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Technical Analysis (Charting)

Updated on December 12, 2014

Technical Analysis Vs Fundamental Analysis

Technical analysis is the art/science of using charts to predict the direction of financial markets (i.e. using the past to predict the future). Various different types of chart may be created and patterns within those charts, intersections of lines or other interactions can be used to identify turning points, markets lows or highs, buying/selling opportunities etc.

There seem to be two opposing views: charts can tell you everything about the market; or that they are useless and the only thing that is important is the fundamentals (the numbers that indicate the strength of the company, country, asset etc. price and earnings ratios etc.) I used to fit into the latter category, but now I believe that both techniques are important: technical analysis for timing, to help identify changes in investor sentiment and simply to create a visual picture of what has happened, momentum and trends. Fundamental analysis should not be ignored.

Anthony Bolton (The UK equivalent of Warren Buffett? and fundamental analysis guru, now working as a mentor at Fidelity) uses technical analysis to help identify market turning points and to time his investments - He ran the Fidelity Special Situations and Special Values unit and investment trusts which were two of the best investment funds in the UK for 25 years (and still going strong)

This article looks at some of the different types of technical analysis, how it can be used and where to get more information. There are a huge variety of methods and theories and many books and web-sites on the subject, but I shall cover some of the basics here.

Disclaimer: Information in this and other linked articles is unregulated and for general information only and is not intended to be relied upon in making specific investment decisions. Appropriate independent advice should be obtained before making any such decision.

The Case For And Against Technical Analysis

TA is followed by a large part of the investment community and also covered by television investment programmes and investment web-sites, newspapers and magazines, so, in many situations there is a self-fulfilling prophecy: If we all interpret the graphs in the same way then we will move the market.

Graphs can sum-up a lot of information in a concise way that will take a huge number of words, making it easier for our brains to absorb the information.

Some of the simpler types of TA, such as moving averages, range-trading and support and resistance lines are easy to interpret.

But...

Many strategies lag the market, so even if they correctly interpret a change in direction it will have already happened.

There can be a lot of false buy or sell signals and some of the more complex theories can be difficult to interpret or may be ignored by much of the investment community.

Unforeseen events move the markets. Some events really are unknown or unexpected so they are unlikely to have been predicted by a significant number of investors/traders - e.g. government intervention, fiscal stimulus and other natural disasters. These events may move the markets, but not be predicted by the charts, hence the requirement for stop-losses being used in a charting strategy, to get out of a trade if it goes horribly wrong.

Technical Analysis Books

For far more detailed description of how to interpret the charts, trading strategies to use and examples see these books.

For some reviews and recommendations for other finance books please click here...

The Basics of TA

Range Trading, Support and Resistance

Support and resistance lines may be drawn on a chart of an asset price e.g. in the simplest case a straight line connecting price lows and another connecting the highs. When the price reaches either line it is a signal to buy or sell the asset. The lines may be horizontal, in the simplest case, rising or falling. If a significant break-out occurs, through one of these support or resistance levels then a change of strategy is required (e.g. cancel the trade and cut your losses)

Moving averages (see below) may also act as support or resistance lines.

Another kind of support and resistance line is the Bollinger Band: a central moving average (e.g. 20-day MA) and a line one standard deviation above and below the central average - the latter two act as support and resistance (over-sold or over-bought, taking into consideration the volatility of the asset price) This can be displayed on many financial web-sites.

Bullish Trends

Higher highs and lows - buy on lows

Bearish Trends

Lower highs and lows - Sell on highs

To see examples of all of these different types of charts see the Technical Analysis book recommendations above or check out one of the many TA web-sites e.g. stockcharts.com

Do you use Technical Analysis?

See results

Fundamental Analysis Books

Alternatively you may prefer to study the fundamentals of the company, market or asset you are trading...

For some reviews and recommendations for other finance books please click here...

Moving Averages

Moving averages can easily be plotted on many web-sites, averaging the closing price of an asset over a certain number of days (e.g. typically 20 day and 50 day moving averages, although this can be longer or shorter depending on typical length of trade anticipated)

Bullish

e.g.

Price crosses moving average, both rising20-day moving average crosses 50-day moving average, both rising

Bearish

e.g.

Price crosses moving average, both falling20-day moving average crosses 50-day moving average, both falling

Advantages: Easy to plot, read and understand. A nice visual representation of a change in sentiment in the market. Longer moving averages smooth out false buy or sell signals.

