Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part II. Before You Start Buying

Chapter 10. Understanding Technical Analysis for Stock Investors

IN THIS CHAPTER

Defining technical analysis

Talking about trends

Checking out charts

Using technical indicators for investing decisions

In my early days as a stock investor, I rarely used technical analysis, but in my later years, I came to see it as a useful part of my overall investing approach. Yes, technical analysis is … well … technical, but it can help you time your decision about when you want to buy, sell, or hold a particular stock. In short, fundamental analysis (what the rest of this book discusses) tells you what to buy, and technical analysis tells you when to buy. I won’t make this chapter an exhaustive treatment of this topic (I bet you just said “Whew!”), but I do want to alert you to techniques and resources that will give you a leg up in today’s volatile and uncertain markets.

tip I’d like to mention some resources right out of the starting gate. Use the following resources to discover more information about technical analysis:

·        Big Charts (www.bigcharts.com)

·        Incredible Charts (www.incrediblecharts.com)

·        International Federation of Technical Analysts (www.ifta.org)

·        Online Trading Concepts (www.onlinetradingconcepts.com)

·        StockCharts (www.stockcharts.com)

·        Stocks & Commodities magazine (www.traders.com)

·        Technical Analysis For Dummies, 3rd Edition, by Barbara Rockefeller (Wiley) (www.dummies.com)

·        TraderPlanet (www.traderplanet.com)

Comparing Technical Analysis and Fundamental Analysis

When figuring out what to do in the investment world, most professionals use one of two basic approaches: fundamental analysis and technical analysis (many use some combination of the two). Both approaches are used in a number of markets ranging from the stock market to commodities, but I limit this chapter to stock investing. The main differences between fundamental analysis and technical analysis are pretty easy to understand:

·        Fundamental analysis goes into the economics of the company itself, such as sales and profit data, as well as external factors affecting it, such as politics, regulations, and industry trends.

·        Technical analysis tries to understand where a stock’s price is going based on market behavior as evidenced in its market statistics (presented in charts, price, and trading volume data). Technical analysis doesn’t try to figure out the worth of an investment; it’s used to figure out where the price of that stock or investment is trending.

In the following sections, I talk about the main principles of technical analysis, and I note its pros and cons as compared to fundamental analysis. I also explain how to combine technical analysis with fundamental analysis, and I list some tools of the trade.

Looking under the hood of technical analysis

To get the most benefit from using technical analysis, you need to understand how it operates and what it is that you’re looking at. Technical analysis, for the purposes of this book, is based on the following assumptions.

The price is the be-all and end-all

The premise of technical analysis is that the stock’s market price provides enough information to render a trading decision. Those who criticize technical analysis point out that it considers the price and its movement without paying adequate attention to the fundamental factors of the company. The argument made favoring technical analysis is that the price is a snapshot that, in fact, does reflect the basic factors affecting the company, including the company’s (or investment’s) fundamentals.

remember Technical analysts (also called technicians or chartists) believe that a company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. The bottom line is that technicians look at the price and its movement to extract a forecast for where the stock is going.

The trend is your friend

The price of a stock tends to move in trends. In the world of technical analysis, the phrase “the trend is your friend” is as ubiquitous as the phrase “you spoiled the broth, now you lie in it!” is in the restaurant industry. Maybe even more so. Following the trend is a bedrock principle in technical analysis, and the data either supports the trend or it doesn’t. When a trend in the stock’s price is established, its tendency is to continue. The three types of trends are up, down, and sideways (but you knew that). (See the later section “Staying on Top of Trends” for more information.)

If it happened before, it will happen again

Another foundational 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’re still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. (I talk about chart patterns in more detail later in this chapter.)

Examining the good and bad of technical analysis

Although technical analysis is the “star” of this chapter, it does have its shortcomings. The major drawback of technical analysis is that it’s a human approach that tracks human behavior in a particular market. In other words, just because it’s called technical analysis doesn’t mean that it’s technical à la the laws of physics. It’s called technical analysis because the data you look at is technical. But the movement of the price of the underlying stock or investment is due to the cumulative decisions of many buyers and sellers who are human — and therefore fallible.

