Introduction to Technical Analysis

Introduction

Introduction to Technical AnalysisTechnical analysis is the evaluation of securities by analysing statistics generated from market activity, past prices and volume.

Technical analysts don’t attempt to measure a security's intrinsic value; instead they look at stock charts for patterns and indicators that will determine a stock's future performance.

Technical analysis has become increasingly popular, as more and more people believe that the historical performance of a stock is a strong indicator of future performance. The use of past performance should come as no surprise. People using fundamental analysis have always looked at the past performance of companies by comparing financial data from previous quarters and years to determine future growth. The difference lies in the technical analyst's belief that securities move according to very predictable trends and patterns. These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable.

There are many cases of investors successfully trading a security using only their knowledge of the security's chart, without even understanding what the company does. However, most agree it is much more effective when used in combination with fundamental analysis.

The most common forms of charts are Candlestick, Bar, Line and Point and Figure Charts. For further information regarding the different charts, see the additional headings in this section.

Technical analysis (or Chartism) is the use of numerical series generated by market activity, such as price and volume, to predict future price trends. Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited. Technical analysis does not try to analyse the financial data of a company such as cashflow, dividends and projection of future dividends. That type of analysis is called fundamental analysis. Nor does it claim to be 100% accurate. It attempts to give the "most likely" outcome. Many academic studies conclude that technical analysis has little, if any, predictive power. However, the practice has a dedicated following especially among active traders and does have support amongst the academic community.


The Basic Assumptions

What Is Technical Analysis?

Technical analysis is the process of evaluating securities by analysing the statistics generated by market activity, such as past prices and volume. Technical analysts don’t attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some technical analysts rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued - the only thing that matters is a security's past trading data and what information this data can provide about where the security might move in the future.

The field of technical analysis is based on three assumptions:

  • The market discounts everything
  • Price moves in trends
  • History tends to repeat itself

History

The premises of technical analysis were derived from empirical observations of financial markets over hundreds of years. Perhaps the oldest branch of technical analysis is the use of candlestick techniques by Japanese traders at least as early as the 18th century, and still very popular today. Dow Theory, a theory based on the collected writings of Dow Jones co-founder and editor Charles Dow, inspired the increasingly widespread use and development of technical analysis from the end of the 19th century.

Theory

Technical analysis is not concerned with why a price is moving (e.g. poor earnings, difficult business environment, poor management, or other fundamentals) but rather whether it is moving in a particular direction or in a particular chart pattern. Technical analysts believe that profits can be made by "trend following." In other words if a particular stock price is steadily rising (trending upward) then a technical analyst will look for opportunities to buy this stock fundamental analysis.

Two well-known sayings among technical analysts are, "The trend is your friend," and "Forget the fundamentals and follow the money."

Three Beliefs of Technical Analysis

1. Price action in the market discounts everything

Technical analysis holds that because every possible bit of information is immediately included in the price of a security, it is not necessary to explicitly analyse the fundamental, economic, political, etc. factors that might influence that price. Because all possible information is reflected in the price, only a study of the price movement is required.

2. Prices move in trends

While it cannot be shown that prices must trend, technical analysis relies on empirical evidence and common sense to assert that prices do trend. To a technician, markets are trending up, trending down, or trending sideways (flat). This definition of a price trend is essentially the one put forward by Dow Theory.

3. History tends to repeat itself

Technical analysts believe that investors repeat the behaviour of the investors that preceded them. "Everyone wants in on the next Apple," "If this stock ever gets to $100 again, I will buy it," "This company's technology will change the industry, therefore this stock will skyrocket,"-- these are all examples of investors' attitudes repeating. To a technical analyst, the human characteristics of the market might be irrational, but they exist. Because investors' attitudes often repeat, investors' actions in the marketplace often repeat as well. i.e., patterns of price movement will develop on a chart that a technical analyst believes have predictive qualities.

Criticism of Technical Analysis

Lack of Evidence

Although chartists believe that their techniques provide excess returns over time, this assertion is controversial to some. Many academics believe that technical analysis has no predictive power. Burton Malkiel Eugene Fama in "Efficient Capital Markets: A Review of Theory and Empirical Work," May 1970 Journal of Finance summarise many early studies, conducted from the 1950s-70s, that show that after trading costs are considered, the returns generated by many technical strategies underperform a simple buy and hold strategy.

Inconsistencies With Other Market Hypotheses

The Efficient Market Hypothesis

The efficient market hypothesis concludes that technical analysis cannot be effective. According to this hypothesis, all relevant information is quickly reflected in a security's price through the actions of traders who have that information. Thus, it is impossible to "beat the market," and technical analysis cannot work. News events and new fundamental developments which influence prices occur randomly and are unknowable in advance. Advocates of EMH have produced many studies that reject the efficacy of technical analysis. Proponents of technical analysis counter that technical analysis does not completely contradict the efficient market hypothesis. Technicians agree with EMH in that they believe that all available information is reflected within a security's price; that is why technicians say a study of the price movement is necessary. Technicians argue that EMH ignores the realities of the market place, namely that many investors base their future expectations on past earnings, track records, etc. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices can influence future prices. Technicians point to the new field of behavioural finance. Behavioural finance essentially says that people are not the rational participants EMH makes them out to be. Market participants can and do act irrationally. Technicians have long held that irrational human behaviour influences stock prices and claim to have ways of predicting probable outcomes based on this behaviour.

The Random Walk Hypothesis

The random walk hypothesis is also at odds with technical analysis and charting. Essentially, the hypothesis claims that stock price moments are a Brownian Motion with either independent or uncorrelated increments. In this model future stock prices are not dependent on past stock prices so trends cannot exist and technical analysis has no basis. Again, proponents of this theory have generated substantial research in support of the hypothesis. Technical analysts maintain that trends are identifiable in the market and that it is impractical to believe that market prices move in a random fashion. To a technician, over time prices will trend in a direction until supply equals demand. Therefore, there cannot be any pure random price movement. As stated earlier, one of the cornerstones of technical analysis is that prices trend. If you do not believe this concept, you will not agree with technical analysis. Also, with regards to EMH and Random Walk Theory, technicians claim that both theories ignore the realities of the marketplace. To a technician, the market is neither composed of completely rational participants as EMH assumes (participants can be greedy, overly risky, etc. at any given time) nor is its stock price movement completely independent of its prior movement. Technicians maintain that both theories would also invalidate numerous other trading strategies such as index arbitrage, statistical arbitrage and many other short-term trading systems.

Industry

Globally, the industry is represented by The International Federation of Technical Analysts (IFTA). IFTA offers certification to professional technical analysts and researchers around the world as part of their Certified Financial Technician designation.

Proponents of Technical Analysis

To many traders, trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John Henry, Larry Hite, Ed Seykota, Richard Dennis, Bruce Kovner, and Michael Marcus (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes through the use of technical analysis and its concepts. George Lane, a technical analyst, coined one of the most popular phrases on Wall Street, The trend is your friend! Many non-arbitrage algorithmic trading systems rely on the idea of trend-following, as do many hedge funds. A relatively recent trend, both in research and industrial practice, has been the development of increasingly sophisticated automated trading strategies. These often rely on underlying technical analysis principles.

Charting Terms and Indicators

Many different techniques and indicators can be used to follow and predict trends in markets, and usually at least a few at a time are considered when making an investment decision.

Some of the most widely known include:

  • Accumulation/distribution index - based on the close within the day's range
  • Average true range - averaged daily trading range
  • Bollinger bands - a range of price volatility
  • Breakout - when a price passes through and stays above an area of support or resistance
  • Commodity Channel Index - identifies cyclical trends
  • Hikkake Pattern - pattern for identifying reversals and continuations
  • MACD - moving average convergence/divergence
  • Momentum - the rate of price change
  • Money Flow - the amount of stock traded on days the price went up
  • Moving average - lags behind the price action
  • On balance volume - the momentum of buying and selling stocks
  • PAC charts - two-dimensional method for charting volume by price level
  • Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
  • Pivot point - derived by calculating the numerical average of a particular currency's or stock’s high, low and closing prices.
  • Point and figure charts - charts based on price without time
  • Relative Strength Index - oscillator showing price strength.
  • Resistance - an area that brings on increased selling
  • Stochastic oscillator - close position within recent trading range
  • Stop loss - controls drawdown
  • Support - an area that brings on increased buying
  • Trend line - a sloping line of support or resistance

The Market Discounts Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, therefore eliminating the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

Price Moves in Trends

In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical analysists believe in this assumption.