Disadvantages: The longer the moving average the later the buy or sell signal is given - i.e. a moving average is a lagging indicator.

To see examples of all of these different types of charts see the Technical Analysis book recommendations above or check out one of the many TA web-sites

MACD - Moving Average Convergence Divergence

How to calculate and interpret MACD

An extension on the Moving Average techniques discussed above is MACD (Moving Average Convergence Divergence)

Moving averages are lagging indicators. Buy and sell signals occur at cross-overs between the price and the moving average lines on the chart, but a 200 day moving average will take a long time to react to changes. A 5 day chart will be much quicker, but may give more false signals. You can predict that a cross-over may occur by looking at the convergence or divergence of the two lines you are considering: The change in separation of the lines. i.e. the magnitude of the longer moving average subtracted from that of the shorter one (i.e. the slow line subtracted from the faster more reactive one)

This variation in separation can be viewed on the moving average charts, but is easier to see plotted on a separate chart and if that is plotted with it's moving average (e.g. the 9-day average of the MACD line) the cross over of these two MACD lines can be used as a prediction of the cross over of the moving average charts - i.e. and early indicator.

The most frequently used periods for MACD analysis are 12 and 26 days

MACD = 12-day Exponential Moving Average - 26-day Exponential Moving Average of price

The signal line (or trigger) is the MACD line smoothed over 9 days:

signal = 9-day Exponential Moving Average of MACD

This may be interpreted in a similar way to a pair of moving averages: e.g. trading signals when MACD line crosses the signal line or the time axis (i.e. y=0)

I find the best way to view this is by plotting the difference between the MACD and the signal line as a histogram

i.e. y = MACD - signal

To see examples of all of these different types of charts see the Technical Analysis book recommendations above or check out one of the many TA web-sites e.g. stockcharts.com

RSI: Relative Strength Index

How to calculate and interpret Relative Strength Index (RSI)

RSI: Relative Strength Index is another popular filter to determine if an asset is over-bought or over-sold: A momentum indicator which compares the magnitude of recent gains to recent losses. This is particularly used by swing traders, but can be used in conjunction with any of the other indicators and strategies discussed here. RSI may be plotted from charting web-sites for most popular stocks and shares or indices, usually as a 9-day or 14 day indicator and may be interpreted simply as follows:

When RSI goes above 70 or below 30 the asset (e.g. stock or share) is overbought or oversold and likely to start trending in the opposite direction.

A reversal is likely after bullish or bearish divergence (a bearish divergence is when the price hits a new high while RSI makes a lower high - Bullish divergence is the reverse situation)

How to calculate the Relative Strength Index (RSI)

RSI = 100 - 100/(1 + RS)

where

RS = ( Average n up closes / Average n down closes ) OR Average gain / Average Loss

and n = number of days

E.G. For a 14 day RSI calculation:

To calculate the average gain and average loss:

1st Average Gain = Sum of Gains over the past 14 periods / 14

1st Average Loss = Sum of Losses over the past 14 periods / 14

Subsequent, calculations are based on the previous averages and the current gain or loss:

Average Gain = ((previous Average Gain) x 13 + current Gain) / 14

Average Loss = ((previous Average Loss) x 13 + current Loss) / 14

Bollinger Band Charts

Bollinger Bands are favoured by forex traders, but can be used for any asset class to determine turning points. Bollinger bands can be plotted by most technical analysis software or web-sites and consist of an 20-day moving average and an upper and lower band derived from the standard deviation of the price equidistant above and below the average. i.e. the separation of the bands represent the volatility of the asset price.

A simple trading strategy for Bollinger Bands is to sell when the price reaches the upper band and sell when it hits the lower one, although this strategy should not really be used on it's own, but used as an extra indicator in conjunction with others discussed here.

