Technical analysis: An Introduction to Charting Techniques

Friday, Feb 05 2010 by
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Technical analysis photoTechnical analysis uses charts of various types to look for significant patterns in the behaviour of a stock (or other investment). There's good evidence that markets tend to behave in particular ways, and this creates detectable graphical patterns on the chart. That's the science bit. However, interpreting those patterns is as much an art as a science. Let's start off just with basic price data.

Trend lines

The simplest thing we can see with charting is trend lines. Put simply - is the stock going up, going down, or flat? That's easy. If you're a momentum investors, you can stop here - you'll buy what's going up and sell what's going down. But there's a lot more to charting than this.

Support and resistance

Pricing is psychological, as supermarkets well know. At £9.99 something will sell, at £10.01 it won't. Investors too have price memories, so they'll remember, for instance, what they paid for a stock, and often won't sell for less than that price - but if they've been under water for ages and have a chance to get out at a penny more than they paid, they'll take the chance. That's the explanation behind support and resistance - significant price levels at which a stock will meet sustained buying or selling pressure that often causes the price movement to reverse and keeps the stock within a trading range.
You can see the support and resistance levels on a chart quite easily by taking a ruler and using it to connect all the peaks or all the troughs. Sometimes these can be very clearly defined. At the top, the upwards-trending price encounters resistance - investors selling out and sending the price back down again. At the bottom, bargain hunters buying the stock provide a support level.

Obviously, it's possible that a stock will break through support on the downside, or break through resistance on the upside. But most of the time, support and resistance levels hold. So if you've made good money out of a rising price, and the stock hits a resistance level, you might be tempted to sell - particularly if, say, you bought it as a value stock but the PE ratio and yield are no longer exceptional value.

By the way, once a stock has broken a resistance line, that price level usually works as a support level for the new trading range. (And conversely, if a stock sinks below the support level, that usually becomes a new resistance level.)

Double bottoms/tops

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A double bottom is not, I hasten to point out, the City equivalent of moobs. Double bottoms occur when a stock falls, bounces a bit, and falls again. It's found at the end of an extended downtrend and looks like a big letter W, forming the moment when the trend reverses and the uptrend begins.

The reason for double bottoms is simple. The first uptrend may have happened from a support level where there were bargain-basement investors. They're happy to sell out for a 10-20 percent gain. So are investors who have been holding on to the stock as it slid, but now see a way to limit their losses. So selling pressure forces the stock back to that support level. Only when it bounces a second time does the real uptrend begin.

A double bottom will usually take a month or more to form. Reversing a downtrend is always slow - investors need to rebuild their confidence. On the other hand a double top can be much quicker to form, as fear and even panic begin to set in. In all other regards, though, double tops are just the same as double bottoms.

Because they predict the change from a downtrend to an uptrend (or vice versa), double bottoms and tops can be incredibly profitable signals. Ignore them at your peril.

Using moving averages

Price charts have a high percentage of noise to signal. By smoothing the daily peaks down to moving averages (MAs), we can sometimes see the longer term trends more clearly. Every chartist has their favourite moving averages. It can be particularly useful to use two, a shorter average (eg 21 days) and a longer one (eg 200 days). By looking at these you can assess whether the stock is diverging from its longer term performance. There's quite a powerful indicator when the two lines show a 'golden cross' - when the shorter term MA moves above the longer term one after a period of falling prices.
Conversely, the 'death cross' (shorter term MA moving downwards through the longer term average) can often show the reversal of an uptrend.

These are only a few of the techniques that chartists use to examine share prices. I haven't even started talking about Bollinger bands or stochastics - but just by spotting a few basic reversals you may be able to improve your performance. I do know that while I'm mainly a fundamental investor, just occasionally a glance at the charts has refined my timing, and that's helped me secure better returns on my investment.


Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. The author may own shares in any companies discussed, all opinions are his/her own & are general/impersonal. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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1 Comment on this Article show/hide all

Dlyricist 6th Feb '10 1 of 1

I have to add , they work better on SET stocks (pure supply and demand) and not so well on AIM stocks, due to MM manipulation

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About Anna Morrell

Keen student of all things financial - always looking for fresh ideas in the markets, whether it be new stocks or innovative instruments.


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