In Part 1 of this series, we discussed the “why” behind technical analysis. Now we turn our attention to answering the “how” of technical analysis.


How Does Technical Analysis Work?

Technical analysis is the study of human behavior. But the way we measure that behavior is through price action. Price action simply refers to the price at which a stock trades. There are four key elements to price action. Every day we have the price at which a stock opens, the lowest price it traded within that day, the highest price it traded within that day, and the price at which it finally closed for the day. These four elements make up the entire price action for the day. A technical analyst also adds one more element to this information known as volume. Volume is simply how many shares are traded that day.

On its own, a stock’s daily price action doesn’t tell us a whole lot. Let’s take a stock like Microsoft for example. Suppose for a moment Microsoft opened the day trading for $21/share. By lunch time the stock was trading for $20/share, but by mid-afternoon the share price had risen to $23/share. By day’s end the people trading Microsoft that day had managed to agree on a price point of $22.50/share.

All this information tells us is that in the morning Microsoft was worth $21, it was worth as much as $23, as little as $20, and for some reason everyone agreed it was worth $22.50 at the end of the day. If we add volume to our analysis, we may see that there was average trading volume on this day. So far we cannot tell a whole lot about the future stock price. We simply have the data from today. But if we plot this data on a chart and combine it with several days of data, we can start to see patterns form in the price of Microsoft. Those patterns reveal something very telling about the people trading Microsoft. And this brings us to our first element of technical analysis: the price chart.


Price Chart

The price chart is the most basic tool of technical analysis. In the old days people had to draw out charts by hand by plotting each price on a piece of paper. Fortunately today we have computers and some excellent software that does all of the dirty work for us.

What a price chart represents is a plotting of all the information I just explained to you. The Open, High, Low, and Closing (OHLC for short) price for each day is plotted along a chart, and that data is now available for the technical analyst to use for his/her behavioral analysis.

There are several types of charts available, but all of them have the same information (OHLC). The three primary charts we use are as follows:

• Line Chart
• Bar Chart
• Candlestick Chart

While each of these charts contain the same data, the way they display it allows the analyst to view the information from a different angle. Sometimes one perspective may shed light that another perspective did not reveal.

Line Charts
The line chart is the simplest type of stock chart. It is created by plotting only the closing price of each day on a chart and then simply connecting the dots with a line. The result is a line chart that looks like this:

Line charts are very useful in the simplest form of analysis.  We can use them to determine primary turning points in a stock, as well as to recognize some price patterns.  But you may already notice that there is some key information missing.  While there are many strengths to the line chart, the great weakness is that it only shows one of the four key price points for the day.  Consequently we need additional types of charts to reveal the rest of the price data. 

Bar Charts
Bar charts are the natural progression from the line chart.  A bar chart plots all four price points for each day.  Consequently, not only do we see the closing prices and basic price action, but we can also see how extreme the trading day was. 

A bar chart is made up of individual bars.  Each bar represents a single day of trading.  (Note: there are variations of a bar chart where each bar could represent either larger or smaller time frames, such as weekly, monthly, or even minute-by-minute, but that is beyond this discussion.) Each bar has a single vertical bar representing the high and low of the day. It also has a small horizontal bar on the left, representing the opening of the day, and a small horizontal bar on the right, representing the closing price of the day.  Here is an example:

Since we read from left to right, the opening price of the day always shows up on the left.  This is the first price of the day.  The high and low are marked by the vertical line, and the closing price is always represented on the right since that is the last price of the day. 

Let’s revisit our Microsoft example from earlier. Here’s what the bar chart would look like:

If you take several days together, you will eventually have a chart that looks like this, with each bar representing one day’s worth of price data.

Bar charts provide many advantages over line charts in that they provide us with all the price data we need to make an educated decision.  And when an analyst trains his eyes to see them, bar charts create something we refer to as “bar patterns,” which are simply clusters of bars together.  These bar patterns can have meaning because when you see a certain pattern form, the stock’s price behavior typically plays out in a certain way. 

Candlestick Charts
Bar charts have been the basis of western technical analysis for many years. But in the 1990s a technical analyst by the name of Steve Nison revealed to the western world a form of charting from Japan called Candlestick Charting.  Candlestick charts are exactly the same as bar charts in the information they give us (Open, High, Low, Close) but are distinctly different in that they add a color to indicate days that are higher or lower. 

Like the bar chart, a candlestick chart draws a single vertical line to represent each day.  The top of the line represents the high of the day, while the bottom of the line represents the low of the day.  But the similarities end there.  With candlestick charts, a small box, or body, is drawn to represent the opening and closing price of the day.  If the closing is higher than the opening, the box is white, representing an up day, and if the closing is lower than the opening, the box is black, representing a down day.  The following image illustrates how candlestick charts are created:

To further illustrate how a candlestick chart is drawn, let’s look at how our example of Microsoft would be drawn on a candlestick chart:

If you were to put several days together, a candlestick chart would look like this:

Candlestick charts offer several distinct advantages over other forms of charting, and they can give the technical analyst a special degree of insight that other forms of charting do not provide.  The most notable and obvious insight is the ease with which an analyst may look at a chart and see if the day was up or down simply based on the color of the candle.  In addition to the obvious addition color brings to the chart, like bar charts, candlesticks also create patterns. These patterns provide insight into what the market may do. 