History Tends To Repeat Itself

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Not Just for Stocks

Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, forex, etc. In this tutorial, we'll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is more frequently associated with commodities and forex, where the participants are predominantly traders. Now that you understand the philosophy behind technical analysis, we'll get into explaining how it really works. One of the best ways to understand what technical analysis is, and is not, is to compare it to fundamental analysis. We'll do this in the next section. For further reading, check out Defining Active Trading, Day Trading Strategies For Beginners and What Can Investors Learn From Traders?.


Fundamental Vs. Technical Analysis

Introduction to Technical AnalysisTechnical analysis and fundamental analysis are the two main schools of thought in the financial markets. As we've mentioned, technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis looks at economic factors, known as fundamentals. We can now look at how these two approaches differ along with the criticisms and how technical and fundamental analysis can be used together to analyse securities.

The Differences

Charts vs. Financial Statements

At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. (For further reading, see Introduction To Fundamental Analysis and Advanced Financial Statement Analysis.) By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company's value. In financial terms, an analyst attempts to measure a company's intrinsic value. In this approach, investment decisions are fairly easy to make - if the price of a stock trades below its intrinsic value, it's a good investment. Although this is an oversimplification (fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial, this simple tenet holds true. Technical traders, on the other hand, believe there is no reason to analyse a company's fundamentals because these are all accounted for in the stock's price. Technicians believe that all the information they need about a stock can be found in its charts.

Time Horizon

Fundamental analysis takes a relatively long-term approach to analysing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years. The different timeframes that these two approaches use is a result of the investing approach to which they follow. It can take a long time for a company's value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock's market price rises to its "correct" value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This "long run" can represent a timeframe of as long as several years, in some cases. (For more insight, read Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?) In addition, the numbers that a fundamentalist analyses are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don't emerge on a daily basis like price and volume information. Remembering that fundamentals are the actual characteristics of a business. New management can't implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyse a stock is generated much more slowly than the price and volume data used by technical analysts.

Trading Versus Investing

Not only is technical analysis more short term in nature that fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, and traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does differentiate between the two schools.

The Critics

Critics of technical analysis would see it as ‘Black Magic’. Don't be surprised to see them question how valid it actually is. In fact, technical analysis has only recently begun to enjoy some mainstream credibility. While most analysts on Wall Street focus on the fundamental side, just about any major brokerage now employs technical analysts as well. Much of the criticism of technical analysis has its roots in academic theory - specifically the efficient market hypothesis (EMH). This theory says that the market's price is always the correct one - any past trading information is already reflected in the price of the stock, therefore, any analysis to find undervalued securities is useless. There are three versions of EMH. Firstly, called Weak Form Efficiency, all past price information is already included in the current price. According to weak form efficiency, technical analysis can't predict future movements because all past information has already been accounted for and, therefore, analysing the stock's past price movements will provide no insight into its future movements. In the second, semi-strong form efficiency, fundamental analysis is also claimed to be of little use in finding investment opportunities. The third is strong form efficiency, which states that all information in the market is accounted for in a stock's price and neither technical nor fundamental analysis can provide investors with an edge. The vast majority of academics believe in at least the weak version of EMH, therefore, from their point of view, if technical analysis works, market efficiency will be called into question. (For more insight, read What Is Market Efficiency? and Working Through The Efficient Market Hypothesis.) There is no right answer as to who is correct. There are arguments to be made on both sides and, therefore, it's up to you to do the homework and determine your own philosophy.

Can They Co-Exist?

Although technical analysis and fundamental analysis are seen by many as polar opposites - the oil and water of investing - many market participants have experienced great success by combining the two. For example, some fundamental analysts use technical analysis techniques to figure out the best time to enter into an undervalued security. This situation occurs when the security is severely oversold. Timing entry into a security, the gains on the investment can be greatly improved. Alternatively, some technical traders might look at fundamentals to add strength to a technical signal. For example, if a sell signal is given through technical patterns and indicators, a technical trader might look to reaffirm his or her decision by looking at some key fundamental data. Having reviewed both the fundamental and technical analysis you can provide the best-case scenario for a trade. The strongest believers in either technical or fundamental analysis often refuse the idea of mixing elements of both but there are certainly benefits to at least understanding both schools of thought. In the following sections, we'll take a more detailed look at technical analysis.


Chart Types

Investors and traders will use four main types of charts depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. To demonstrate this in the following sections, we will focus on the S&P 500 Index during the period of January 2006 through May 2006. Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is different.

Line Chart

The most basic of the four charts is the line chart because it represents only the closing prices over an exact timeframe. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. The closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts.

Bar Charts

The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. The close however is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black representing an up period for the stock which means it has gained value. A bar that is coloured red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Candlestick Charts

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colours to explain what has happened during the trading period. A major problem with the candlestick colour configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two colour constructs for days up and one for days that the price falls. When the price of the stock is up and closes above the opening trade, the candlestick will usually be white or clear. If the stock has traded down for the period, then the candlestick will usually be red or black depending on the site. If the stock's price has closed above the previous day's close but below the day's open, the candlestick will be black or filled with the colour that is used to indicate an up day. (To read more, see The Art Of Candlestick Charting - Part 1, Part 2, Part 3 and Part 4.)

Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the stock, which can distort traders' views of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis. (For further reading, see Point and Figure Charting.)

When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward price trends and the Os represent downward price trends. There are also numbers and letters in the chart; these represent months, and give investors an idea of the date. Each box on the chart represents the price scale, which adjusts depending on the price of the stock: the higher the stock's price the more each box represents. On most charts where the price is between $20 and $100, a box represents $1, or 1 point for the stock. The other key observation of a point and figure chart is the reversal criteria. This is usually set at three but it can also be set according to the chartist's discretion. The reversal criteria set how much the price has to move away from the high or low in the price trend to create a new trend or, in other words, how much the price has to move in order for a column of Xs to become a column of Os, or vice versa. When the price trend has moved from one trend to another, it shifts to the right, signalling a trend change.

Conclusion

Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being shown on a chart and the information that it provides. Now that we have an idea of how charts are constructed, we can move on to the different types of chart patterns.


Trendlines

With all the fundamental analysis that you can apply to a stock there should also be room in your decision making process for the charts. Most people are used to the concept of identifying either Bullish or Bearish sentiment very easily by the application of a trendline.

We have mentioned trendlines several times in previous articles and it is prudent to examine them in more detail and understand a little more of what they can indicate. Trendlines are drawn from peak to peak during a bearish (down) period and from trough to trough for Bullish (up) periods, either from the extreme points or from the most touches. The trendline shows us some important aspects of the stock, most importantly it indicates direction, whether the stock is Bullish or Bearish, therefore if the stock touches an existing bullish trendline and 'bounces' from it then it may present a buying opportunity.

However if the stock breaks through the trendline then it could indicate that the trend may reverse creating a shorting opportunity (subject to confirmation). Trendlines can have different degrees of validity dependent upon the length of time they have been established, hence the degree of importance attached to long term trendlines that have been established for months or even years.

Further validation occurs every time the share price touches, and bounces off of the trendline, indicating that the majority in the market recognise its existence. When such touches are accompanied by an increase in volume of trades then further confirmation can be taken. Changes in the steepness or angle of the trendline indicate changes in sentiment, these may be new short term trends that, if they fail, will indicate a reversal back to the more established trend and may even carry enough momentum to break through, as mentioned previously, to form a major reversal. Therefore it’s prudent to consider placing stop losses at, or about, trendlines.


Trend Channels

A trend channel is most commonly based on a weekly chart, but sometimes on a daily, intraday, or monthly chart. This is an extremely valuable tool that is simple to use, and often hugely profitable. As in the Weekly chart of Newcrest Mining (NCM) below, the upward trend line (lower line) is drawn. If a parallel line can be drawn at the price tops, the Trend Channel is the area between the two lines. The second line is called the 'return line' because it marks a point at which a price is about to return towards the trend line. A trend-channel is "validated" when three points are confirmed as acting as support or resistance. Thus we can draw a simple up-trendline connecting the points labelled "A" and "B," and when the stock gets support and rallies off of point "C," the trendline is validated.