Why mention this? Everyone is looking to make money, and many trading systems and approaches are based on technical analysis. Unfortunately, making profitable investments isn’t a matter of two plus two equals four. If technical analysis made things so easy that mere computer models or trading systems could give you a voilà-moneymaking decision, everyone could — and would — do it. Yet, that’s not the case.

Here’s my take on it. I favor fundamental analysis for long-term investing. I shun technical analysis for choosing individual stocks because I don’t see the long-term value in it. Long-term investors don’t have to bother with things such as triangles, pennants, cup-and-handles, or other paraphernalia. Long-term investors just ask questions like “Is the company making money?” or “Are financial and economic conditions still favorable for my investment?” When the fundamentals are in your favor, any short-term move against you is a buying opportunity (provided that you choose wisely from the start). But unfortunately, too many investors aren’t patient, and they get too busy with the short-term trees to be bothered by the long-term forest. Yet that long-term forest has a lot more green, if you know what I mean (I hope I’m not meandering here).

technicalstuff If you were to do a nose count of successful investors in stock market history and what approaches they used, you’d find that those long-term investors who used some variation of fundamental analysis (such as those who used a value-investing approach) overwhelmingly comprise the larger category. Legendary investors like Warren Buffett and Peter Lynch rarely looked at a chart. Think about it: Warren Buffett is obviously one of history’s greatest success stories in the world of stock investing. His track record and multibillion-dollar net worth attest to this. Yet, he rarely (if ever) looks at any technical analysis. He isn’t concerned with short-term squiggles and fluctuations. He is indeed a long-term investor, and one of his greatest assets is patience. He has held some stocks for decades. The point makes for an interesting observation into human nature. Everyone wants to succeed like Warren Buffett, but few are willing to go the distance.

The short term is a different animal. It requires more attention and discipline. You need to monitor all the indicators to see whether you’re on track or whether the signals are warning a change in course. The technicals can be bearish one month and bullish the next. And the month after that, the signals can be mixed and give no clear warnings at all. Being a proficient technician ultimately requires more monitoring, more trading, and more hedging.

Note that all this activity also means more taxes, more transaction costs (commissions and the like), and more administrative work (tax reporting and so on). After all, who do you think will pay more in taxes: someone who buys and holds for a year or longer or someone who makes the same profit by jumping in and out based on which way the technical winds are blowing? Short-term gains don’t have the same favorable rates as long-term gains. Sometimes the issue isn’t what you make but what you keep (I cover taxes in Chapter 21).

remember But before you throw out technical analysis with the bath water, read on. Those who use technical analysis in short-term trading or speculating in larger-scope investments tend to do better than those who don’t use it. That means that if you apply technical analysis to something larger than a company, such as an index or a commodity, you’ll tend to do better. If you’re getting into trading stocks and/or stock-related exchange-traded funds (ETFs; see Chapter 5), then understanding the basics of technical analysis will make you, overall, a better (and hence more profitable) trader. Because short-term market behavior and psychology can be very mercurial and irrational (human), technical analysis has its usefulness. It’s most useful for those folks who are trading and/or speculating during a relatively short time frame measured in days, weeks, or months. It isn’t that useful when you’re trying to forecast where a stock’s price will be a year or more down the road.

Combining the best of both worlds

I think that a useful way to combine both fundamental analysis and technical analysis is to take advantage of the strength of each. Fundamental analysis helps you understand what to invest (or trade or speculate) in, whereas technical analysis guides you as to when to do it. Because markets ebb and flow, zig and zag, technical analysis can help you spot low-risk points to either enter or exit a trade. Technical analysis, therefore, helps you stack the deck a little more in your favor. Considering how markets have been going lately, every little bit helps.

Blending the two approaches to some extent has been done with success. Obviously, if the fundamental and the technical factors support your decision, then the chance for a profitable trade has more going for it. How does this blend occur?

For an example, look at the concepts of oversold and overbought (see the section “The Relative Strength Index,” later in this chapter). If you’re looking at buying a stock (or other investment) because you think it’s a strong investment but you’re not sure about when to buy, you want to look at the technical data. If the data tells you that it has been oversold, it’s a good time to buy. Oversold just means that the market was a little too extreme in selling that particular investment during a particular period of time.