Candlestick charting is such an effective means of charting that an entire study within the field of technical analysis has been devoted to it.  However, at this early point in your new venture into the field of technical analysis, simply knowing what a candlestick chart is and how it is created is more than sufficient. 

Volume
The last element of the price chart is volume.  Volume is simply a measurement of how many shares were traded of that particular stock during that particular day.  Volume is plotted along the bottom of a chart and is used in conjunction with the other forms of price charts we have already discussed.  Below is an image of a candlestick chart with volume plotted across the bottom so you can see how the two work together.

These five elements, Opening Price, High Price, Low Price, Closing Price, and Volume, are the basis for the entire study of technical analysis. They are a numerical representation of how the people trading the stock feel. These numbers represent the emotion of those traders. And since people are predictable, we can use this data and information to draw several excellent conclusions about the future price action of a given stock.


Market Sentiment

So what do the four prices and volume have to do with predicting the future price of a stock? They reflect something we call market sentiment. Market sentiment is simply how the traders feel about a stock. If the overwhelming feeling is higher, we call that bullish sentiment. If the overall sentiment is lower, we call that bearish sentiment. As one who is wanting to profit from the stock market, your main goal should be to understand when the masses are feeling bullish or bearish on a stock. Then you are better prepared to trade in that direction and make a profit.

What tends to happen in the stock market is that the people trading a stock start to herd, that is, they follow each other. When one person sees another is bearish, he may follow suit and decide to be bearish as well. Then someone observes the second man has become bearish and that person follows as well. This begins a chain reaction, and the whole market will turn bearish on that stock. Then, seemingly out of nowhere, someone decides they are bullish, and the whole cycle starts again in the other direction.

This ebb and flow of bullishness vs. bearishness is the essence of market sentiment. And the price chart, made of up the Opening, High, Low, and Closing prices, is the way we track and chart the sentiment. We can visually see how the traders are feeling because their emotion is factored into the price. If the prices are falling, the sentiment is moving bearish. If the prices are rising, the sentiment is moving bullish. We use the amount of volume to confirm whether or not there are a lot of people feeling that way, or just a few. If we have a bearish move on a stock but there is very little volume, then the price is telling us that very few people are bearish and the rest of the people are just sitting on the sidelines. On the other hand, if we have a bearish move and the volume is average or above average, then we know that a lot of people are bearish and they agree with this move.

One of the most fascinating effects of the herd phenomenon is that it becomes predictable. Since herds move together, the price at which they move becomes obvious. We call it a pivot point, or some people call it a swing point. That’s the point where a stock price switches direction and swings the other way. These pivot, or swing points, are not random. They occur over and over, and they tend to occur at the same place. Better yet, they show up on the price chart and allow us to observe them and provide a place to start building our analysis.


Support & Resistance

When a pivot or swing point is recognized several times, it becomes a key pivot point, and we call it either support or resistance. Think of support as the floor and resistance as a ceiling. Support is always on the bottom, and resistance is always on the top. When a stock trades UP to a pivot point and then falls back down, that price point is called resistance. When a stock trades DOWN to a pivot point and then turns around and continues higher, that price point is called support.

So think of it this way: support is on the bottom and is the price at which new buyers rush in to support the stock. Resistance is at the top and is the price where stock holders choose to sell or liquidate their positions. Consequently, the price meets “resistance” and has a hard time pushing higher. Take a look at this image:

Every time this stock trades up to about $124/share, the price moves lower. And every time it trades down to $116/share, the price moves higher. The resistance is $124, and the support is $116.


Trading Predictable Market Behavior

As you can see, once you learn how to draw lines correctly on a stock, the price action looks much less erratic. In fact it starts to look a bit predictable doesn’t it? This report covers the very basic building blocks of technical analysis, yet all technical analysis ultimately comes down to these principles you have just learned. Once we draw the price for each day, we can see a reflection of the sentiment of the traders. And once we have an idea of what the traders are thinking, we can devise a logical plan to enter and exit a trade.


How to Learn More

If what you have just read makes sense to you and you’d like to learn more, then you would benefit greatly by adding technical analysis to your investment decisions. The best place to start is Trade Smart University’s free workshop called the Foundations of Stocks and Options. This free online workshop will teach you all you need to know about technical analysis—really!

Jeremy Whaley is co-founder of Trade Smart University, an education company dedicated to helping everyday people learn to trade the stock market for consistent profits. If you would like to learn how to trade your own money for steady profits, visit www.TradeSmartU.com and experience affordable, accessible stock market education.