Trend channels most often appear in the more frequently traded stocks. Often the case, volume increases as price reaches the bottom of the channel and the top of the channel. This could signal that there are supply and demand constraints within the trend channel. If a price penetrates the upper or lower trend lines, it could signal a change in trend. In the NCM example, the channel was temporarily broken in May and June of 2005, only to return the channel once again.

How to Trade The Channel?

After the share price has bounced from point and any significant resistance/support lines have been breached, the CFD/option or share trader would be bullish until the share price hits and rejects the upper return line. From here on, given the right entry confirmation signal, the trader would be bearish in the short term. The more conservative trader would wait until the share price has bounced off from the trend line (lower line) in order to trade with the trend. An example of a more recent trend channel is the Daily Chart from December 2005 to May 2006 of Resmed Incorporated (RMD). This chart also includes the Moving Average Convergence/Divergence (MACD) indicator. As can be seen on the chart, the MACD indicator at crossover has assisted the short-term share and derivatives trader to confirm the move up from the bottom of the channel (highlighted in yellow on the MACD indicator) and the two occasions in February and April, the softening in price as it hits the upper trend channel resistance.


Support and Resistance

Once you understand the concept of a trend, the next major concept is that of support and resistance. You'll often hear technical analysts talk about the ongoing battle between the bulls and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support).

Why Does it Happen?

These support and resistance levels are seen as important in terms of market psychology and supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these trendlines are broken, the supply and demand and the psychology behind the stock's movements is thought to have shifted, in which case new levels of support and resistance will likely be established.

Round Numbers and Support and Resistance

One type of universal support and resistance that tends to be seen across a large number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be important in support and resistance levels because they often represent the major psychological turning points at which many traders will make buy or sell decisions. Buyers will often purchase large amounts of stock once the price starts to fall toward a major round number such as $50, which makes it more difficult for shares to fall below the level. On the other hand, sellers start to sell off a stock as it moves toward a round number peak, making it difficult to move past this upper level as well. It is the increased buying and selling pressure at these levels that makes them important points of support and resistance and, in many cases, major psychological points as well.

Role Reversal

Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. As the price moves past a level of support or resistance, it is thought that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance. (For further reading, see Retracement or Reversal: Know the Difference.)

The Importance of Support and Resistance

Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the security moves toward this point because it is unlikely that it will move past this level. Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as the price of the share remains between these levels of support and resistance, the trend is likely to continue. It is important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For example, if prices moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel. Being aware of these important support and resistance points should affect the way that you trade a stock. Traders should avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If you feel confident about making a trade near a support or resistance level, it is important that you follow this simple rule: do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number, but flirts with it instead. So if you're bullish on a stock that is moving toward an important support level, do not place the trade at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing stops or short selling, set up your trade price at or below the level of support.


Gaps - Why They Can be an Important Trading Tool

What is a Gap?

Introduction to Technical AnalysisA "gap" is a term used to describe the circumstance of when a stock price opens either at a higher or lower price than it reached at any time the previous day. Gaps in prices can be up or down and they can happen to all stocks. If the trading that day continues to trade above that point, a gap will exist in the price chart. What causes gaps? Usually it is news driven. Individual stocks can gap up or down due to news such as earnings reports, earnings pre-announcements, analysts' upgrades and downgrades, rumours, message board posts, electronic media or key people in the company commenting or buying/selling the company stock. Whatever the exact reason, gaps are the result of some kind of event happening while the market is closed. The result is the buying or selling pressure at the open of the next day, which will make the stock open at a different price than where it closed. Why are they important? Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. This sudden move by a stock, the sudden change in demand, is often the beginning of a major move. As gaps demonstrate strong buying or selling of a stock, they cannot be ignored when they occur at price levels that would otherwise be very significant, such as primarily areas of support and resistance.

The daily chart of BHP shows clear gaps in March and April of 2005 at key resistance levels. The first gap indicated broke the strong upward trend line, suggesting a major change in market sentiment was in play. BHP share price then consolidated for a brief period of two weeks before gapping again, breaking the first resistance line shown. The very next day the share price gapped again, breaking a second resistance line. Gaps clearly alert the market to a turn-around in market sentiment when they break key points of resistance and are a very useful tool for all market participants.


The Importance of Volume

To this point we've only discussed the price of a security. While price is the primary item of concern in technical analysis, volume is also extremely important.

What is Volume?

Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do.

Why Volume is Important

Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. Therefore if you are looking at a large price movement you should also examine the volume to see whether it tells the same story. Say for example that a stock jumps 5% in one trading day after being in a long downtrend. Is this a sign of a trend reversal? This is where volume helps traders. If volume is high during the day relative to the average daily volume, it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal. (To read more, check out Trading Volume - Crowd Psychology.) Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end. When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward trend on declining volume. (For additional insight, read Divergences, Momentum and Rate of Change.)

Volume and Chart Patterns

The other use of volume is to confirm chart patterns. Patterns such as head and shoulders, triangles, flags and other price patterns can be confirmed with volume, a process that will be covered in more detail later in this tutorial. In most chart patterns, there are several pivotal points that are vital to what the chart is able to convey to chartists. Basically, if the volume is not there to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern is weakened.

Volume Precedes Price

Another important idea in technical analysis is that price is preceded by volume. Volume is closely monitored by technicians and chartists to form ideas on upcoming trend reversals. If volume is starting to decrease in an uptrend, it is usually a sign that the upward run is about to end. Now that we have a better understanding of some of the important factors of technical analysis, we can move on to charts, which help to identify trading opportunities in prices movements.


Gauging Support and Resistance

With Price By Volume

Many say that charting is nothing more than predicting the direction of a price between significant support and resistance levels. We know that a support level is a price level which a stock has had difficulty falling below. This is where a lot of buyers tend to enter the stock. Similarly, we know that resistance is a price level above which a stock has difficulty climbing. This is where a lot of buyers take profits and shorts enter. Typically a stock's price will range between these levels until it breaks out or breaks down. Hundreds of different methods can be used to locate these areas of support and resistance, but one of the most underrated methods is simply using price by volume (PBV) charts. In this article we explain what PBV charts are and explore techniques that you can use to make effective trades using these charts. Trend lines, chart patterns, pivot points, Fibonacci lines and Gann lines are among the most popular methods used to identify areas of support and resistance. But the less commonly used PBV charts, which illustrate volume using a vertical volume histogram, can be invaluable when determining not only the location of key support and resistance levels, but also the strength of these levels. (For further reading, see Support and Resistance Zones - Part 1 and Part 2.)

What Are PBV Charts?

A Price by Volume chart is simply the standard volume histogram reapplied to price instead of time (price is seen on the Y axis and time on the X axis). So, instead of being able to determine when a stock is going in and out of favour (indicated by increasing volume levels over time), PBV enables you to determine the level of buying or selling interest at a given price level.

Using PBV Charts

PBV charts are relatively easy to use and understand. There are three major elements involved:

  • Volume strength indicates the amount of shares that traded at the given price level (this is indicated by the horizontal length of the PBV histogram)
  • Volume type refers to the number of shares sold compared to the number of shares bought (this is indicated by the two different colours seen on each bar)
  • Successful reactions or tests means the number of times a stock successfully tests and "bounces off" a given level

Together, these three factors will allow you to determine the strength of a particular price level. Once you have a good idea of price strength, you can combine this information with trend lines and other studies to determine support and resistance levels, find support bases and even play gaps.

Finding Support Bases

Support bases are simply instances in which a stock ranges before continuing a trend, or reversing.

To determine when a stock is basing, simply follow these steps:

  • Draw two parallel, horizontal lines that connect parallel highs and lows in a trading range after a trending move
  • Then, use the PBV histogram to see if these parallel lines are located near key price levels
  • Finally, note the buying or selling pressure (colours) as well as the total volume to determine in which direction a breakout is likely to occur

Locating Support and Resistance Levels

Support and resistance levels are simply areas beyond which the price has difficulty moving due to large buying or selling interests.