Stochastic Oscillators

How to Interpret and Calculate Fast and Slow Stochastic Oscillators

Stochastic (derived from the Greek) means to guess or to aim and for technical analysis Stochastics are calculated by TA software and web-site to give a percentage value representing the possibility of a trend continuing: 0% mean impossible, 100% means completely certain. Stochastic "oscillators"come in two versions: Slow and Fast. Fast stochastics produce more signals, but Slow stochastics are less prone to false signals. For full understanding Stochastic Oscillators I would recommend reading A good book or web-site on the subject, but the basics of how to interpret Stochastics are outlined here:

Two lines will be plotted: a solid line (called %K) and a dotted line (%D)

Buy SIgnal: %K crosses up through %D in an oversold territory

Sell SIgnal: %K crosses down through %D both in an overbought territory

How to Calculate Stochastic Oscillators

Lowest Low and Highest High are for a selected look-back period

%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100

%D = 3-day SMA of %K

%K is multiplied by 100

Patterns

Many people also look for patterns that typically announce a high, low or change of direction

Bearish:

The most popular pattern to look for in a chart is the "Head and Shoulders": a high, followed by a higher high, followed by a lower high (of a similar height to the first).

The simpler "Double Top" - two highs of similar height

Bullish

Inverse "Head and Shoulders" - the opposite of the above pattern.

"Double Bottom"

Fibonacci and Gann Retracement, Elliot Wave Theory

Stock prices or other asset prices often retrace some of their gain or loss, after a big movement in price. This may not be a change in direction of the asset price and it is important to be able to tell the difference between a retracement and an actual change in direction. The two main theories of retracement are Gann theory and Fibonacci (The latter being perhaps more popular than ever since the popularity of the Da Vinci Code, but I digress)

Gann Theory

In the early 1990s W.D. Gann, a trader, noticed that when an asset price moved up a lot it often fell back by 50% of the total magnitude of the move (from low point to high point) e.g. a move from $2 to $6 might be followed by a drop to $4 before continuing the upward movement: A 50% retracement of the original $4 increase. It is not guaranteed that the upward movement will resume and indeed at 50% retracement could indicate a true reversal, but getting in at this point could result in a good profit - As with most trades of this type if you are wrong, you should get out quickly and cut your losses. If the upward momentum continues the exit point would generally be above the previous high. e.g. "buy on dips"

Gann also noticed a similar effect at retracements of 25%, 12.5% etc. So there is a certain amount of luck involved in picking the right level to get back in.

Fibonacci retracement levels

Many people prefer Fibonacci retracement levels: Fibonacci was a 13th century Italian mathematician who noticed the interesting properties of a series of numbers, where each number is the sum of the previous two The Fibonacci Series :1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 ... etc. to infinity Interestingly the ratio of any consecutive numbers is approximately 1.618:1 after the first few numbers at least (or 0.618 going backwards through the sequence) Many structures in nature are built on the same ratios (e.g. the leaves on a fern, seashells, whirlpools... and many more) and even many man-made structures, because it forms a pattern that is pleasing to the eye.

Another trader, Ralph Elliott, believed that the behaviour of other traders would would also follow the Fibonacci series when reacting to stock-price retracements and if everyone else is doing it the market will react (similar to the theory behind Gann 50% retracements, based on people reacting to a simple halving of the initial price movement, but based on human nature or animal instinct, rather than simple maths) The assumption is that when the price retraces a previous large move by 38% i.e. (1 - 0.618) or by 62% it has moved by the Fibonacci ratio and is therefore a significant point to reenter the trade.

Elliott Wave Theory

Elliott interpreted the patterns created in the charts, caused by the retracements at Fibonacci ratios, as a wave, hence the name Elliott wave theory. Many traders just trade the Fibonacci retracement levels in conjunction with Gann retracement levels without paying too much attention to Elliott Wave Theory (e.g. retracements at 23.6%, 38%, 50% and 62%, 100%) and refer to it as Fibonacci retracement even if mathematicians protest.

Technical Analysis Strategies

Combining Techniques

The market signals given by technical analysis will sometimes fail, so combining two or more of the above strategies will improve the accuracy of the results by rejecting or confirming some signals.

A classic strategy and perhaps one of the most widely used, is the 5/20 strategy (invented by or attributed to Richard Donchian) This is very simple and involves using the 5-day and 20-day moving averages:

Buy when the 5-day moving average crosses above the 20-day moving average.

Sell when the closing price crosses below the 5-day

This strategy will give some false signals, but can then be combined with one or more other strategies to filter, i.e. confirm or reject the buy and sell signals. e.g. this classic moving average method could then be filtered with a momentum or relative strength indicator, although the combinations chosen would depend on the entity being traded, timescales and the methods you are adopting (see the Technical Analysis books for more information and examples)

Summary

This article just covers the basics of Technical Analysis and there are many more theories and trading techniques that I have not covered. There are many books on the subject which cover the theory and explain how to put it into practice (See the books section above) Short-term traders very often use TA to predict the direction of the market whereas longer-term investors may just use it more for timing in conjunction with Fundamental analysis.

