The Basics of Technical Analysis

The Basics of Technical Analysis

Today, I’m going to tackle a dull subject, and why you should be very interested in it — even if it doesn’t seem exciting at first.

Charts.

Now, don’t get me wrong, I love charts. The problem is, they are boring to write about, and even more boring to read about it. There’s just no way to jazz it up.

But today’s article is sort of like the beginners guide to technical analysis. This is the final part of the ‘how to’ series I’ve been running with.

A couple of months ago, I discovered that many female investors didn’t know where to start when it came to investing in shares. If you’ve missed out on my earlier emails, click here to catch up.

Right. Let’s get started.

Technical analysis is the idea that past share price movement, fundamental details and market psychology are all included in the share price. Chartist believe that the market is never wrong. Leaving them with only the share price, and supply and demand (volume) to analyse.

Furthermore, they’ll tell you that stock prices only move in trends. In other words, once a trend is established, future price movements are likely to follow the trend. Analysts assume that stock price movement is purely mathematical, and history repeats itself. Chartists will tell you the repetitive nature of price movement is nothing more than market psychology. And that investors all react to the same ‘stimuli’ over time.

Don’t get me wrong, technical analysis isn’t without criticism. The biggest one being that it discounts everything else that happens in the marketplace.

Technical analysts assume the market price is always the correct one. Whereas with fundamental analysis, you are looking for a contrast between the market and the intrinsic value of the company, by analysing its balance sheets.

However, I believe both fundamental and technical analysis have their place. You should always do you own research on a company first. But you can use some basic technical analysis to help set your stop loss level and profit-taking point on shares.

Once you start fiddling around with charts, you quickly discover you can set it to any time period you like. It could show 30 second price data, through to 1 hourly data for a short term market view. If you have a more long term view, set the chart to show weekly or even monthly price data.

What timeframe you use depends on your view of the market. Day traders tend to look for trends within 30 second to 1 minute cycles. Short term traders may use hourly, or even 4-hourly data to determine a short term trend. For those of you with a more medium–long term views, daily or weekly data may work. As I said above, you can use technical analysis to set your entry and exit points with shares. Daily and weekly price data will help most in this area.

For beginners, it’s best to start with two of the most common types of charts: Candlestick and bar charts.

There’s no right or wrong one to use. It comes down to personal preference.

The candle stick chart looks like this:


Source: Online Trading Concepts
[Click to enlarge]

To keep things simple, we are going to assume this candlestick is set to the daily period.

Let’s start with the green candlestick. At the bottom of the body of the candlestick, that base is the ‘opening’ price of the share. And the top of body of the candlestick, is the closing price for that day.

The two little spikes you see at the top and the bottom of the candle indicate the high and low for the day. The main volume of the trading however, is inside the open and close price.

It’s a similar story for the red candlestick on the right. Except in this case, the top of the body of the candlestick represents the opening price, and the bottom of the candlestick is the closing of the price.

The reason for the colours is simple. At a glance you can see the price direction for the share. Green means the stock price moved higher for the day. Red means the stock price headed lower for the day.

Bar charts are quite similar too.


Source: Online Trading Concepts
[Click to enlarge]

In this case, the bar chart is a straight line up and down, with smaller lines coming out from the left and the right. The line on the left represents the opening price, and the line on the right is the closing price for the day. The image above indicates the share price rose higher for the day.

Normally, if you were using a bar chart, an ‘up’ trading day would be shown as green. On the other hand, if the stock traded down for the day, the closing price on the right would be lower than the opening price, and the entire bar would be shown as red.

And with that, we move onto our next topic, support and resistance.

Support is a price point that the stock rarely falls through. In other words, this is a place where traders look to buy into a stock. To analysts, it indicates that the stock is unlikely to go much lower than this.

A resistance line on the other hand, is a price point where the share price hasn’t been able to break through. Generally, this appears to be the point where investors pull out of the stock. That’s another way of saying that people no longer believe the share price can go any higher.

Daily — 1 year chart


Source: CMC Markets
[Click to enlarge]

Meet Mystery Company One. Here I have used a daily bar chart over 12 months.

The black line at the bottom of the chart is the support line. This is where our mysterious company has find found ‘price support’. When the share price has fallen to around $5.12, the stock has changed direction and headed back up.

The blue line however, is our resistance line. This is the point where the share price has hit $5.76, and struggled to ‘break through’ and move higher.

When you’re looking for price support, you’re looking for a price point the share price frequently retraces to (at least two or three times). Often you’ll find a stock quickly plunges through a support or resistance point quite quickly.

The important thing to remember with support and resistance lines is that once one is broken, the role of support or resistance is reversed. I’ll show you what I mean.

Daily chart — 3 Months


Source: Yahoo Finance
[Click to enlarge]

Meet Mystery Company Two.

Here we have support (black line) sitting around $54.50, and the resistance (blue line) around $57.00.

Shortly after March 21, the share price pushed through the resistance line, and has remained above it. This indicates a new trend may be beginning for the share price (upwards). As result, the resistance line is now becoming the ‘support’ line for the stock price.

It takes some practice to find support and resistance on a share price. But there are some basic guidelines to remember.

People love round numbers like 10, 20, 35, 50 and 100. These tend to be major psychological trading points. Many people set stop losses and take profits around these levels. Extra volatility can occur with round numbers, causing more people to move in and out of a stock.

As a share price drops to an important round number, like $20 or $50, it’s unlikely the price will fall through this. The closer the price trades towards these psychological numbers, the more people are likely to buy in.

It’s a similar story as a share price approaches one of these points. The closer it gets, the more you’ll see investors start selling, making it harder for the share price to move about this level. This increased pressure at these levels then reinforces the importance of these points to technical analysts.

Also, most analysts believe that once a trend is established, you’re more likely to see it continue than suddenly reverse. This is where the saying ‘the trend is your friend’ comes from.

Those new to technical analysis often make the mistake of trying to ‘catch’ the change in direction before the rest of the market does. Sometimes, it really is best let the trend establish itself first, before jumping on board.

However, that doesn’t mean a sudden reversal in a share price can’t happen. The markets a volatile and can be unpredictable.

So there are some basic technical details to get you started. But don’t worry if you didn’t find it interesting. Technical analysis isn’t for everyone when it comes to investing. If you are after a more speculative type of investment, I have just the thing for you…check it out here.

Kind Regards,

Shae Russell,
Editor, Strategic Intelligence

Editor’s Note: This article was originally published in Money Morning.

Shae Russell

Shae Russell

Drawing on her extensive experience, Shae is the lead editor of Markets & Money. Each day, Shae looks at broad macro trends developing around the world, combining them with her distaste for central banks and irrational love of all things bullion.

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