By the way, I like to think that the technical terms oversold and overbought have a parallel to fundamental terms such as undervalued and overvalued. Because fundamental analysis is a major part of a school of thought referred to as value investing, the concepts make sense (yes, I’m into value investing). Just as investing in an undervalued stock is usually a good idea, so is buying a stock that has been oversold. It’s logical to presume that an oversold stock is undervalued (all things being equal). Of course, the other terms (overbought and overvalued) can also run in tandem. I may as well finish here before you’re overwhelmed and underinterested.

On the other hand, the fundamentals can help a technical analyst make a better trading decision. Say that a technical analyst has a profitable position in a particular stock called Getting Near a Cliff Corp. (GNAC). If the technical indicators are turning bearish and the new quarterly earnings report for GNAC indicates a significantly lower profit, then selling GNAC’s stock is probably a good idea. (Of course, because you’re reading this book, you’re doing something better like immediately putting on a trailing stop, right? See Chapter 17 for details on trailing stops.)

Using the technician’s tools

When you roll up your sleeves and get into technical analysis, what will you be dealing with? It depends on what type of technical analyst you are. In technical analysis, there are two subcategories: those who predominantly use charts (these technicians are called … chartists!) and those who predominantly use data (such as price and volume data). Of course, many technicians use a combination of both (and I discuss both later in this chapter):

·        Charts: Charts are the neat pictures that graph price movements (such as chart patterns).

·        Data: Data includes price and volume information (along with technical and behavioral indicators derived from it).

Technical analysts don’t look at the fundamentals because they believe that the marketplace (as depicted in the charts, price, and volume data) already take into account the fundamentals.

Staying on Top of Trends

Identifying trends is a crucial part of technical analysis. A trend is just the overall direction of a stock (or another security or a commodity); you can see trends in technical charts (I provide details about charts later in this chapter). Which way is the price headed? In the following sections, I describe different types of trends, talk about trend length, and discuss trendlines and channel lines.

Distinguishing different trends

Three basic trends exist:

·        An uptrend or bullish trend is when each successive high is higher than the previous high and each successive low is higher than the previous low.

·        A downtrend or bearish trend is when each successive high is lower than the previous high and each successive low is lower than the previous low.

·        A sideways trend or horizontal trend shows that the highs and the lows are both in a generally sideways pattern with no clear indication of trending up or down (at least not yet).

It’s easy to see which way the stock is headed in Figure 10-1. Unless you’re a skier, that’s not a pretty picture. The bearish trend is obvious.

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© John Wiley & Sons, Inc.

FIGURE 10-1: Generic chart sloping in a definite downward direction.

What do you do with a chart like Figure 10-2? Yup … looks like somebody’s heart monitor while he’s watching a horror movie. A sideways or horizontal trend just shows a consolidation pattern that means that the stock will break out into an uptrend or downtrend.

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© John Wiley & Sons, Inc.

FIGURE 10-2: Generic chart showing a sideways pattern.

Regardless of whether a trend is up, down, or sideways, you’ll notice that it’s rarely (closer to never) in a straight line. The line is usually jagged and bumpy because it’s really a summary of all the buyers and sellers making their trades. Some days the buyers have more impact, and some days it’s the sellers’ turn. Figure 10-3 shows all three trends.

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© John Wiley & Sons, Inc.

FIGURE 10-3: Chart that simultaneously shows an up, down, and sideways trend.

remember Technical analysts call the highs peaks and the lows troughs. In other words, if the peaks and troughs keep going up, that’s bullish. If the peaks and troughs keep going down, it’s bearish. And if the peaks and troughs are horizontal, you’re probably in California (just kidding).

Looking at a trend’s length

With trends, you’re not just looking at the direction; you’re also looking at the trend’s duration, or the length of time that it goes along. Trend durations can be (you guessed it) short-term, intermediate-term, or long-term.

·        A short-term (or near-term) trend is generally less than a month.

·        An intermediate-term trend is up to a quarter (three months) long.

·        A long-term trend can last up to a year. And to muddy the water a bit, the long-term trend may have several trends inside it (don’t worry; the quiz has been canceled).

Using trendlines

trendline is a simple feature added to a chart: a straight line designating a clear path for a particular trend. Trendlines simply follow the peaks and troughs to show a distinctive direction. They can also be used to identify a trend reversal, or a change in the opposite direction. Figure 10-4 shows two trendlines: the two straight lines that follow the tops and bottoms of the jagged line (which shows the actual price movement of the asset in question).

