Seeing Is Believing: An Introduction to Technical Analysis

Understanding the Methodology

Technical analysis is the forecasting of future financial price movements based on strategic analysis of past financial data, charted in a variety of visual formats. A technician — that’s someone who reads stock charts — uses price charts and market statistics (such as trading volume) to develop a profitable trading plan. Some technicians even say that price charts indicate where a stock’s price is heading simply by showing where it has been. Detractors liken technical analysis to fortune‐telling. However, it’s important to remember that whether you’re a numbers‐driven fundamentalist or a charts‐focused technician, both strategies are attempting to accomplish the same goal: use reliable analysis methods to make informed investing decisions.

At its core, the objective of technical analysis is to analyze how the forces of supply and demand affect market prices. A constant tug of war takes place between the buyers and sellers of a stock, and technicians watch it all unfold by analyzing the charts. Market price is the end result of that battle, so technicians uncover insights into which camp is winning by answering two important questions: What is the current price, and how have past prices changed over time to lead to that current price?

Technicians try to anticipate what is likely to happen in the future and make trading plans based on price‐chart indicators. Technical analysis isn’t about predicting the future. Its real purpose is to identify probable events that are most likely to occur and to make trading plans in case they do occur and alternative plans in case they don’t. Technicians use a logical framework to identify price trends, turning points, trading ranges, and breakouts. These important trading concepts are covered in Chapters 9, 10, and 11.

Understanding technical analysis methods requires familiarity with a few key concepts:

Everything about a company is reflected in its price.
Price movements are sometimes random.
Price changes are caused by an imbalance between supply and demand.

In the following sections we dig into these three concepts. We also discuss exactly how technicians analyze where things have been and make informed forecasts about where they’re headed. You need to know how to read price movements and how they’re impacted by the basics of supply and demand, so we explore these topics here.

Finding everything in the price

The stock market is a remarkably efficient information‐processing machine. So efficient, in fact, that every bit of information currently known about a company is immediately priced into its stock. In other words, the current price reflects the combined wisdom of everyone in the market, including corporate insiders, pension and mutual fund managers, individual investors, stock analysts, fundamental analysts, technicians, and you.

The charts used in technical analysis provide a synopsis of all the fundamental, economic, and psychological factors that affect the price of a stock. Although we personally think putting all your eggs in the price basket is taking the point to an extreme, that’s why some technicians don’t even try to evaluate the fundamentals. Why bother trying to outsmart the smartest when everything’s already reflected in the price?

Technicians are more concerned with understanding what is happening than they are with understanding why it’s happening. The technician’s understanding of why a stock’s price moves is not important. Technicians don’t necessarily care whether the price movement was caused by the most recent analyst’s report or by a CEO’s resignation. They are concerned only with

What the price is now
What the price history is

Technical analysts examine current prices relative to the histories of price movements to understand and plan for what is most likely to happen next. Fundamental analysts ask why, trying to understand what piece of news causes a particular rise in price or what bit of insider knowledge causes a sell off. Technicians try to visualize everything the price represents and base their trades only on what they see.

The stream of news is endless and ever‐changing. You can’t know what causes every ripple in the price continuum. So why try? Focus on first determining what is happening and how to act on it, and then worry about why it happened.

Seeing that price movements are not always random

Sometimes prices move higher. Sometimes prices move lower. And sometimes prices bounce up and down within a tight trading range. When prices move higher or lower, we say prices are trending. The trading periods often appear to be random price movements, and at times, they may actually be random. But when you zoom in to view the price movements within those seemingly random trading‐range periods, you find that the trading range is made up of many mini trends. The closer you look, the less random these price movements appear. That pattern is the crux of technical analysis. These concepts are important for trading and are covered more fully in Chapter 10.

At its core, technical analysis is used to identify the periods of time during which trends occur. In general, technicians want to base their trades on trending markets. The idea is to determine when trends begin and when they end. But which trend? Are you the type of trader who is interested in the little mini trends that make up a trading range? Or are you most interested in trading longer‐lasting trends?

The key to technical trading, therefore, is identifying a stock’s price trend within the time frame during which you want to trade. Depending on the length of time you plan to hold the stock, you should base your trades on analyses done in the corresponding time frame. If you’re primarily concerned with long‐lasting trends that span many weeks, months, or even years, you want to analyze charts showing daily, weekly, and/or monthly prices. If, instead, you plan to hold your stock for no more than a few hours or a few days, you want to analyze intraday charts showing one‐minute, five‐minute, or one‐hour prices. When looking at intraday price charts, you see many examples of mini trends and trading ranges. However, if you’re buying a stock and holding your position for weeks or months, those mini intraday trends and trading ranges are meaningless. We cover these concepts more fully in Chapter 9.

Balancing supply and demand

If you’ve ever watched the nightly business news, you’ve probably heard reporters claim that prices rose because more buyers were looking for stocks than sellers were willing to part with them. But of course, even novice investors realize that every trade must have a buyer and a seller.

