Investing Tools for Investors Looking to Excel
10/21/02  

The analysis of chart patterns and trading volume to identify promising buy and sell signals.

Technical Analysis

This widely used approach employs charts depicting price charts (daily or weekly), and daily and weekly trading volumes. Each price tick will show the daily range and the closing price. Pure Technicians do not involve themselves with the business, competitive dynamics, valuation, growth rates, etc. Technicians use chart patterns to forecast future price movements. Fundamentalists also can use technical charts to determine entry and exit points where stocks are extended or have retraced a big price move and should commence a new up-leg.

Investment time periods vary from the day (day trading), to short term, to intermediate, to long term. Short term normally implies days to weeks, intermediate implies weeks to months, while long term means months to years. The types of charts each type of trading horizon should employ is listed below. Moving Averages suggest the smooth trends in the stock most often used by technical investors based on time horizon.

First, let's define trendlines. An uptrend is a series of higher highs and higher lows. An up-trend is drawn underneath the beginning low and the lowest low of an up-move. A downtrend is a series of lower highs and lower lows. A downtrend line is drawn from the initial high to next highest high of the downtrend. 

Now, let's define support and resistance. Support is an area of prior purchases which acts as a source of demand for the stock on the way down. Resistance is an overhead source of supply of stock to sell triggered by an area of prior purchases. Unsophisticated investors will not sell their losers, they will wait until the price returns to their entry level so that they can end the pain by selling at a breakeven. Likewise unsophisticated investors who at a lower level and saw the stock run up significantly only to return to their purchase are likely to buy at their prior entry level.

It is important to not buy in the face of immediate overhead supply or resistance, or short a stock with support or demand directly below your entry point. Trading positions should have some room to run.

Typical patterns consist of breakdowns, breakouts, countertrend retracements in either bull or bear markets, pullbacks, corrections, and trend reversals. Sideways trading patterns are common where a stock trade between prices but within a horizontal pattern.

Let's define these.

Breakdowns- Generally a break in an up-trend represented by a price breaking below a uptrend line, or a moving average such as the 50 day Moving Average, the 150 day Moving Average, or the 200 day Moving Average. Stocks can breakdown before the fundamental logic for such a move is apparent. Generally, a stock breaking below a major moving average will continue to the next major moving average unless major support intervenes to stop the downward fall. Further, stocks that get oversold can rally even if the rally uptimately fails. It is a bad sign for stocks to breakdown on low volume because price follows volume. Often downtrends and breakdowns will end with a climactic sellof on huge volume intra-day, followed by a close above the open and at the top of the range. This suggests the selling has "washed out" weak owners of the stock. This is known as a "Key Reversal Day" and is a buy signal for short term traders and investors looking for prime entry points. Key Reversal days can occur on exhaustion sell-offs setting up a good buy the next day if the stock opens positively. Conversely, a big gap up open, followed by a retreat to the lowest part of the trading range can signal that buying power is temporarily, suggesting the stock may have to pullback to support of either past buying or a moving average. 

Breakouts- Generally these involve breaking above the major moving averages and all major overhead resistance (of current history, say within the last two years) or it could be constituted by a stock breaking to all time high. Resistance and support diminish overtime. Bullish Breakouts should occur on material increases in volume over average daily trading activity. Generally, it is a bad sign for breakouts that are not accompanied by high volume. These can fail in short order.   

Breakouts and Breakdowns- Retests

Any breakout is normally followed by an eventual pullback and test of the breakout point. If you felt the stock you bought was extended from the breakout and you sold, you may want to reenter the stock (if the fundamentals have not changed) if the retest of breakout holds and the stock bounces on good volume.

Breadth is a key determinant of the strength of a move. Breadth is measured by the Advance/Decline line (# of stocks rising in a day minus stocks declining) on a cumulative basis, and by the volume on up-ticks versus the volume on downticks. If the stock market hits a new high but the advance/decline line fails to confirm, we have a bearish non-confirmation.  There are other forms of non-confirmation. If the Dow Jones Industrials, but the NASD and or the Dow Transportation or the Russell 2000 lags well below former highs, this is a non-confirmation, because it suggests money is only flowing to the blue chips. These non-confirmations are resolved normally in no more than six months from the date of the non-confirmation with either the Dow declining or the other averages moving to belated breakouts.