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© John Wiley & Sons, Inc.

FIGURE 10-4: Chart that shows the jagged edge going upward along with the trendlines.

Watching the channel for resistance and support

remember The concepts of resistance and support are critical to technical analysis the way tires are to cars. When the rubber meets the road, you want to know where the price is going.

·        Resistance is like the proverbial glass ceiling in the market’s world of price movement. As a price keeps moving up, how high can or will it go? That’s the $64,000 question, and technical analysts watch this closely. Breaking through resistance is considered a positive sign for the price, and the expectation is definitely bullish.

·        Support is the lowest point or level that a price is trading at. When the price goes down and hits this level, it’s expected to bounce back, but what happens when it goes below the support level? It’s then considered a bearish sign, and technical analysts watch closely for a potential reversal even though they expect the price to head down.

Channel lines are lines that are added to show both the peaks and troughs of the primary trend. The top line indicates resistance (of the price movement), and the lower line indicates support. Resistance and support form the trading range for the stock’s price. The channel can slope or point upward or downward, or go sideways. Technical traders view the channel with interest because the assumption is that that the price will continue in the direction of the channel (between resistance and support) until technical indicators signal a change. (To me, this tells me to change to a cable channel, but that’s just me. Please continue reading… .) Check out the channel in Figure 10-5; it shows you how the price is range-bound. The emphasis on trends is to help you make more profitable decisions because you’re better off trading with the trend than not.

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© John Wiley & Sons, Inc.

FIGURE 10-5: Chart showing a channel.

In Figure 10-5, you see a good example of a channel for a particular stock. In this case, the stock is zigzagging downward, and toward the end of the channel, it indicates that the stock is getting more volatile as the stock’s price movement is outside the original channel lines. This tells the trader/investor to be cautious and on the lookout for opportunities or pitfalls (depending on your outlook for the stock).

Getting the Scoop on Technical Charts

Charts are to technical analysis what pictures are to photography. You can’t avoid them ’cause you’re not supposed to. If you’re serious about trading stocks (or ETFs, commodities, or whatever), charts and the related technical data come in handy. In the following sections, I describe different types of charts and chart patterns.

Checking out types of charts

Technical analysts use charts to “diagnose” an investment’s situation the same way any analyst uses different tools and approaches. Different charts provide fresh angles for viewing the data. In terms of visualization and utility, the following are the four most common charts used in technical analysis.

Line charts

A line chart simply shows a series of prices plotted in a graph that displays how the price has moved over a period of time. The period of time can be a day, week, month, year, or longer. The prices that are usually chosen for a line chart are the closing prices for those market days.

With a yearlong line chart (like those that appear earlier in this chapter), you can see how the stock has progressed during the 12-month period, and you can do some simple analysis. When were the peaks? How about the troughs? What were the strongest seasons for this stock’s price movement?

tip I prefer to use five-year charts; I like to encourage my clients, students, and readers to focus on the longer term because positive results can be easier to achieve.

Bar charts

Bar charts are a little fancier. Whereas the line chart only gives you the closing prices for each market day, the bar chart gives you the range of trading prices for each day during the chosen time period. Each trading day is a vertical line that represents the price movements, and you see the stock’s high, low, and closing prices.

In a bar chart, the vertical line has two notches. The notch on the left indicates the opening price, and the notch on the right indicates the closing price. If the opening price notch is higher than the closing price notch, the line is in red to indicate that the closing price of the stock declined versus the opening price. An up day is in black, and the closing price notch is higher than the opening price notch.

Candlestick charts

Candlestick charts have been all the rage in recent years. They’re basically bar charts, but they’re a little more complex. A candlestick chart provides a more complete picture by adding a visualization of other data that simple charts don’t contain, such as the high, low, and closing price of the security the chart is tracking. It stands to reason that because candlestick charts provide more information in a visual form than bar charts, they can provide more guidance in trading. Candlestick charting is too involved to adequately describe in this space, so please continue your research with the resources provided at the start of this chapter.

technicalstuff The full name for these charts is Japanese candlestick charts because they originated as a form of technical analysis in the 17th century, when the Japanese were trading in rice markets. You know, they do look like candlesticks (but I’m waxing eloquent here).

