lower.

Resistance - is a price level above the current market price, at which selling pressure should be strong enough to overcome buying pressure and thus keep the price from going any higher. One of two things can happen when a stock price approaches a support/resistance level. The first is, it can act as a reversal point, in other words, when a stock price
drops to a support level, it will go back up. The other possibility is that S/R levels reverse roles once they are penetrated. For example, when the market price falls below a support level, that former support level will then become a resistance level when the market later trades back up to that level.

The chart above shows an excellent example of support and resistance levels for General Electric (GE). Notice that once the stock price penetrated below the support level in December, it became the resistance level.
Another characteristic you should understand is that S/R levels vary in strength, leading to certain price levels being designated as major or minor S/R levels. For example, a 5-year high on a bar chart would be a much more significant and useful resistance level than a 1-month resistance level.

ELLIOTT WAVE THEORY

Ralph Nelson Elliott developed the Elliott Wave Theory in the late 1920s by discovering that stock markets, thought to behave in a somewhat chaotic manner, in fact traded in repetitive cycles.

Elliott discovered that these market cycles resulted from investors' reactions to outside influences, or predominant psychology of the masses at the time. He found that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided further into patterns he termed "waves".

Elliott's theory is somewhat based on the Dow theory in that stock prices move in waves. Because of the "fractal" nature of markets, however, Elliott was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. Elliott discovered stock-trading patterns were structured in the same way.



Market Predictions Based On Wave Patterns
Elliott made detailed stock market predictions based on unique characteristics he discovered in the wave patterns. An impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves, five waves can again be found. In this smaller pattern, the same pattern repeats itself ad infinitum. These ever-smaller patterns are labeled as different wave degrees in the Elliott Wave Principle. Only much later were fractals recognized by scientists.
 
In the financial markets we know that "every action creates an equal and opposite reaction" as a price movement up or down must be followed by a contrary movement. Price action is divided into trends and corrections or sideways movements. Trends show the main direction of prices while corrections move against the trend. Elliott labeled these "impulsive" and "corrective" waves.

Theory Interpretation
The Elliott Wave Theory is interpreted as follows:

• Every action is followed by a reaction.
• Five waves move in the direction of the main trend followed by three corrective waves (a 5-3 move).
• A 5-3 move completes a cycle.
• This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.
• The underlying 5-3 pattern remains constant, though the time span of each may vary.