To determine areas of support or resistance, simply do the following:

  • Identify areas where the PBV histogram shows significant buying or selling interest
  • Determine whether these large interests are buying or selling interests
  • Draw horizontal trend lines parallel to these PBV bars, giving preference to those that also connect highs and lows on the chart

Playing Gaps

Gaps occur when an asset's price rapidly moves from one point to another, creating a visible gap or break between prices in the chart. You can use PBV charts to help predict when a gapping stock will find support simply by looking for an area where there was a lot of prior interest. Also, gaps themselves can produce areas of future support and/or resistance, which can be reinforced by the PBV histogram.

Conclusion

PBV charts can be an invaluable tool in your stock analysis arsenal. When you combine it with other methods such as trendline analysis and Fibonacci, it is easy to see how much additional insight can be gained from this charting method.

Here are some key points to remember:

  • The first colour represents volume on days when the price moved higher
  • The second colour represents volume on days when the price moved lower
  • When one colour of the bar is significantly longer than the other, strong support or resistance is present
  • Horizontal trend lines connect the top of the PBV bar for resistance and the bottom of the PBV bar for support
  • PBV bars are used for support and resistance levels, trading bases and gap areas

Market Breadth

Introduction

Introduction to Technical AnalysisEach day a battle between bulls and bears rages. Each side tries to pull the market in the desired direction while frustrating the other side. As prices move up and down, the winner of the day is printed on each stock's price chart. Internal indicators can be used to measure the force of the bulls and bears as they exert themselves. Volume indicates traders' level of participation - are they buying stocks that are going up, or selling shares of the losers? Stocks making new highs or lows for the year reveal traders' level of enthusiasm for the direction of market prices. The number of stocks ticking up or down speaks of the breadth of a rally or a retreat, that is, the number of stocks included in the move - something an index or simple price chart cannot do. Charting volume, new high/low and advance/decline data for a given market is a way to confirm the direction of prices. Various calculations can be applied to these values to fine-tune their signals. In this feature on internal indicators, we will examine the more useful and popular methods of measuring market breadth, from volume to point-and-figure indicators.

Market Breadth: Volume Studies

The basic signals conveyed by volume data are easy to read. When a stock is traded, the transaction is recorded and included in the daily volume. When volume levels spike for a stock, index or exchange, the spike points to a price at which a large portion of ownership has changed hands. These prices are significant because they mark a break-even point for the new shareholders and are likely candidates for support/resistance levels - the larger the spike, the more significant the price. Over time, if price moves steadily upward with strong volume, this indicates that buyers are accumulating shares and supply is becoming increasingly limited: bulls are winning the fight. Alternatively if price moves steadily downward with strong volume, sellers are unloading shares and outstripping demand: bears are taking this battle.

Cumulative Volume Index

By separating the up volume from the down volume, traders can design internal indicators to support their assertions about the direction of the given stock, index or market. The first indicator we examine is called the cumulative volume index, or CVI. CVI is calculated by subtracting the down volume (that is, how many shares of losing stocks changed hands) from the up volume (the tally of shares traded in winning stocks) each day and adding that number to the previous day's value for CVI.

The formula looks something like this:

CVI = (Up Volume - Down Volume) + Previous Day's CVI A chart of cumulative volume is usually drawn with a line connecting each day's value. The chart can be analysed in the same manner as a price chart: by drawing trendlines to indicate direction and support/resistance levels. The actual value of cumulative volume is not important - only the direction and pattern of the chart matter. The chart of cumulative volume is most useful when drawn together with a price plot. In this format, look for cumulative volume to reach new highs or lows in tandem with price. This situation indicates that the majority of shares are taking part in the market's direction, so the move can be confirmed. When cumulative volume fails to track the movement in price, a divergence is signalled, indicating that the majority of stocks are not taking part in the move. Look for reversals near these locations on the price chart.

On-Balance Volume

On-Balance Volume (OBV) is quite similar to the cumulative volume index, but OBV adds or subtracts each day's volume from the previous day's volume based on whether the price moves up or down.

If today's price is higher than yesterday's, the formula for on-balance volume looks like this:

OBV = Previous Day's Value + Today's Volume

If today's price is lower than yesterday's, this is the formula:

OBV = Previous Day's Value - Today's Volume A chart of OBV is interpreted in the same way as a chart of cumulative volume. The chart should look similar to the price chart, and it can also be studied with trendlines and moving averages.

Up/Down Volume Spread

The up/down volume spread is similar to cumulative volume, except the difference isn't added together each day. The formula is simply this: Volume Spread = Up Volume - Down Volume This calculation creates a fast oscillator that revolves around a zero line. Traders can fine-tune a moving average of volume spread to smooth the signals. As the oscillator crosses the zero line, watch for a change in trend. When the oscillator reaches its extremes, the market could be overbought or oversold. Again, here it is useful to study volume spread in conjunction with a price chart.

Up/Down Volume Ratio

Just as its name indicates, the up/down volume ratio is up volume divided by down volume:

Volume Ratio = Up Volume / Down Volume A value of 3, for example, indicates that three times as many shares advanced as declined on a given day. The chart can be smoothed using a moving average if so desired. Look for a peaking ratio value at new highs to confirm an upward move in stocks. Fractional values indicate market weakness and should be used to confirm new lows on the price plot.

Accumulation/Distribution & the Chaiken Oscillator

Designed by Marc Chaiken, the accumulation/distribution indicator is based on the assumption that when a stock or index closes near its high of the day, traders are accumulating shares. In other words, accumulation/distribution weighs volume according to how close to a given day's high or low a stock or index closes.

The formula for weighted volume looks like this:

Weighted Volume = Volume [(Close - Low) - (High - Close)] / (High - Low)

This value is then used to calculate accumulation/distribution:

Accumulation/Distribution = Weighted Volume + Previous Day's Value The same rules for interpreting the other volume indicators apply to the accumulation/distribution line. It is used to confirm price movement in a given stock or index. It should be plotted in its own pane and can be smoothed with a moving average. A similar indicator called the Chaiken Oscillator further refines the accumulation/distribution line by calculating the spread between its three-day and 10-day exponential moving averages.

The formula looks like this:

Chaiken Oscillator = Three-day EMA of A/D - 10-day EMA of A/D Below is an example of a bar chart of the Dow Jones Industrial Average with its accumulation/distribution line and Chaiken Oscillator below it: As the Dow Industrials reach a new intermediate high in early September, the accumulation/distribution chart below it confirms the move by also reaching a new intermediate high, but the Chaikin Oscillator points to slowing momentum because it fails to reach the level of its last peak.

Force Index

The force index combines price and volume into one value, attempting to measure the force behind a move in price. It can be read as an oscillator or cumulatively.

Here's the formula:

Force Index = Volume(Today's Price - Yesterday's Price) Crosses above and below the zero line can be read as a change in market trend. Because of the volatility of the force index, using a moving average to smooth and fine-tune the signals can be helpful.

In Conclusion

Keep in mind that this overview is not to meant to be an exhaustive study, but a useful primer for the novice market technician. It may be difficult to find a free source for a few of these charts but StockCharts.com provides free charting tools, and many of these indicators are included. Most professional trading software packages include all of the above data and charts for those willing to pay a steep price.

Market Breadth: 52-Week Highs/Lows

Because of the broad market implications and forceful nature of new 52-week highs/lows, market technicians keep a close eye on this statistic. The field of technical analysis has designed a number of indicators to grade the underlying momentum created by the events driving the market in either direction.

Forces of Highs and Lows

When shares of a publicly traded company hit a new high for the year, everyone involved can rest assured that things are on the right track. Investors are rewarded, and the work of the company's CEO, executives and employees is validated. All this optimism in the business attracts new attention from traders and institutional investors looking to capitalize on the stock's momentum. Rallies from a new 52-week high can be explosive, picking up steam as traders migrate to stocks that are making a consistent profit. If the broader market begins to see many shares making new highs, that has the power to drive most everything up, squeezing short sellers and igniting a rally - perhaps even a new bull market. Of course, the opposite is also true. When a stock hits a new 52-week low, something at that business has definitely gone awry, resulting in angry investors. A new 52-week low could mean margins are being squeezed, customers are drying up, or a brand is shedding market share. The negativity can feed on itself as short sellers drive the stock lower and fund managers make the tough decision to take their lumps and wash their hands of a bad trade. Bear markets often begin after a business reports a disappointing performance, forcing down expectations for the broader market. Each day the financial news networks and websites report the number of new highs and new lows. That data is incorporated into market breadth indicators and then compared to index charts to judge market force and direction.