Point-and-figure charts

A more obscure chart that chartists use is the point-and-figure chart. When you look at it, you’ll notice a series of Xs and Os. The Xs represent upward price trends, and the Os represent downward price trends. This type of chart enables the stock trader to easily determine which prices are “support levels” and which are “resistance levels” to better judge buy and sell prices.

Picking out chart patterns

Chart patterns are the graphical language of technical analysis, and a very interesting language at that. For technical analysts, the pattern is important because it provides a potential harbinger for what is to come. It’s not 100 percent accurate, but it’s usually accurate better than 50 percent of the time as odds go. In the world of trading, being right more than 50 percent of the time can be enough. Usually a proficient technician is better than that. The following sections cover common chart patterns.

remember Technical analysts don’t say that the next step after a particular pattern is a certainty; it’s a probability. Probable outcomes, more times than not, tend to materialize. Increasing the probability of success for more profitable decision-making (entering or exiting a trade) is the bottom-line mission of technical analysis.

Above the rest: The head and shoulders

The head and shoulders pattern is essentially bearish. It’s usually a signal that an uptrend has ended and the pattern is set to reverse and head downward. Technical analysts consider this to be one of the most reliable patterns.

The pattern shows three peaks and two troughs. The three peaks break down into the tall center peak (the head) and the shorter peaks (the shoulders) that are on either side of the center peak. The two troughs form the neckline.

The head and shoulders pattern tells technical analysts that the preceding trend basically ran out of gas. The selling pressures build up and overpower the buyers. Hence, the price starts to come down. The shoulder on the right is like a last effort for the bullish trend to regain its traction, but to no avail. Keep in mind that the neckline in this pattern is the support (which I discuss in the earlier section “Watching the channel for resistance and support”). As support is broken, the tendency is a bearish expectation.

In reverse: The reverse head and shoulders

As you can infer, this pattern is the opposite of the prior chart pattern, and it’s essentially bullish. This pattern signals that a downtrend has ended and is set to reverse and head upward. In this pattern, you have three troughs and two peaks. The middle trough is usually the deepest one. The small trough on the right is an interim low, which is higher than the middle trough low and typically indicates the trend is moving upward.

In this pattern, buying pressures build up and form a base from which to spring upward. Note that a bullish pattern is a series of higher highs and higher lows. In the reverse head and shoulders pattern, the neckline is resistance (which I discuss earlier in this chapter). After resistance is broken, the expectation is for an upward move.

Wake up and smell the coffee: The cup and handle

This pattern is generally bullish. In the pattern, the price first peaks and then craters into a bowl-shaped trough (the cup). It peaks again at the end with a small downward move (the handle) before it moves up.

This pattern basically tells the technician that the stock’s price took a breather to build support and then continued its bullish pattern.

Twice as nice: The double top and the double bottom

Both the double top and the double bottom chart patterns indicate a trend reversal.

·        The double top is essentially a bearish pattern wherein the price makes two attempts (the double top) to break through resistance but fails to do so. The bottom of the trough between the two peaks indicates support. However, the two failed attempts at the resistance level are more significant than the support at the trough, so this pattern signals a potential downturn for that stock’s price.

·        The double bottom is the opposite reversal pattern. It’s a bullish pattern because the support level indicators are stronger than the resistance. This pattern signals a potential upturn in the stock’s price. Because this indicates a support level, bullish traders tend to look at it as a generally safe entry point to get positioned for the next potential up-move in the stock.

technicalstuff Triple tops and triple bottoms are variations of double tops and double bottoms. These are sideways or horizontal patterns that do portend a trend reversal. Don’t even ask about quadruple tops and bottoms!

Triangles (And I don’t mean Bermuda!)

A triangle is formed when the resistance line and the support line converge to form the triangle point that shows a general direction in the stock’s price movement. There are three types of triangles: symmetrical, ascending, and descending.

·        Symmetrical: The symmetrical triangle points sideways, which tells you it’s a horizontal pattern that becomes a setup for a move upward or downward when more price movement provides a bullish or bearish indicator.

·        Ascending: The ascending triangle is a bullish pattern.

·        Descending: The descending triangle is bearish.

Of course, if you see a divergent trapezoidal and octagonal candlestick formation supported in a bowl-shaped isosceles triangle, do nothing! Just take two aspirin and try again tomorrow.