To see examples of all of these different types of charts see the Technical Analysis book recommendations above or check out one of the many TA web-sites

Investment Books... For Dummies

Despite the title, I have found the ...For Dummies books about technical analysis etc. to be very useful overview of this subject, comprehensively covering the basics to more complex strategies, how to build s trading system and how to use technical analysis to predict and time market movements.

Do you use Technical Analysis and has it been useful?

Do You Use Technical Analysis?

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    • profile image

      mstcourtjester 3 years ago

      Yes, very. I use fundamentals to find value, then use a simple 10 ma on a one month mountain chart as my stoploss. Price above I stay long, price below I'm out.

    • profile image

      jo9091 4 years ago

      This a fantastic lense my favorite indicator is macd i am all about momentum trading

      http://97f635rzfz9k2t17zs47v72t2l.hop.clickbank.ne...

    • robertred24 profile image

      robertred24 4 years ago

      I have bought Murphy's "Technical analysis of the financial markets" and it's a very good book

    • profile image

      pdean123 5 years ago

      One of the best trading indicators is the RSI Indicator .

    • profile image

      anonymous 5 years ago

      Very useful information about investment technical analysis.

      you can contact here : http://www.capitaltrends.in/CT/view/InvestorsEduca... for better technical analysis plans.

    • Andy-Po profile image
      Author

      Andy 5 years ago from London, England

      @anonymous: Thanks very much. Yes. I agree. I was really just trying to give an overview or introduction. To really master these techniques you would need to read one or more of the many books on the subject (I listed a few here), or experiment with trading web-sites.

    • profile image

      anonymous 5 years ago

      great tips too basic though

    • profile image

      TradingTips 6 years ago

      Great lens, charting patterns that are black and white are easy to learn. it's the ones which need a bit of judgement that takes some practice!

    • profile image

      MoneyHoney01 7 years ago

      Great lens. I use Fibs for the most part.

    • ElizabethJeanAl profile image

      ElizabethJeanAl 7 years ago

      Very informative.

      Thanks for sharing

      Lizzy

    • profile image

      gregforex 8 years ago

      This is a great lens. I have to say I'm of the fundamental analysis school, though: check out some of my team's analysis at www.tradeforexfundamentally.com

    • profile image

      anonymous 8 years ago

      Excellent lens Andy, and you explained the fundamentals very well.

      Thanks for the information!

      Susie

    • Andy-Po profile image
      Author

      Andy 8 years ago from London, England

      [in reply to JaguarJulie]

      I hope your 401k has recovered a bit now. We've had a few good days. Unfortunately technical analysis can't predict everything and a lot of people did get caught out by recent events.

    • profile image

      julieannbrady 8 years ago

      Andy -- I wonder if technical analysis/charting would have helped me with my 401k since it lost 35% of value in 2008 and another almost 7% in the first quarter of this year??? I was hoping to recoup some of the value before I pull it out.

    • Andy-Po profile image
      Author

      Andy 8 years ago from London, England

      Thanks. That's a very good question. In fact the reason I wrote the article was that I didn't think technical analysis should work, then discovered that Anthony Bolton (the UK equivalent of Warren Buffett) uses fundamental analysis for identifying what to buy and Technical Analysis for timing, so I have done lots of research into if it works and why. And the answer is... sometimes and probably because investors move the markets and TA help identify what they are, on average, investing in. TA is certainly not an exact science and should not be the only source of trading information.

      BTW: I tried to follow your link and it didn't work.

      [in reply to MysteryLeo]

    • profile image

      MysteryLeo 8 years ago

      The question of does technical analysis really work comes up.

      Take a look at this page. That's all they do with track histories:

      http://www.traderbot.com/stocks/AllPortfolios.aspx

    • SandyMertens profile image

      Sandy Mertens 8 years ago from Frozen Tundra

      I don't understand all the stock terms. Nice lens.

    • TonyPayne profile image

      Tony Payne 8 years ago from Southampton, UK

      Very nice lens Andy, 5***** I get really confused by the technical terms when it comes to buying and selling stocks. Wish I could have bought some several weeks ago though, lots of opportunity to double your money.