Advance-decline line: One of the most widely used indicators to measure the breadth of a stock market advance or decline. Each day (or week) the number of advancing issues is compared to the number of declining issues. If advances outnumber declines, the net total is added to the previous cumulative total. If declines outnumber advances, the net difference is subtracted from the previous cumulative total. The advance-decline line is usually compared to a popular stock average, such as the Dow Jones Industrial Average. They should trend in the same direction. When the advance-decline line begins to diverge from the stock average, an early indication is given of a possible trend reversal.
Arms index: Developed by Richard Arms, this contrary indicator is a ratio of the average volume of declining stocks divided by the average volume of advancing stocks. A reading below 1.0 indicates more volume in rising stocks. A reading above 1.0 reflects more volume in declining issues. A 10 day average of the Arms index over 1.20 is oversold, while a 10 day average below .70 is overbought.
Ascending triangle: A sideways price pattern between two converging trendlines, in which the lower line is rising while the upper line is flat. This is generally a bullish pattern. (See Triangles.)
Bar chart: On a daily bar chart, each bar represents one day’s activity. The vertical bar is drawn from the day’s highest price to the day’s lowest price (the range). A tic to the left of the bar marks the opening price, while a tic to the right of the bar marks the closing price. Bar charts can be constructed for any time period, including monthly, weekly, hourly, and minute periods.
Bollinger bands: Developed by John Bollinger, this indicator plots trading bands two standard deviations above and below a 20 period moving average. Prices will often meet resistance at the upper band and support at the lower band.
Breakaway gap: A price gap that forms on the completion of an important price pattern. A breakaway gap usually signals the beginning of an important price move. (See Gaps.)
Channel line: Straight lines drawn parallel to the basic trendline. In an uptrend, the channel line slants up to the right and is drawn above rally peaks; in a downtrend, the channel line is drawn below price troughs and slants down to the right. Prices will often meet resistance at rising channel lines and support at falling channel lines.
Confirmation: Having as many market factors as possible agreeing with one another. For example, if prices and volume are rising together, volume is confirming the price action. The opposite of confirmation is divergence.
Continuation patterns: Price formations that imply a pause or consolidation in the prevailing trend. The most common types are triangles, flags, and pennants.
Descending triangle: A sideways price pattern between two converging trendlines, in which the upper line is declining while the lower line is flat. This is generally a bearish pattern. (See Triangles.)
Divergence: A situation where two indicators are not confirming each other. For example, in oscillator analysis, prices trend higher while an oscillator starts to drop. Divergence usually warns of a trend reversal. (See Confirmation.)
Double top: This price pattern displays two prominent peaks. The reversal is complete when the middle trough is broken. The double bottom is a mirror image of the top.
Down trendline: A straight line drawn down and to the right above successive rally peaks. A violation of the down trendline usually signals a reversal of the downtrend. (See Trendlines.)
Dow Theory: One of the oldest and most highly regarded technical theories. A Dow Theory buy signal is given when the Dow Industrial and Dow Transportation Averages close above a prior rally peak. A sell signal is given when both averages close below a prior reaction low.
Elliott wave analysis: An approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. An ideal Elliott wave pattern shows a five wave advance followed by a 3-wave decline. (See Fibonacci numbers).
Envelopes: Lines placed at fixed percentages above and below a moving average line. Envelopes help determine when a market has traveled too far from its moving average and is overextended.
Exhaustion gap: A price gap that occurs at the end of an important trend, and signals that the trend is ending. (See Gaps.)
Exponential smoothing: A moving average that uses all data points, but gives greater weight to more recent price data. (See Moving average.)
Fibonacci numbers: The Fibonacci number sequence (1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62 percent, which is a popular Fibonacci retracement number. The inverse of 62 percent, which is 38 percent, is also used as a Fibonacci retracement number. The ratio of any number to the next smaller number is 1.62 percent, which is used to arrive at Fibonacci price targets. (See Elliott wave analysis).
Flag: A continuation price pattern, generally lasting less than three weeks, which resembles a parallelogram that slopes against the prevailing trend. The flag represents a minor pause in a dynamic price trend. (See Pennant.)
Fundamental analysis: The opposite of technical analysis. Fundamental analysis relies on economic supply and demand information, as opposed to market activity.
Gaps: Gaps are spaces left on the bar chart where no trading has taken place. An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day. A down gap is formed when the highest price on a day is lower than the lowest price of the prior day. An up gap is usually a sign of market strength, while a down gap is a sign of market weakness. Three types of gaps are breakaway, runaway (also called measuring), and exhaustion gaps.