There are five popular indicators that are constructed with new high/low data:

  • The cumulative new high/low line;
  • The new-high minus new-low oscillator;
  • The new high/low ratio;
  • The percentage of new high to new high plus new low and;
  • The percentage of new highs to total market.

It is important to remember that the differences between these five indicators are subtle and can best be mastered by continued observance.

Cumulative New High/Low Line

The formula for the cumulative new high/low line looks like this:

Today's Value = Yesterday's Value + (Today's New Highs - Today's New Lows) The values for cumulative new high/low are differentiated by market, whether the NYSE or Nasdaq - stocks are not all lumped together. This indicator is plotted as a line connecting each day's value, and then it is usually compared to a price plot. Generally, the chart will look similar to the price plot, with the two making new highs and lows near the same spots. Just like the breadth indicators using volume, the cumulative new high/low signals a change in momentum and could be forecasting a new direction in price when the line diverges from the price chart. When the new high/low indicator gets ahead of the price chart, this signals strong momentum in the underlying market. While a plot of the 52-week high/low line is most common, any time frame can be used (such as 100-day or 200-day). Moving averages and other technical indicators can be applied to the cumulative new high/low line just like a price chart.

New-High Minus New-Low Oscillator

The formula for the new-high minus new-low oscillator looks like this:

Oscillator = Today's New Highs - Today's New Lows This formula creates a fast oscillator that can be smoothed or fine-tuned with a moving average. The oscillator revolves around a zero line, signalling a change in trend when it crosses above or below zero. The extremes of the oscillator signal overbought and oversold conditions respectively. (An extreme is usually around 80% or 20%, but the definition can be tuned using market specific data.) The most common are the 52-week highs/lows, but any time frame can be used to construct this oscillator.

New High/Low Ratio

The formula for new high/low ratio looks like this:

Ratio = Today's New Highs / Today's New Lows This ratio is like an oscillator because it revolves around the value 1. Although this oscillator is much slower than the oscillator discussed above, it can be smoothed further using a moving average. Anything below 1 means there are more stocks making new lows than highs - this is extremely negative. Because of the fractional nature of the negative territory, a logarithmic chart enhances readability. The indicator spends more time above 1, meaning more stocks are making new highs than lows. Since this chart is a ratio, it is impossible for the value to be less than zero. The extremes of the indicator represent overbought/oversold territory. The new high/low indicator can be examined further using other technical indicators - the relative strength index (RSI) is especially useful.

Percentage of New-High to New High + New Low

The formula for this breadth indicator looks like this:

% New Highs = Today's New Highs / (Today's New Highs + Today's New Lows)

The reverse of this formula can also be used to construct the percent of new lows:

% New Lows = Today's New Lows / (Today's New Highs + Today's New Lows)

Both indicators are percentages, so, like the high/low ratio, their values will always be between 0 and 1, never negative. Obviously, when there is a high percentage of stocks that are making new highs, this is positive for the broader market; conversely, a large percentage of new lows doesn't bode well for the market. Technicians monitor the shape and direction of this indicator to judge momentum, and they monitor extremes to judge overbought/oversold territory. This indicator can be compared to the underlying price chart and analysed further using other tools of technical analysis. As with all these high/low indicators, any time frame can be used (52-weeks being the most common).

Percentage of New Highs to Total Market

This indicator's formula looks like this:

% New Highs = Today's New Highs / Total # of Listed Stocks in Given Market

The opposite formula can also be constructed:

% New Lows = Today's New Lows / Total # of Listed Stocks in Given Market

The indicators that measure the percentage of new highs or lows to total market are very similar to the percentage we looked at above: values cannot be less than zero, direction and shape determine momentum, and other technical indicators are applicable. Since you are comparing a much larger base to the new highs or lows, the percentage values here will be much lower. Stockcharts.com provides free charts that can be customized for many of the market breadth indicators we discussed here. For others, technicians will need to search for a fee-based charting service that provides a wider array of breadth data.

Advance/Decline Indicators

Thirty stocks make up the Dow Jones Industrial Average. If the Dow moves up 20 points, there's no way to tell from that number if the increase is the result of only one stock going way up or many stocks each going up a small amount. The advance/decline data for the Dow can answer this question. If five stocks advance and 10 stocks decline (while 15 remain unchanged), then only a few stocks are responsible for carrying the market higher. Therefore, the rally is not broad-based. In this section, we examine the many ways market technicians use advance/decline data to interpret the breadth of the market. The advance/decline numbers for the NYSE and the Nasdaq are reported each day, and some of the related charts are the most popular internal indicators.

Advance/Decline Line

The advance/decline line is the most popular of all internal indicators by far. It is a very simple measure of how many stocks are taking part in a rally or sell-off. This is the very meaning of market breadth, which answers the question, "How broad is the rally?"

The formula for the advance/decline line looks like this:

A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Yesterday's A/D Line Value

The most popular data used for the A/D line is from the NYSE or Nasdaq markets. It is cumulative and normally plots a line similar to the price chart of the given index. The A/D line can be used alone or together with the price chart to look for divergences. A divergence suggests that a move in the price chart is unsupported by the broad market, and it should, therefore, be taken as a warning of an impending turning point in the index or market. A traditional technical indicator, such as a moving average or a stochastic oscillator, can be applied to the chart or used to smooth the signals it gives.

Advance/Decline Spread

A variation on the A/D line is the A/D spread. Just as its name implies, the A/D spread charts the difference between the number of advancing stocks and declining stocks in a given market on a given day. Unlike the A/D line, the spread is not a cumulative chart, so each day is calculated separately.

The formula for the A/D spread looks like this:

A/D Spread = # of Advancing Stocks - # of Declining Stocks

The chart of the A/D spread is an oscillator that revolves around a zero line. The A/D spread is interpreted much like any oscillator with overbought and oversold levels near the extremes of the chart. When the A/D spread crosses above its zero line, this means more stocks are advancing than declining, and vice versa. This oscillator is extremely fast, so a moving average is usually applied to slow the chart's movements and signals. The technician can fine tune the number of days set for the moving average to the market data.

Advance/Decline Ratio

Another variation on the A/D line is the advance/decline ratio, which divides the advancers by the decliners.

Here is the formula:

A/D Ratio = # of Advancing Stocks / # of Declining Stocks

This formula creates values that cannot be less than zero because it is a fraction (or ratio). A value of 3 means that three times as many stocks advanced as declined. Any value less than 1 means more stocks declined than advanced. Because of the nature of fractions, the chart is more legible using a logarithmic scale. Like the A/D spread, this chart moves quickly, so it's usually smoothed with a moving average.

Absolute Breadth Index

The absolute breadth index is a measure of internal volatility. It calculates the absolute value of the difference between the number of advancing and declining stocks, making it a slight variation on the A/D spread.

The formula for ABI looks like this:

ABI = | (# of Advancing Stocks - # of Declining Stocks)

Because the ABI is an absolute, its value will always be positive. The chart is a representation of the volatility in the spread between advancers and decliners. The ABI can be smoothed using a moving average to facilitate drawing longer-term trend lines. A fast-paced, choppy chart of the ABI can indicate a choppy, range-bound market.

Breadth Thrust

Breadth thrust is an internal indicator that is somewhat more complicated and harder to find. It is a ratio of moving averages that creates an excellent judge of market momentum.

The formula looks like this:

Thrust = x-Day Moving Average of Advancing Stocks / x-Day Moving Average of (Advancing Stocks + Declining Stocks )

Since this formula creates a ratio whose denominator is a sum of both advancers and decliners, the value cannot be greater than 1 or less than zero. The breadth thrust indicator, therefore, creates a percentage value that moves just like a traditional oscillator from 1 to 100 (or .01 to 1.00). Breadth thrust can be read just like a stochastic or RSI, where overbought and oversold levels are at the extremes. Divergence with the underlying price chart points to weakening momentum. The number of days to set for the moving averages should be determined by the time-period being evaluated.