What the reporter really means is that supply and demand in the market were out of balance. Price is a function of supply and demand, so an imbalance between the two leads to a movement in one direction. In macroeconomics, this concept is illustrated using a freely traded commodity like wheat. When farmers grow more wheat than bakers need, the price of wheat falls because farmers have to attract customers by selling at lower prices. When bakers need more wheat than farmers grow, bakers bid higher prices to get the wheat they need.

In many ways, the price of a stock works just like the price of wheat. When buyers want to buy more shares of a stock than sellers are willing or able to sell, buyers bid the stock price higher until they find sellers willing to part with their shares. Conversely, when sellers can’t find enough buyers, they offer their shares at lower and lower prices until enough buyers can be found.

Changes in a company’s business plan, a new competitor, or any number of other factors can throw the balance between supply and demand out of whack. Realizing that imbalances cause prices to move — and not the news itself — is the point where technical analysis is concerned.

Understanding where you’ve been

Technicians examine price history, trading volume, and additional market statistics to evaluate the balance between supply and demand. The conceptual framework is easy to understand. If prices are rising, then demand exceeds supply, and buyers are more interested in buying than sellers are in selling. The reverse is equally true. Falling prices mean that supply exceeds demand, and sellers are more interested in selling than buyers are in buying. When a stock trades within a tight range of prices, neither the buyers nor the sellers are dominant in the marketplace. A balance between supply and demand has been achieved, so prices simply bounce up and down. This situation is evident on the price chart when a stock trades within a clear trading range. Examples are shown in Chapter 9.

Technical analysis uses past and present price data, trading volume, and other important market statistics. Technicians examine charts in search of the price levels where buying pressure stops a stock’s price from falling further or where selling pressure squashes a rally.

Here’s a hypothetical scenario to illustrate finding the right point to buy. A high‐profile investment advisor issues a recommendation to buy shares of XYZ, which closed at $18.50 the day before and has traded in a tight price range of $17 to $18.75 during the past four months. The recommendation to buy is in effect only if the stock trades for less than $19 a share. The idea is not necessarily to buy the instant that a recommendation is made, but rather to buy at a good price.

Taking the hypothetical example a step further, say that the advisor has a devoted following of active investors. Invariably, the recommendation is quickly followed by a surge in the volume of buyers purchasing shares of XYZ, even as the price of the stock rises to $21 due to increased demand.

Buying surges based on these kinds of recommendations have a tendency to stall out and return to the buy‐under price (in this case, $19) after all the early buyers make their trades. Patient subscribers of this advisor have seen this movie many times before, so they wait for the pullback and place a limit order near the $19 price (limit orders are discussed in Chapter 2). Enough patient investors are usually in the market for the stock to keep its price from falling further. When the price falls back to the target level recommended by the advisor, the patient subscribers will jump in and buy. That activity supports the price from declining further.

Now imagine that you’re watching this stock without knowledge of the investment advisor’s recommendation. You’d likely see the price of XYZ shares take the following steps during the course of a week or two:

XYZ breaks out of its trading range and rallies on higher‐than‐normal volume.
Buying of XYZ drops off, and the price pulls back.
High‐volume buying of XYZ resumes as the price falls near $19.

This type of market activity is what intelligent technicians wait patiently for. You see this scenario play out over and over again, in individual stocks, in exchange‐traded funds (ETFs), and in the general market indexes. Chapter 9 discusses how to recognize and trade this scenario, but for now, know that it’s a textbook example of a trading‐range breakout defined by the following:

A high‐volume breakout after a long period of range‐bound trading
A low‐volume pullback
A high‐volume rally to new highs

If you were interested in this stock, you may have taken a position. In fact, given this setup, the three logical places where a technician takes a position are

At the breakout: Buy as soon as the stock breaks through the resistance level at the upper end of the trading range.
After the pullback: Buy immediately as the stock begins trading higher after its price pulls back on low volume.
At the double top: When the stock retraces the move from the pullback to its high price, it’s called a double top. Buy on strength as the stock makes a new high for the move.

Of these three alternatives, our favorite is the second. Buying immediately after the pullback is a relatively low‐risk, high‐reward trade. By trading at pretested prices, you have a better understanding of how the forces of supply and demand for the stock will play out. Our least favorite trade is the last one. Trading the double top as the stock makes a new high is the riskiest of the three alternatives. Both the breakout and the pullback trades are covered in much more detail, including example charts, in Chapter 9.

Technical analysis can allow you to find shrewd entry prices on your trades while also helping keep your losses small. When understood and implemented properly, it is a powerful trading tool to have at your disposal.

Understanding where you’re headed

Stock prices move in a never‐ending series of upward rallies and downward reactions. Technical analysis helps you discover and analyze where buyers took action throughout those past rallies and reactions. If you recognize where buyers have stepped in before, you can reasonably expect that they will do so again in the future. When they do as you expect, you need to be able to trade on that information profitably.