Time to cheer: Flags and pennants

Flags and pennants are familiar chart patterns that are short-term in nature (usually not longer than a few weeks). They’re continuation patterns that are formed immediately after a sharp price movement, which is usually followed by a sideways price movement. Both the flag and the pennant are similar except that the flag is triangular whereas the pennant is in a channel formation (I talk about channels earlier in this chapter).

Cut it up: Wedges

The wedge pattern can be either a continuation or reversal pattern. It seems to be much like a symmetrical triangle, but it slants (up or down), whereas the symmetrical triangle generally shows a sideways movement. In addition, the wedge forms over a longer period of time (typically three to six months).

Watch your step: Gaps

A gap in a chart is an empty space between two trading periods. This pattern occurs when the difference in the price between those two periods is substantial. Say that in the first period, the trading range is $10 to $15. The next trading session opens at $20. That $5 discrepancy will appear as a large gap between those two periods on the chart. These gaps are typically found on bar and candlestick charts. Gaps may happen when positive (or negative) news comes out about the company, and initial buying pressure causes the price to jump in the subsequent period as soon as trading commences.

There are three types of gaps: breakaway, runaway, and exhaustion. The breakaway gap forms at the start of a trend, and the runaway gap forms during the middle of the trend. So what obviously happens when the trend gets tired at the end? Why, the exhaustion gap of course! See, this stuff isn’t that hard to grasp.

Surveying Technical Indicators for Stock Investors

An indicator is a mathematical calculation that can be used with the stock’s price and/or volume. The end result is a value that’s used to anticipate future changes in price. The two types of indicators are leading and lagging:

·        Leading indicators help you profit by attempting to forecast what prices will do next. Leading indicators provide greater rewards at the expense of increased risk. They perform best in sideways or trading markets. They work by measuring how overbought or oversold a stock is.

·        Lagging (or trend-following) indicators are best suited to price movements in relatively long trends. They don’t warn you of any potential changes in price. Lagging indicators have you buy and sell in a mature trend, when the risk is reduced.

The following sections describe a variety of leading and lagging indicators.

The Relative Strength Index

As noted in the earlier section “Combining the best of both worlds,” the technical conditions of overbought and oversold are important to be aware of. They’re good warning flags to help you time a trade, whether that means getting in or getting out of a position. The Relative Strength Index (RSI) is a convenient metric for measuring the overbought/oversold condition. Generally, the RSI quantifies the condition and gives you a number that acts like a barometer. On a reading of 0 to 100, the RSI becomes oversold at about the 30 level and overbought at about the 70 level.

The RSI is a metric usually calculated and quoted by most charting sources and technical analysis websites. It’s generally considered a leading indicator because it forewarns potential price movements.

tip For stock investors, I think the RSI is particularly useful for timing the purchase or sale of a particular stock. I know when I’m looking at a favorite stock that I like and notice that its RSI is below 30, I check to see whether anything is wrong with the stock (did the fundamentals change?). If nothing is wrong and it’s merely a temporary, market-driven event, I consider buying more of the stock. After all, if I loved a great stock at $40 and it’s now cheaper at $35, all things being equal, I have a great buying opportunity. Conversely, if I’m not crazy about a stock and I see that it’s overbought, I consider either selling it outright or at least putting a stop-loss order on the stock (see Chapter 17).

Moving averages

In terms of price data, a favorite tool of the technical analyst is the moving average. A moving average is the average price of a stock over a set period of time (which can range from five days to six months — or sometimes longer). It’s considered a lagging indicator. Frequently a chart shows price movements as too jumpy and haphazard, so the moving average smoothes out the price movements to show a clearer path. This technique helps to decipher the stock’s trend and plot out the support and resistance levels. Moving averages are also very helpful in identifying all the various peaks and troughs necessary to analyze the trend’s direction. There are three types of moving averages: simple, linear, and exponential.

A snapshot: Simple moving averages (SMA)

The first (and most common) type of average is referred to as a simple moving average (SMA). You calculate it by simply taking the sum of all the past closing prices over the chosen time period and dividing the result by the number of prices used in the calculation. For example, in a 10-day simple moving average, the last 10 closing prices are added together and then divided by 10.