Arms Index (TRIN)

Developed by Richard Arms, TRIN is a double-ratio that divides the A/D ratio by the A/D volume ratio. The formula is somewhat long but, fortunately, the TRIN charts for the NYSE and NASDAQ are some of the easier internal indicators to find on the internet.

Here's the formula:

TRIN = (# of Advancing Stocks / # of Declining Stocks) / (Volume of Advancing Stocks / Volume of Declining Stocks)

For reasons that should now be obvious, the value of TRIN cannot be less than zero. The Arms Index is read somewhat counter intuitively. A value of less than 1 means advancing stocks are getting more than their share of volume, which is bullish for the market. When the value of TRIN is more than 1, declining shares are taking an outsized amount of volume, which is bearish for the market. TRIN is usually smoothed using a moving average, which should be tuned to the time-period being evaluated. Trend lines drawn from the moving average reveal the direction of market momentum. (Remember that the value for TRIN moves down as advancing volume goes up).

McClellan Oscillator

Searching for an even more refined internal indicator, Sherman McClellan designed his own oscillator. Though the calculations for McClellan's Oscillator are far too complicated to compute by hand, they help demonstrate how the indicator works.

Here they are:

McClellan Oscillator = [ 19-Day Exp. Moving Average of (# of Advancing Stocks - # of Declining Stocks) ] / [ 39-Day Exp. Moving Average of (# of Advancing Stocks - # of Declining Stocks)]

This formula creates a ratio comparing the 19-day and 39-day EMA of the A/D spread. The chart is an oscillator that ranges from +100 to -100 with overbought and oversold levels usually found at +70 and -70 respectively. The McClellan Oscillator can be read just like any other oscillator and is usually not smoothed, but it can be charted with a moving average as an indicator line.

Conclusion

This directory on market breadth introduces traders to how they can gain an advantage in the market, but it will take time to master the movements of each individual indicator. Try following two or three internal indicators every day instead of trying to master them all. Many of the indicators overlap, so find the ones that work for your personal trading style and focus on those. Always rely first on the price data of the vehicle you're trading, and then check that the internal indicators reinforce your position.

Here is an overview of the main points we dealt with in this tutorial on market breadth:

  • Internal indicators measure market breadth, which refers to the amount of force and the level of participation behind market moves
  • The most common data used to build internal indicators are volume, advance/decline and new highs/lows
  • Strong volume in the day's winners indicates buyers are winning the day, and vice versa
  • Advance/decline data gives traders a look into how many different companies are taking part in a rally or decline. The more companies taking part, the broader the move
  • New highs or lows for a company indicate exceptionally positive or negative feelings toward its performance. If many stocks are making new highs or lows, movements in the broad market should mirror that sentiment
  • Point-and-figure charting, by removing the time element from the chart and recording only larger price moves, helps filter out market noise
  • Internal indicators are most useful when used in conjunction with a price chart
  • Market breadth should never be used to rationalize an otherwise bad trade. The price action trumps everything else when it hits a stop-loss
  • Internal indicators are used to confirm price moves in a given market, and they should generally print the same shape as the underlying price chart, making highs and lows near the same date
  • An important warning signal is given when an internal indicator diverges from the direction of the market in question, indicating that a price move is not widely supported by market participants
  • A reversal occurring when an internal indicator is in an overbought or oversold condition may mean fast moving price changes are ahead

Force Index

The force index combines price and volume into one value, attempting to measure the force behind a move in price. It can be read as an oscillator or cumulatively.

Here's the formula:

Force Index = Volume (Today's Price - Yesterday's Price)

Crosses above and below the zero line can be read as a change in market trend. Because of the volatility of the force index, using a moving average to smooth and fine-tune the signals can be helpful.

In Conclusion

Keep in mind that this overview is not to meant to be an exhaustive study, but a useful primer for the novice market technician. It may be difficult to find a free source for a few of these charts but some websites provide free charting tools, and many of these indicators are included. Most professional trading software packages include all of the above data and charts for those willing to pay a steep price.

Market Breadth: 52-Week Highs/Lows

Because of the broad market implications and forceful nature of new 52-week highs/lows, market technicians keep a close eye on this statistic. The field of technical analysis has designed a number of indicators to grade the underlying momentum created by the events driving the market in either direction.

Forces of Highs and Lows

When shares of a publicly traded company hit a new high for the year, everyone involved can rest assured that things are on the right track. Not only are investors rewarded, but the work of the company's CEO, executives and employees is validated. All this optimism in the business attracts new attention from traders and institutional investors looking to capitalize on the stock's momentum. Rallies from a new 52-week high can be explosive, picking up steam as traders migrate to stocks that are making a consistent profit. If the broader market begins to see many shares making new highs, that has the power to drive most everything up, squeezing short sellers and igniting a rally - perhaps even a new bull market. Of course, the opposite is also true. When a stock hits a new 52-week low, something at that business has definitely gone awry, resulting in angry investors. A new 52-week low could mean margins are being squeezed, customers are drying up, or a brand is shedding market share. The negativity can feed on itself as short sellers drive the stock lower and fund managers make the tough decision to take their lumps and wash their hands of a bad trade. Bear markets often begin after a business reports a disappointing performance, forcing down expectations for the broader market. Each day the financial news networks and websites report the number of new highs and new lows. That data is incorporated into market breadth indicators and then compared to index charts to judge market force and direction.

There are five popular indicators that are constructed with new high/low data:

  • The cumulative new high/low line;
  • The new-high minus new-low oscillator;
  • The new high/low ratio;
  • The percentage of new high to new high plus new low and;
  • The percentage of new highs to total market.

It is important to remember that the differences between these five indicators are subtle and can best be mastered by continued observance.

Cumulative New High/Low Line

The formula for the cumulative new high/low line looks like this:

Today's Value = Yesterday's Value + (Today's New Highs - Today's New Lows)

The values for cumulative new high/low are differentiated by market, whether the NYSE or NASDAQ - stocks are not all lumped together. This indicator is plotted as a line connecting each day's value, and then it is usually compared to a price plot. Generally, the chart will look similar to the price plot, with the two making new highs and lows near the same spots. Just like the breadth indicators using volume, the cumulative new high/low signals a change in momentum and could be forecasting a new direction in price when the line diverges from the price chart. When the new high/low indicator gets ahead of the price chart, this signals strong momentum in the underlying market. While a plot of the 52-week high/low line is most common, any time frame can be used (such as 100-day or 200-day). Moving averages and other technical indicators can be applied to the cumulative new high/low line just like a price chart.

New-High Minus New-Low Oscillator

The formula for the new-high minus new-low oscillator looks like this:

Oscillator = Today's New Highs - Today's New Lows

This formula creates a fast oscillator that can be smoothed or fine-tuned with a moving average. The oscillator revolves around a zero line, signaling a change in trend when it crosses above or below zero. The extremes of the oscillator signal overbought and oversold conditions respectively. (An extreme is usually around 80% or 20%, but the definition can be tuned using market specific data.) The most common are the 52-week highs/lows, but any time frame can be used to construct this oscillator.

New High/Low Ratio

The formula for new high/low ratio looks like this:

Ratio = Today's New Highs / Today's New Lows

This ratio is like an oscillator because it revolves around the value 1. Although this oscillator is much slower than the oscillator discussed above, it can be smoothed further using a moving average. Anything below 1 means there are more stocks making new lows than highs - this is extremely negative. Because of the fractional nature of the negative territory, a logarithmic chart enhances readability. The indicator spends more time above 1, meaning more stocks are making new highs than lows. Since this chart is a ratio, it is impossible for the value to be less than zero. The extremes of the indicator represent overbought/oversold territory. The new high/low indicator can be examined further using other technical indicators - the relative strength index (RSI) is especially useful.

Percentage of New-High to New High + New Low

The formula for this breadth indicator looks like this:

% New Highs = Today's New Highs / (Today's New Highs + Today's New Lows)

The reverse of this formula can also be used to construct the percent of new lows:

% New Lows = Today's New Lows / (Today's New Highs + Today's New Lows)

Both indicators are percentages, so, like the high/low ratio, their values will always be between 0 and 1, never negative. Obviously, when there is a high percentage of stocks that are making new highs, this is positive for the broader market; conversely, a large percentage of new lows doesn't bode well for the market. Technicians monitor the shape and direction of this indicator to judge momentum, and they monitor extremes to judge overbought/oversold territory. This indicator can be compared to the underlying price chart and analyzed further using other tools of technical analysis. As with all these high/low indicators, any time frame can be used (52-weeks being the most common).

