Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
The field of technical analysis is based on three assumptions:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
Use the stock chart to identify the current trend. A trend reflects the average rate of change in a stock’s price over time. Trends exist in all time frames and all markets. Day traders can establish the trend of their stocks to within minutes. Long term investors watch trends that persist for many years. Trends can be classified in three ways: UP, DOWN or RANGEBOUND.
In an uptrend, a stock rallies often with intermediate periods of consolidation or movement against the trend. In doing so, it draws a series of higher highs and higher lows on the stock chart. In an uptrend, there will be a POSITIVE rate of price change over time.
In a downtrend, a stock declines often with intermediate periods of consolidation or movement against the trend. In doing so, it draws a series of lower highs and lower lows on the stock chart. In a downtrend, there will be a NEGATIVE rate of price change over time.
Rangebound price swings back and forth for long periods between easily seen upper and lower limits. There is no apparent direction to the price movement on the stock chart and there will be LITTLE or NO rate of price change.
Trends tend to persist over time. A stock in an uptrend will continue to rise until some change in value or conditions occurs. Declining stocks will continue to fall until some change in value or conditions occurs. Chart readers try to locate TOPS and BOTTOMS, which are those points where a rally or a decline ends. Taking a position near a top or a bottom can be very profitable.
Trends can be measured using TRENDLINES. Very often a straight line can be drawn UNDER three or more pullbacks from rallies or OVER pullbacks from declines. When price bars then return to that trendline, they tend to find SUPPORT or RESISTANCE and bounce off the line in the opposite direction.
A famous quote about trends advises that “The trend is your friend”. For traders and investors, this wisdom teaches that you will have more success taking stock positions in the direction of the prevailing trend than against it.
Volume measures the participation of the crowd. Stock charts display volume through individual HISTOGRAMS below the price pane. Often these will show green bars for up days and red bars for down days. Investors and traders can measure buying and selling interest by watching how many up or down days in a row occur and how their volume compares with days in which price moves in the opposite direction.
Stocks that are bought with greater interest than sold are said to be under ACCUMULATION. Stocks that are sold with great interest than bought are said to be under DISTRIBUTION. Accumulation and distribution often LEAD price movement. In other words, stocks under accumulation often will rise some time after the buying begins. Alternatively, stocks under distribution will often fall some time after selling begins.
The concept of SUPPORT AND RESISTANCE is essential to understanding and interpreting stock charts. Just as a ball bounces when it hits the floor or drops after being thrown to the ceiling, support and resistance define natural boundaries for rising and falling prices.
Buyers and sellers are constantly in battle mode. Support defines that level where buyers are strong enough to keep price from falling further. Resistance defines that level where sellers are too strong to allow price to rise further. Support and resistance play different roles in uptrends and downtrends. In an uptrend, support is where a pullback from a rally should end. In a downtrend, resistance is where a pullback from a decline should end.
Support and resistance are created because price has memory. Those prices where significant buyers or sellers entered the market in the past will tend to generate a similar mix of participants when price again returns to that level.
When price pushes above resistance, it becomes a new support level. When price falls below support, that level becomes resistance. When a level of support or resistance is penetrated, price tends to thrust forward sharply as the crowd notices the BREAKOUT and jumps in to buy or sell. When a level is penetrated but does not attract a crowd of buyers or sellers, it often falls back below the old support or resistance. This failure is known as a FALSE BREAKOUT.
Support and resistance come in all varieties and strengths. They most often manifest as horizontal price levels. But trendlines at various angles represent support and resistance as well. The length of time that a support or resistance level exists determines the strength or weakness of that level. The strength or weakness determines how much buying or selling interest will be required to break the level. Also, the greater volume traded at any level, the stronger that level will be. Support and resistance exist in all time frames and all markets. Levels in longer time frames are stronger than those in shorter time frames.