Say that the prices for the last 10 trading days (in order) are $20, $21, $22, $20, $21, $23, $24, $22, $22, and $24. It’s hard to derive a trend from that data, but a moving average can help. First you add up all the prices; in this case the total is $219. Then you take the total of $219 and divide it by 10 (the total number of trading days). You get an average price of $21.90. As you do this with more and more price data (in 10-day chronological sets), you can see a trend unfolding.

Say that on the 11th day, the closing price is $26. At this point, the next 10-day trading period starts with $21 (the closing price from the second day in the example from the preceding paragraph) and ends with a new closing price for the 10th day, $26. Now when you add up this new 10-day range, you get a total of $225. When you divide that number by 10, you get the average of $22.50 ($225 total divided by 10 days). In this brief and simple example, the 10-day moving average tells you that the price trend is up (from $21.90 to $22.50).

Of course, you need to see a much longer string of 10-day sets to ascertain a useful 10-day moving average, but you get the point. You can also plot these averages on a graph to depict the trend and help render a trading decision. The more time periods you graph, the easier it is to see how strong (or weak) the trend is.

Technical analysts most frequently use 10-day, 20-day, and 50-day averages for short-term trading. To confirm longer-term trends, they also watch the 100-day and 200-day moving averages. Of course, other time frames are used as well, but these are the most common.

remember The longer-period moving averages help to put the short terms in perspective so that the trader can still view the big picture. In other words, you may have a stock “correct” or pull back and see its price fall significantly, but does it mean that a trend has reversed? If the stock is in a long-term bull market, it’s common for it to violate (or go below) its short-term (such as 10-, 20- or 50-day) moving averages temporarily. The more serious red flags start to appear when it violates the longer-term averages, such as the 200-day moving average. And if it violates the 10-year moving average … hey … watch out!

More complex tactics: Linear and exponential averages

Some critics believe that the SMA is too limited in its scope and therefore not as useful as it should be. Therefore, they use more involved variants of the SMA such as the linear weighted average (LWA) and the exponential moving average (EMA). These averages are too involved to adequately cover in this book. You can get more details on them through the resources at the start of this chapter. For beginners, though, the SMA is sufficient.

Moving average convergence/divergence

The moving average convergence/divergence (MACD) is a lagging indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A 9-day EMA of the MACD, called the signal line, is then plotted on top of the MACD, which acts as a trigger for making buy and sell orders.

tip That’s the technical definition of the MACD, but don’t worry if you didn’t understand it on the first go-round. Fortunately, it’s not something that you have to calculate on your own; the MACD indicator is usually provided by the technical analysis software or trading service that you may use.

Crossovers and divergence

crossover is the point when the stock’s price and an indicator intersect (or cross over). It’s used as a signal to make a buy or sell order. Say that a stock, for example, falls past $20 per share to $19, and the 20-day moving average is $19.50. That would be a bearish crossover, and it would indicate a good time to sell or risk further downward movement. The opposite is true as well; some crossovers indicate a good time to buy.

Divergence occurs when the price of a stock and an indicator (or index or other related security) part company and head off in opposite directions. Divergence is considered either positive or negative, both of which are signals of changes in the price trend.

·        Positive divergence occurs when the price of a stock makes a new low while a bullish indicator starts to climb upward.

·        Negative divergence happens when the price of a stock makes a new high, but bearish indicators signal the opposite, and instead the closing price at the end of the trading day is lower than the previous high.

Crossovers and divergence are usually leading indicators.

Oscillators

Oscillators are indicators that are used when you’re analyzing charts that have no clear trend. Moving averages and other indicators are certainly important when the trend is clear, but oscillators are more beneficial under either of the following circumstances:

·        When the stock is in a horizontal or sideways trading pattern

·        When a definite trend can’t be established because the market is volatile and the price action is very uneven

Oscillators may be either leading or lagging indicators, depending on what type they are. Momentum oscillators, for example, are considered leading indicators because they’re used to track the momentum of price and volume. Use the resources I mention earlier in this chapter to do your homework on oscillators.

Bollinger bands

Bollinger bands have nothing to do with musical groups. A band is plotted two standard deviations away from a simple moving average. The Bollinger band (a lagging indicator) works like a channel and moves along with the simple moving average.

Bollinger bands help the technical analyst watch out for overbought and oversold conditions. Basically, if the price moves closer to the upper band, it indicates an overbought condition. If the price moves closer to the lower band, it indicates an oversold condition.