Percentage of New Highs to Total Market

This indicator's formula looks like this:

% New Highs = Today's New Highs / Total # of Listed Stocks in Given Market

The opposite formula can also be constructed:

% New Lows = Today's New Lows / Total # of Listed Stocks in Given Market

The indicators that measure the percentage of new highs or lows to total market are very similar to the percentage we looked at above: values cannot be less than zero, direction and shape determine momentum, and other technical indicators are applicable. Since you are comparing a much larger base to the new highs or lows, the percentage values here will be much lower. Stockcharts.com provides free charts that can be customized for many of the market breadth indicators we discussed here. For others, technicians will need to search for a fee-based charting service that provides a wider array of breadth data.

Moving Averages

Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of a security's overall trend. One simple method traders use to combat this is to apply moving averages. A moving average is the average price of a security over a set amount of time. By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favour. (To learn more, read the Moving Averages tutorial.)

Types of Moving Averages

There are a number of different types of moving averages that vary in the way they are calculated, but how each average is interpreted remains the same. The calculations only differ in regards to the weighting that they place on the price data, shifting from equal weighting of each price point to more weight being placed on recent data. The three most common types of moving averages are simple, linear and exponential.

Simple Moving Average (SMA)

This is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation. For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. As you can see in Figure 1, a trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse. Many individuals argue that the usefulness of this type of average is limited because each point in the data series has the same impact on the result regardless of where it occurs in the sequence. The critics argue that the most recent data is more important and, therefore, it should also have a higher weighting. This type of criticism has been one of the main factors leading to the invention of other forms of moving averages.

Linear Weighted Average

This moving average indicator is the least common out of the three and is used to address the problem of the equal weighting. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods. For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers.

Exponential Moving Average (EMA)

This moving average calculation uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. As you can see in Figure 2, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesn’t seem like much, but it is an important factor to be aware of since it can affect returns.

Major Uses of Moving Averages

Moving averages are used to identify current trends and trend reversals as well as to set up support and resistance levels. Moving averages can be used to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average. As you can see in Figure 3, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend. Another method of determining momentum is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend. Moving average trend reversals are formed in two main ways: when the price moves through a moving average and when it moves through moving average crossovers. The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in Figure 4, it is a sign that the uptrend may be reversing.

The other signal of a trend reversal is when one moving average crosses through another. For example, as you can see in Figure 5, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the price will start to increase. If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend. Another major way moving averages are used is to identify support and resistance levels. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For example, if the price breaks through the 200-day moving average in a downward direction, it is a signal that the uptrend is reversing. Moving averages are a powerful tool for analysing the trend in a security. They provide useful support and resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks. Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend. So far we have been focused on price movement, through charts and averages. In the next section, we'll look at some other techniques used to confirm price movement and patterns.



How Divergence Can be Used as an Indicator

If you questioned a sample of share and derivative traders on their thoughts on divergence you would receive a variety of answers, ranging from enthusiasm to disbelief. However divergence has been examined at length and many trading systems have been designed based on divergences alone with some degree of success.

What is it?

Divergence is a comparison of price to technical indicators. Divergence occurs when the indicator you are examining is moving in opposite direction to the price of the underlying share or index. It is as simple as that and can also apply to nearly all financial instruments.

Why doesn't everybody use it?

Divergence can signal an up-coming change in trend, a change of trend in progress or that a trend should continue. Therein lays the problem. In doesn't necessarily mean a change in the direction of the share price, or if there is a change, it may only be a short-term change. A divergence signal suggests "watching" for a trading opportunity in the direction of the signal. Divergences may continue over many swing highs/lows so price action should confirm your trade.

Why the Popularity?

It can be used with many indicators including Stochastic, Moving Average Convergence Divergence (MACD), and RSI to name a few. Divergence also applies to the "market-neutral" trading strategy of pairs trading. Most traders or investors use divergence as some form of a warning system. Divergences tells the observer two obvious things about possible market conditions. First is that the trend could be coming to an end or secondly, that the current trend may be a very strong trend and possibly worth milking for a large trade. BHP late 2004 / early 2005 springs to mind. BHP's trend showed various divergence signals over that time however, the underlying trend was the dominating factor, so the savvy trader waited to ride the upside.

The Trap

Most traders fall prey to the concept of divergence and see it as the end or reversal of the prevailing trend of the market. All would be right in the world if markets were to reverse from simple divergence. But there are times when sentiment and momentum are so strong that the market continues to make new highs or lows. Momentum and price corrections, when they do materialize, are usually sharp and swift. After these brief respites the market is then ready to resume its normal upward or downward trend. With each successive new high or low and a divergence pattern formed, anxious traders are ready to call for a top or a bottom, and reversal of trend. However, in strongly trending markets, multiple divergences can and do develop, which only lead to corrections of the overbought (oversold) condition of the market. "If a trader attempted to take positions based solely on divergences, he or she would need deep pockets and eventually exhaust his or her trading capital," The ability of a trader to recognize a trend change quickly, reverse a position and trade in the direction of that next trend is the skill that traders must develop to be successful. Divergence is a tool that can help identify changes and is particularly useful for CFD and Option traders. However it must be used in combination with other tools, including fundamental and technical analysis, and some good old fashioned "hands on" experience.


Simple Moving Average Crossover

Technical analysis relies upon indicators as a means of identifying and confirming trends and trend reversals. As explained in an earlier lesson the Simple Moving Average Price Crossover is one of the oldest and simplest trading indicators.

When using an individual Simple Moving Average (SMA), as long as the share price is above the SMA, the trend is defined as bullish. Likewise, as long as the price is below the SMA, the trend is defined as bearish. Theoretically, when using two Simple Moving Average trend lines with different time periods, the buy and sell signals are generated when the fast moving SMA crosses the slower moving SMA.

A bullish signal is generated on the share price chart when price the fast moving SMA - the shorter period SMA - crosses up from below over the slow moving SMA - the longer period SMA. Conversely, when the fast-moving SMA crosses down from above the slower-moving SMA, a bearish signal is generated. One of the more common combinations is the 7 & 21 Day moving averages.

There are many combinations of periods used. Once you become more comfortable with SMS crossovers, you should experiment with varying the values of the moving averages to suit your personal trading style. Conceptually, the crossing of the two SMA suggests that a change in the short-term trend has occurred. Depending upon the time periods used, it dictates whether it is a short, medium or long-term change in trend. As moving averages lag the market they can only confirm, not predict the trend.


Chart Patterns - Broadening Top

Identified by a gentleman called Schabacher back in the thirties, the Broadening Top is a large reversal pattern. It can often be confused as a consolidation pattern which is characterised by investor consensus and a general lack of volatility, where as time passes and more information is disseminated, investors come to a collective decision and volatility slows. The opposite is true of broadening tops: as time passes broadening tops feature increasing wide ranges and greater volatility caused by increasing market indecision.

Broadening tops are characterised by three distinct stages:

  • A rally to a new high on increasing volume. Normally, this rally will be the result of better than expected earnings, product or sales news and/or a plethora of broker recommendations, as the stock surges to new highs more sellers appear, taking profits and it is not long before the stock settles back to a prior support level.
  • After a period of consolidation more positive news pushes the stock to yet another new high on increased volume (2nd top) which should be a sign that the stock is very bullish but once again the stock falters, falling to a relative new low.
  • Although the original positive news is still valid, the rumour mill grinds out the predictable stories that the 'big boys' are selling out, taking profit and liquidating their positions. Bullish investors rally to defence of the stock and the Media continues to put a positive spin on the stock. Brokerage firms’ recommendations contain high price targets and once again, the stock begins to move higher. Although volume is strong, it’s less than in the previous rallies. Nevertheless, the stock moves to third new high (3rd top) in as many attempts. Whilst the stock is making a new high, there is still a case of the jitters among some investors. Soon afterwards the stock begins to top out on increased volume but no specific news. Several days later the stock is collapsing and support at the most recent low is in jeopardy. Panic set in and the stock sinks back to the longer-term support level.