Countertrend Retracements- There are couter-trend reversals and re-tracements. A retracement is a pullback to a moving average or trendline without a breakdown or reversal in the trend. These retracements can be a buying opportunity. Fibonacci retracements are 1/3, 1/2 or 60 % of the most recent uptrend. Stocks which break the 1/3 level will likely retrace back to the 1/2 level. Stocks which break down below the 60% retracement level are most likely reversing a bullish or bearish trend.

Countertrend Reversal- This represents an end to a bullish or bearish trend and constitutes a breakdown. This suggests a major shift and should be indicated by a break of major uptrend and a break of either the 150 or 200 day moving averages. Also, to be conclusive, you would like to see the stock trade below the breakpoint for a couple of days to confirm.

Moving Averages are arithmetic averages of closing stock prices over a given time period. Most critical moving averages are the 50, 150 and 200 day moving averages. Day traders sometimes will employ 10 day moving averages.

Promising Chart Patterns-

Double Tops and Bottoms- This occurs when a stock hits a high or a low after a sizable move, pullsback but fails to hit the old high (or low). A variation of the Double Top (or bottom) is the 1-2-3 chart pattern. The 1 is a retest of recent old low with a failure to breach the immediately prior low. 2, is a move up again which breaks the the downtrend. Finally, 3 is where the stock price rises above the channel created by the first low and bounces up. If the 1-2-3 is accompanied by a big increase in volume it is normally a good sign for a retracement or some magnitude back into major overhead resistance or major moving averages. A top pattern is just the reverse.

1-2-3's are also called double bottoms and  Cup and Handle.The breakout should be accompanied by strong volume significantly higher than recent trading.

Head and Shoulder Tops and Bottoms- This is a less common topping or bottoming pattern than the cup and handle, and may be more powerful. A Head and Shoulder involves a new high, a pullback, a break new another new high which takes out the recent high and pullback to same area as the first pullback, and a final retest of the old high and a subsequent failure. The sell signal occurs when the neckline (which is the low of the H&S formation) is breached.

Basing Patterns and Topping Patterns- These patterns can be broad and lengthy from the perspective of time and represent stocks trading in narrow ranges for long periods while continuing to fail to breach old lows. Once the price breaches the top the narrow trading range, a lengthy uptrend can ensue. The broader the base, generally the longer the subsequent price move. The Topping process is the reverse.

Detrending Oscillators-

 Stocks do not move in straight lines. They wiggle, they do sawtooth patterns, and they whipsaw all within trends that can be defined by trendlines and moving averages. Price action can be smoothed with the trendlines and moving averages. Another approach to take the confusion out of the volatility and price swings is detrending oscillators. The purpose of these oscillators is determine whether stocks are overbought and vulnerable to the downside or oversold and susceptible to upside surprise moves. While stocks can stay overbought and oversold for long periods, these techniques establish buy and sell signals once certain criteria are met.

These oscillators consist of Stochastics, Moving Average Convergence Divergence, Wilder RSI, and Momentum. They are based on a simple concept that a ball thrown in the air eventually loses upward momentum and reaches its zenith and then falls.

There are two broad types of markets- trending and trading. In a long trending market which has the steep ascent we have had in the 90's, detrending oscillators would have given you many sell signals. However, these signals, in many cases, were given off just as minor pullbacks and retracements were finished. In other words, the experience was the oscillators were too slow and would have punished your results, by getting you out and in at precisely the wrong times.

These oscillators require computers with the algorithms to compute the necessary signals. However, you can look at a stock's or index's price versus its major moving averages and what has happened historically when the charts go that relatively low or high. This may be more accurate and easy than the omenously named detrending oscillators.  Stocks generally regress to the mean (trendline of moving average) and so risk can be visually "eyeballed" with moving averages.

Trading Channels and Bollinger Bands- This is another attempt to determine if a trending stock is ahead of itself. Trending stocks and markets move in sawtooth patterns, either up, down, or sideways. A Trading Channel is drawn by making a line represented by the higher highs and a line representing the higher lows. Generally is the stock has tested this channel on numerous occasions, it will bounce off the channel and go down or up within that channel. If it breaches the channel to upside, it can mean an acclerated rise or steeper ascent and further, can mean that the top of the breached channel is actually support.

Bollinger Bands represent two standard deviations from a given moving average, say the 50 day moving average, and will generally define the trading bands for trending markets. Stocks tend to bounce off the bands and trade up to or down the moving average.

Warning

No technical signal should be simplistically followed. You should look at a variety of signals and make possible trades pass a series of tests. If you do not do a trade, don't fret. Another opportunity will come along in a short time.

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