Post on 11 August 2011 by Dongfu
To some it’s a way of making sense out of the apparent chaos of markets so that the past can be used to forecast the future. To others it’s little more than another form of astrology. But, believe or not, technical analysis plays a key role in today’s markets. Some say the reason it works is because enough people believe enough, prompting other people to act on the predictions thrown up by this form of analysis, so triggering self-fulfilling prophecies. Because of the influence it could have on markets, it is better for you to know the basics of technical analysis so that you can understand how it can sometimes drive markets.
How does “technical” analysis differ from “fundamental” analysis?
Fundamental analysis concentrates on the underlying numbers that can affect investment decisions. These include profit and loss accounts, balance sheets, cash flow statements, net asset values, price earnings ratios, returns on equity and various other ratios used to evaluate the health of a company. Market and economic trends are also included in the analysis. Technical analysis covers a wide spectrum of techniques for analysing past price movements. The use of charts is the most basic and widely-used form of technical analysis. Adherents of the system believe that patterns that can be discerned in past price movements will identify probable future trends and key buying or selling opportunities – that is, history repeats itself.
What can a chart, which looks backward, tell me about the future?
Technical analysts believe that stock prices move in trends. A rising trend is plotted among several troughs to identify price support. A falling trend is drawn among several peaks to find out price resistance. Once a trend has been formed, it will remain intact until broken. Trends do not last forever. They eventually change direction, and when they do, they typically follow a pattern, which indicates the changing of investors’ expectations. Some examples are:
Rounding tops and bottoms: A rounding top arises as expectations gradually change from bullish to bearish, while a rounding bottom is a shift from bearish to bullish.
Double tops and bottoms: A double top shows a price moving up to a certain level, back down and then back up again. The resulting pattern is “M” shaped. This implies resistance to further upward movements or the beginning of a downtrend. The opposite is the double bottom, which looks like a letter “W” and indicates a support.
Head-and-shoulders: This well-known pattern looks like its name, and consists of a top, a fall, a higher top, another decline, a move back to the first top. After that comes a big fall. The opposite is inverse head-and-shoulders which often coincides with market bottoms.
Triangles: This appears as the range between peaks and troughs narrows and constricts the price. With increasing “pressure” as the triangle narrows, prices usually break out rapidly from a triangle.
I see that charts sometimes have “moving average” (MA) lines. Are they part of technical analysis?
Yes. Technicians track price averages over different periods, say 10, 20, 50 and 200 days, and then compare them. Generally, when a short-term average breaks through a long-term one, it is a buy signal, and vice versa.
I have also heard about MACD. What’s it?
The MACD or Moving Average Convergence/Divergence is the difference between the 26-day and 12-day moving averages. A 9-day average, called the “signal” line, is drawn on top of the MACD to show buy or sell opportunities – sell when the MACD falls below its signal line (or below zero), and vice versa. The MACD is also used as an overbought or oversold indicator – when the MACD rises dramatically, the stock price might be overextending and is expected to return to more reasonable levels.
Any other popular technical indicators?
Relative Strength Index (RSI): It shows the internal strength of a stock over a given time period, say 14 days. The RSI ranges between 0 and 100. Analysts usually look for a divergence in which the stock trends upward while the RSI trends downward, and vice versa. Prices are expected to correct and move in the direction of the RSI.
Stochastic Oscillator: The closing price is compared to the price range over a period of time. Two lines are drawn – the main line is called %K and the second line is called %D which is the moving average of %K. Buy when the %K line rises above the %D line, or when either %K or %D falls below a specific level, and vice versa.
How can I generate charts on the stocks I am interested in?
Many information vendors and websites provide charting services which allow you to build your own charts. Less serious players might read the standard charts in newspapers.
What should I be aware of? How can I learn more about technical analysis?
This is a vast subject. What we discuss above is only the general interpretation of some popular technical indicators. What is indicated by a chart (e.g. a buy signal or expected change in direction of price movement) may not always realise. It should be interpreted with care and skill. Do not simply look at a single indicator and make an investment decision accordingly. You need to consider a number of technical indicators and how they may affect the interpretation of each other. After all, you should always take into account the fundamentals, in addition to the technical indicators. To find out more, visit the “Technical Analysis” section on the e-Library which has links to sites explaining the subject in depth.
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