The theory suggests that the break out of the pattern will result in the share price falling approximately the same as the height between point and point.


The Relative Strength Index (RSI)

There are a few different tools that can be used to interpret the strength of a stock. One of these is the Relative Strength Index (RSI), which is a comparison between the days that a stock finishes up and the days it finishes down. This indicator is a big tool in momentum trading.

The RSI is a reasonably simple model that anyone can use. It is calculated using the following formula. (Don't worry, you will probably never have to do this manually.)

RSI = 100 - [100/(1 + RS)]

where:

RS = (Avg. of n-day up closes)/(Avg. of n-day down closes) n= days (most analysts use 9 - 15 day RSI)

The RSI ranges from 0 to 100. At around the 70 level, a stock is considered overbought and you should consider selling. But this number is not written in stone: in a bull market some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30, a stock is considered oversold and you should consider buying.

Again, make the adjustment to 20 in a bear market. The smaller the number of days used, the more volatile the RSI is and the more often it will hit extremes. A longer term RSI is more rolling, fluctuating a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks in some industries will go as high as 75-80 before dropping back, while others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (one year or more) to determine at what level the historical RSI has traded and how the stock reacted when it reached those levels.


The Money Flow Index

Now that we've looked at the Relative Strength Index (RSI), let's take a look at a more stringent momentum indicator. The Money Flow Index (MFI) measures the strength of money flowing into and out of a stock. The difference between the RSI and the MFI is this: while the RSI looks only at prices, the MFI also takes volume into account. The MFI is a bit more difficult to calculate than the RSI:

First we need the average price for the day:

Average Price = Day High + Day Low + Close

Now we need the Money Flow:

Money Flow = Average Price x Day's Volume

Now, to calculate the money flow ratio you need to separate the money flows for a period into positive and negative. If the price was up in a particular day, this is considered to be "positive money flow". If the price closed down, it is considered to be "negative money flow".

Money Flow Ratio = Positive Money Flow

Negative Money Flow It is the Money Flow Ratio that is used to calculate the Money Flow Index. The money flow ranges from 0 to 100. Just as with the RSI, a stock is considered overbought in the 70- 80 range and oversold in the 20-30 range. The smaller the number of days you use, the more volatile the money flow is.


The Bollinger Bands

The Bollinger band indicator uses three lines: the upper, the lower and the simple moving average (SMA) that is between the two. The upper/lower bands are plotted two standard deviations away from a SMA. Standard deviation is a measure of volatility; therefore, Bollinger bands adjust themselves to market conditions.

When the markets become more volatile, the bands widen, and they contract during less volatile periods. The closer the prices move to the upper band, the more overbought the stock is. The closer the prices move to the lower band, the more oversold the stock is.


Gaps - Island Reversal

Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. This sudden move by a stock, the sudden change in demand, is often the beginning of a major move.

Today we are going to highlight a rare Gap situation, the 'Island Reversal'. This formation consists of:

  • An exhaustion gap in the direction of the share price move
  • A tight trading range. This could be one or more candles
  • A breakaway gap in the reverse direction of the earlier prevailing trend
  • The result is a candle or candles that are left as an island

As the name implies, an "exhaustion" gap occurs at the end of a move. It is often referred to as the last fevered push of the bulls. Moreover, "Exhaustion gaps" are typically closed in one trading week or less. Technical analysts suggest that once the "exhaustion" gap has been closed, the short to medium-term trend has peaked. Within an Island Reversal Formation, the more candles in the island, the stronger the reversal signal. This pattern is rare because the market is reversing its view on the stock. While the Island Reversal sounds like a very important event, pragmatically, the second gap usually just produces a reversal of the previous movement. In other words, the stock, if it is a "bearish island reversal," is likely to retrace to approximately where it was when the upturn started.


Dow Theory

Introduction to Technical AnalysisThe Dow Theory prescribes to the broader market, not to any individual company. There is always value in knowing whether the market's primary trend is bullish or bearish. In a balanced widely spread portfolio, the Dow Theory is a tool that can preserve capital as it can assist in keeping investors on the right side of the primary trend. One of the main reasons the Dow Theory has supposedly stood the test of time is that it avoids the frequent "whipsawing" that occurs with other market-timing models.

In theory, investors who prescribe solely to the Basic Tenet of the Dow Theory will ride with a long-term bull market and therefore avoid trading out of stocks during that time. As we all know missing the major turns in a market can lead to loss of capital or at the least missing out on maximising share market returns. When using the Dow Theory, it is important to realise that the Theory does not project how high or low primary market trends will carry.

The goal of the theory is to determine changes in the major trends or movements of the market. It simply points out a trend. By the time the Theory has signalled that a change in the primary trend has taken place, the market could already be well off its bull-market high or bear-market low. While the Theory is unlikely to get an investor in at the exact top or bottom of the market - no timing tool can make this guarantee - it is generally seen as an aid to investors/traders. The theory states that the market has discernible cycles. The hypothesis is predicated on the idea that each cycle lasts between two to ten years, and within the cycle there are primary, secondary and minor trends.

The three trends are:

  • Uptrend - three successive higher peaks (highs) and three higher troughs (lows)
  • Downtrend - three successive lower peaks and three lower troughs
  • Sideways - peaks and troughs don successively rise or fall

Conclusion

This introductory section of the technical analysis tutorial has provided a broad overview of technical analysis.

Here's a brief summary of what we've covered:

  • Technical analysis is a method of evaluating securities by analysing the statistics generated by market activity. It is based on three assumptions: 1) the market discounts everything, 2) price moves in trends and 3) history tends to repeat itself.
  • Technicians believe that all the information they need about a stock can be found in its charts.
  • Technical traders take a short-term approach to analysing the market.
  • Criticism of technical analysis stems from the efficient market hypothesis, which states that the market price is always the correct one, making any historical analysis useless.
  • One of the most important concepts in technical analysis is that of a trend, which is the general direction that a security is headed is. There are three types of trends: uptrends, downtrends and sideways/horizontal trends.
  • A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock.
  • A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and resistance.
  • Support is the price level through which a stock or market seldom falls. Resistance is the price level that a stock or market seldom surpasses.
  • Volume is the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security.
  • A chart is a graphical representation of a series of prices over a set time frame.
  • The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually.
  • The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to past data points. It can be either linear or logarithmic.
  • There are four main types of charts used by investors and traders: line charts, bar charts, candlestick charts and point and figure charts.
  • A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. There are two types: reversal and continuation.
  • A head and shoulders pattern is reversal pattern that signals a security is likely to move against its previous trend.
  • A cup and handle pattern is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.
  • Double tops and double bottoms are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through.
  • A triangle is a technical analysis pattern created by drawing trendlines along a price range that gets narrower over time because of lower tops and higher bottoms. Variations of a triangle include ascending and descending triangles.
  • Flags and pennants are short-term continuation patterns that are formed when there is a sharp price movement followed by a sideways price movement.
  • The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction.
  • A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there is a large difference in prices between two sequential trading periods.
  • Triple tops and triple bottoms are reversal patterns that are formed when the price movement tests a level of support or resistance three times and is unable to break through, signalling a trend reversal.
  • A rounding bottom (or saucer bottom) is a long-term reversal pattern that signals a shift from a downward trend to an upward trend.
  • A moving average is the average price of a security over a set amount of time. There are three types: simple, linear and exponential.
  • Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend.
  • Indicators are calculations based on the price and the volume of a security that measure such things as money flow, trends, volatility and momentum. There are two types: leading and lagging.
  • The accumulation/distribution line is a volume indicator that attempts to measure the ratio of buying to selling of a security.
  • The average directional index (ADX) is a trend indicator that is used to measure the strength of a current trend.
  • The Aroon indicator is a trending indicator used to measure whether a security is in an uptrend or downtrend and the magnitude of that trend.
  • The Aroon oscillator plots the difference between the Aroon up and down lines by subtracting the two lines.
  • The moving average convergence divergence (MACD) is comprised of two exponential moving averages, which help to measure a security's momentum.
  • The relative strength index (RSI) helps to signal overbought and oversold conditions in a security.
  • The on-balance volume (OBV) indicator is one of the most well-known technical indicators that reflects movements in volume.
  • The stochastic oscillator compares a security's closing price to its price range over a given time period.

 


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