Head and shoulders: The best known of the reversal patterns. At a market top, three prominent peaks are formed with the middle peak (or head) slightly higher than the two other peaks (shoulders). When the trendline (neckline) connecting the two intervening troughs is broken, the pattern is complete. A bottom pattern is a mirror image of a top and is called an inverse head and shoulders.
Intermarket analysis: An additional aspect of market analysis that takes into consideration the price action of related market sectors. The four sectors are currencies, commodities, bonds, and stocks. International markets are also included. This approach is based on the premise that all markets are interrelated and impact on one another.
Island reversal: A combination of an exhaustion gap in one direction and a breakaway gap in the other direction within a few days. Toward the end of an uptrend, for example, prices gap upward and then downward within a few days. The result is usually two or three trading days standing alone with gaps on either side. The island reversal usually signals a trend reversal. (See Gaps.)
Key reversal day: In an uptrend, this one day pattern occurs when prices open in new highs, and then close below the previous day’s closing price. In a downtrend, prices open lower and then close higher. The wider the price range on the key reversal day and the heavier the volume, the greater the odds that a reversal is taking place. (See Weekly Reversal.)
Line charts: Price charts that connect the closing prices of a given market over a span of time. The result is a curving line on the chart. This type of chart is most useful with overlay or comparison charts that are commonly employed in intermarket analysis. It is also used for visual trend analysis of open end mutual funds.
MACD: Developed by Gerald Appel, the moving average convergence divergence system shows two lines. The first (MACD) line is the difference between two exponential moving averages (usually 12 and 26 periods) of closing prices. The second (signal) line is usually a 9 period EMA of the first (MACD) line. Signals are given when the two lines cross.
MACD histogram: A variation of the MACD system that plots the difference between the signal and MACD lines. Changes in the spread between the two lines can be spotted faster, leading to earlier trading signals.
McClellan oscillator: Developed by Sherman McClellan, this oscillator is the difference between the 19 day (10% trend) and the 39 day (5% trend) exponentially smoothed averages of the daily net advance decline figures. Crossings above the zero line are positive and below zero are negative. Readings above +100 are overbought while readings below -100 are oversold.
McClellan summation index: A cumulative sum of all daily McClellan oscillator readings that provides longer range analysis of market breadth. Used in the same way as an advance-decline line.
Momentum: A technique used to construct an overbought-oversold oscillator. Momentum measures price differences over a selected span of time. To construct a 10 day momentum line, the closing price 10 days earlier is subtracted from the latest price. The resulting positive or negative value is plotted above or below a zero line. (See Oscillators.)
Moving average: A trend following indicator that works best in a trending environment. Moving averages smooth out price action but operate with a time lag. A simple 10 day moving average of a stock, for example, adds up the last 10 days’ closing prices and divides the total by 10. That procedure is repeated each day. Any number of moving averages can be employed, with different time spans, to generate buy and sell signals. When only one average is employed, a buy signal is given when the price closes above the average. When two averages are employed, a buy signal is given when the shorter average crosses above the longer average. There are three types: simple, weighted, and exponentially smoothed averages.
On balance volume: Developed by Joseph Granville, OBV is a running cumulative total of upside and downside volume. Volume is added on up days and subtracted on down days. The OBV line is plotted with the price line to see if the two lines are confirming each other. (See Volume.)
Open interest: The number of options or futures contracts that are still unliquidated at the end of a trading day. A rise or fall in open interest shows that money is flowing into or out of a futures contract or option, respectively. In futures markets, rising open interest is considered good for the current trend. Open interest also measures liquidity.
Oscillators: Indicators that determine when a market is in an overbought or oversold condition. When the oscillator reaches an upper extreme, the market is overbought. When the oscillator line reaches a lower extreme, the market is oversold. (See Momentum, Rate of change, Relative strength index, and Stochastics.)
Overbought: A term usually used in reference to an oscillator. When an oscillator reaches an upper extreme, it is believed that a market has risen too far and is vulnerable to a selloff.
Oversold: A term usually used in reference to an oscillator. When an oscillator reaches a lower extreme, it is believed that a market has dropped too far and is due for a bounce.
Pennant: This continuation price pattern is similar to the flag, except that it is more horizontal and resembles a small symmetrical triangle. Like the flag, the pennant usually lasts from one to three weeks and is typically followed by a resumption of the prior trend.
Percent investment advisors bullish: This measure of stock market bullish sentiment is published weekly by Investor’s Intelligence of New Rochelle, New York. When only 35% of professionals are bullish, the market is considered oversold. A reading of 55% is considered to be overbought.
Price patterns: Patterns that appear on price charts and that have predictive value. Patterns are divided into reversal and continuation patterns.
