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Share trading
Technical
analysis for profit
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What is technical analysis?
As a technical analyst, you will scrutinise charts and indicators of past share price and index movements to forecast the future. As a method, it is not always successful.
This is because share price and market movements may not repeat themselves in the same form, on the same time scale.
In our experience, many make money writing and lecturing about technical analysis, but few from using it. Despite this, you cannot afford to ignore the charts. Why is this?
The importance of technical analysis
So many people use technical analysis when deciding on when to buy or sell shares that it becomes a self-fulfilling prophecy. So how does it work?
Varieties of chart
Technical analysts typically use any of the following four chart types:
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1. Bar chart
The bar chart is popular, and gives the technician a lot of information instantly. In this, the share price or index level is plotted against price and time. |
2. Line chart
The line chart provides less information than a bar chart, but is more useful for charting long term trends. It has a line that plots only the closing price against time. |
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3. Point-and-figure chart
The point-and-figure chart shows even less information than a line chart. But it cuts out still more
noise of detail, focusing further on trends. |
4. Candlesticks
Candlesticks provide similar information to bar charts but, for advanced users, have an extra intuitive element. These originate from the far East, and are said to have the intuitive
qualities that this suggests.
Candlesticks are presented as a vertical rectangle known as a real body. When the closing price
was higher than at opening, the real body is transparent, and in the reverse case, it is black.
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How to use the charts
Trends
A share price moves in trends. Any trend remains until it is broken. As an investor, you should go with the flow.
An up-trend in the share price shows that demand is greater than supply, and you should buy the shares for as long as this lasts. Conversely, if the trend is down, you should sell the shares.
The trend is defined by resistance and support levels. The resistance level represents the top price level to which a share or index may rise, and the support level the bottom. The more these levels are tested, the more reliable they prove, according to die-hard technical analysts.
Once the share price has broken a trend – climbing above the resistance level or below the support level – this is known as penetration of the trend. At this point, some see a good buying opportunity, particularly if the penetration seems major, and is accompanied by heavy trading volume (displayed at the bottom of many charts).
Continuation patterns
Chart patterns that suggest continuation confirm the trend. Some of these are as follows:
The triangle
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The triangle is formed from a zig-zag pattern that dwindles into a point. This represents a battle between buyers and sellers.
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The rectangle
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The rectangle appears less often than the triangle but is arguably a more reliable predictor. It lasts until the share price breaks through either its bottom line – representing support – or its top line – representing resistance.
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The flag
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The flag is a brief consolidation in the share price that lasts up to a few weeks. It follows a sharp rise that resembles a flagpole (observable on a spaciously scaled chart). |
Reversal patterns
Reversal patterns indicate that a trend is changing. This will typically happen when a bull or bear market is coming to an end. They include the following.:
Head and shoulders
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The head and
shoulders (forget the shampoo jokes) is a bearish signal. The share price
on the chart trends upwards to a first shoulder, then drops back, re-rising
to form a head and again falling. It forms another shoulder, then – theoretically
at least – falls far. The reverse head and shoulders is a bullish pattern. |
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Double top
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The double top is another bearish pattern. Here the share price rises, and drops back, then returns to its old peak and back again. It looks like two humps on a camel's back. The double bottom – a bullish pattern – is a double top in reverse. |
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Saucer top
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The saucer top is more rounded than the head and shoulders or double top, and it occur in tired bull markets. It shows the share price rise, turn slowly and reverse into decline. The saucer bottom – a feature of tired bear markets – does the reverse. |
Moving averages
Charts of moving averages show changes in the average share price over a given period.
Some technical analysts advise you to buy shares at a price below this level.
If you have a short term (10–30 days) moving average and a long term (up to 200 days) one running together, and they cross over on your chart while moving upwards, this is a golden cross. It is a bullish sign. If they cross downwards, this is a dead cross, which is bearish. Either of these crosses is stronger if it is backed by substantial trading volume.
An envelope consists of two moving averages. If the share price touches the upper band, it has gone too high, and this is a sell signal. If it touches the lower band, it has fallen too far and this is a buy signal. Bollinger bands are a popular kind of envelope.
Advanced theories
Fibonacci
Some technical analysts swear by the Fibonacci series of numbers, where each number equals its two predecessors added together. On this theory, a stock market trend is likely to retrace itself specifically by either 61.8%, 50% or 38.2%.
The Fibonacci sequence helped to inspire Elliott Wave theory. This holds that market cycles have an impulse wave of five parts, reaching new highs, which is followed by a corrective wave of three parts. The waves interrelate according to various rules, including the Fibonacci numbers. The problem is, where does one wave finish and another start.
To find out more about technical analysis in a hurry, read Everyone's
Guide to Online Stock Market Investing by Alexander Davidson, published
by Kogan Page. It gives you a grounding in the basics.
For comprehensive explanations of technical analysis, complete with charts
(from Sharescope), be sure to read The Times: How to Understand the Financial
Pages, by Alexander Davidson, published by Kogan Page.
If you are ready for a no-holds-barred critical overview of technical analysis, read
How to Win in a Volatile Stock Market, by Alexander Davidson, published by Kogan Page.
Stock Market Rollercoaster has an amusing – and frighteningly authentic – portrait of a technical analyst in action. To find out more, click here.
| NEVER RELY COMPLETELY ON TECHNICAL ANALYSIS IN MAKING YOUR INVESTMENT DECISIONS. |
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