Rate of change: A technique used to construct an overbought-oversold oscillator. Rate of change employs a price ratio over a selected span of time. To construct a 10 day rate of change oscillator, the last closing price is divided by the closing price 10 days earlier. The resulting value is plotted above or below a value of 100.
Ratio analysis: The use of a ratio to compare the relative strength between two entities. An individual stock or industry group divided by the S&P 500 index can determine whether that stock or industry group is outperforming or underperforming the stock market as a whole. Ratio analysis can be used to compare any two entities. A rising ratio indicates that the numerator in the ratio is outperforming the denominator. Trend analysis can be applied to the ratio line itself to determine important turning points.
Relative strength index (RSI): A popular oscillator developed by Welles Wilder, Jr. and described in his self published 1978 book, New Concepts in Technical Trading Systems. RSI is plotted on a vertical scale from 0 to 100. Values above 70 are considered to be overbought and values below 30, oversold. When prices are over 70 or below 30 and diverge from price action, a warning is given of a possible trend reversal. RSI usually employs 9 or 14 time periods.
Resistance: The opposite of support. Resistance is marked by a previous price peak and provides enough of a barrier above the market to halt a price advance. (See Support.)
Retracements: Prices normally retrace the prior trend by a percentage amount before resuming the original trend. The best known example is the 50% retracement. Minimum and maximum retracements are normally one third and two thirds, respectively. Elliott wave analysis uses Fibonacci retracements of 38% and 62%.
Reversal patterns: Price patterns on a price chart that usually indicate that a trend reversal is taking place. The best known of the reversal patterns are the head and shoulders and double and triple tops and bottoms.
Runaway gap: A price gap that usually occurs around the midpoint of an important market trend. For that reason, it is also called a measuring gap. (See Gaps.)
Sentiment indicators: Psychological indicators that attempt to measure the degree of bullishness or bearishness in a market. These are contrary indicators and are used in much the same fashion as overbought or oversold oscillators. Their greatest value is when they reach upper or lower extremes.
Simple average: A moving average that gives equal weight to each day’s price data. (See Exponential smoothing and Weighted average.)
Stochastics: An overbought-oversold oscillator popularized by George Lane. A time period of 14 is usually employed in its construction. Stochastics uses two lines—%K and its 3 period moving average, %D. These two lines fluctuate in a vertical range between 0 and 100. Readings above 80 are overbought, while readings below 20 are oversold. When the faster %K line crosses above the slower %D line and the lines are below 20, a buy signal is given. When the %K crosses below the %D line and the lines are over 80, a sell signal is given.
Support: A price, or price zone, beneath the current market price, where buying power is sufficient to halt a price decline. A previous reaction low usually forms a support level.
Symmetrical triangle: A sideways price pattern between two converging trendlines in which the upper trendline is declining and lower trendline is rising. This pattern represents an even balance between buyers and sellers, although the prior trend is usually resumed. The breakout through either trendline signals the direction of the price trend. (See Ascending and Descending triangles.)
Technical analysis: The study of market action, usually with price charts, which includes volume and open interest patterns. Also called chart analysis, market analysis and, more recently, visual analysis.
Trend: Refers to the direction of prices. Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend. A trading range is characterized by horizontal peaks and troughs. Trends are generally classified into major (longer than a year), intermediate (one to six months), or minor (less than a month).
Trendlines: Straight lines drawn on a chart below reaction lows in an uptrend, or above rally peaks in a downtrend, that determine the steepness of the current trend. The breaking of a trendline usually signals a trend reversal.
Triangles: Sideways price patterns in which prices fluctuate within converging trendlines. The three types of triangles are the symmetrical, the ascending, and the descending.
Triple top: A price pattern with three prominent peaks, similar to the head and shoulders top, except that all three peaks occur at about the same level. The triple bottom is a mirror image of the top.
Up trendline: A straight line drawn upward and to the right below reaction lows. The longer the up trendline has been in effect and the more times it has been tested, the more significant it becomes. Violation of the trendline usually signals that the uptrend may be changing direction. (See Down trendline.)
Visual analysis: A form of analysis that utilizes charts and market indicators to determine market direction.
Volume: The level of trading activity in a stock, option, or futures contract. Expanding volume in the direction of the current price trend confirms the price trend. (See On-balance volume.)
Weekly reversal: An upside weekly reversal is present when prices open lower on Monday and then on Friday close above the previous week’s close. A downside weekly reversal opens the week higher but closes down by Friday. (See Key reversal day.)
Weighted average: A moving average that uses a selected time span, but gives greater weight to more recent price data. (See Moving average.)