If they don’t act as you expect, you may have to exit your trade, and yet you’ve still discovered a great deal of valuable information. You hope that the price you pay for that knowledge isn’t too great, but you nevertheless know more than you did before. You know that the last wave of buying exhausts demand, and thus you need to begin looking for further evidence of a reversal.

You don’t have to adhere to arguments that technical analysis is a good forecasting tool merely to recognize that it is a useful trading tool.

Answering the Detractors

A few arguments against technical analysis may actually make some sense, but the irrelevant complaints far outweigh the legitimate. For example, some people wrongly assert that no technicians have been successful over the long run and that no technician has mustered the stature or success of illustrious market moguls like Warren Buffett, Benjamin Graham, or Peter Lynch.

As if to further this argument, they point to some infamous technician who blew up his portfolio in spectacular fashion. Then a few years later, they harp on another well‐known technician who made a boneheaded call, and then it happened again, and they therefore claim technical analysis is useless. Detractors usually leave out the fact that many high‐profile fundamental analysts have also blown client portfolios.

In fact, many successful technicians have long, profitable trading careers. While most toil in self‐imposed obscurity, some are prominent and outspoken. For example, John W. Henry, who owns the Boston Red Sox, made his fortune as a trend‐following technician. Additional examples include Ed Seykota, a trader with 35 years of experience and one of the people profiled in the book Market Wizards, and Bill Dunn of Dunn Capital Management, Inc. This is just a tiny sample of the many successful independent traders and fund managers who employ technical‐analysis tools to make trading decisions.

Another argument about the alleged ineffectiveness of technical analysis is a chart‐reading challenge that no technician has ever attempted (or would even consider). It works like this: The technical analyst is given the first half of a price chart with all identifying information removed. From that information, the technician is supposed to tell whether the stock’s price was higher or lower at any point in the second half of the chart.

Of course, nobody ever claims the prize for having accomplished this feat, and that, therefore, is supposed to be proof that no technician ever has enough confidence in technical analysis to even try. Accomplished technicians aren’t any better at telling the future than a tarot‐card reader — and neither, for that matter, are fundamental analysts. Technical analysis is not fortune‐telling; it’s simply a trading tool.

In the following sections we present and examine arguments against a couple of the more common theories about why technical analysis doesn’t work. We review the random walk theory and questions raised about trading signals.

Walking randomly

The random walk theory has nothing to do with hiking without a map, but instead is an academic theory that says stock prices are completely random. What happened to a stock yesterday has nothing to do with what happens to its price tomorrow.

Furthermore, this theory claims that the market is so efficient that consistently outperforming broad‐based market indexes is impossible. In other words, any edge that you may gain from fundamental analysis, technical analysis, or any other strategy is useless and expensive. After all, transaction costs far outweigh any performance improvement that your analysis provides.

Armed with computer models and reams of study results, academic experts cling to these efficient‐market hypotheses as gospel. Several challenges oppose their argument. No less an authority than the Federal Reserve Bank of New York published a study showing that using support and resistance levels (see Chapter 9) improved trading results for several firms. Additionally, articles published in the Journal of Finance suggest that trading based on moving averages and head and shoulder reversal patterns outperformed the market averages. (We discuss reversal patterns in Chapter 9 and moving averages in Chapter 11.)

Of course, these studies don’t prove that technical analysis is effective all the time. But they cast doubt on the validity of the random walk theory, especially the assertion that technical analysis can’t be used to consistently improve results compared to the market averages.

Debating these arguments to a logical conclusion is nearly impossible. Even when you use technical analysis successfully, random walkers claim your performance is the result of random chance — nothing more than good luck. Don’t believe them. Instead, believe that luck favors the prepared mind.

Trading signals known to all

Anyone who cares to look can see exactly the same patterns and has access to the same indicators as every other trader. So one argument against technical analysis is that there’s nothing new under the sun — or in the markets — for analysts to find.

Although some traders create proprietary indicators to gain a trading edge, many more use well‐known, off‐the‐shelf trading tools. The patterns and indicators described in Chapters 9, 10, and 11 are all well known. Some are freely available on the Internet for anyone to use. Thus, if everyone sees the same thing, how can you use those trading signals profitably? The question is perfectly legitimate.

As we show these tools, we also show you how to develop these charts at StockCharts.com.

Although everyone can see the same patterns and indicators, this equality is a strength rather than a weakness. Technical analysis gives you insight into what future actions you can expect from your fellow market participants. With practice, you can use that information to construct a consistently profitable trading plan.

After you become familiar with traditional patterns and indicators, you can incorporate your experience and market knowledge into your trading plans and thus come to an understanding of when to use specific tools and when results are meaningless. From these plans, you can find out when a trading signal works and when it fails. You can make trades based on indicators and patterns that help and ignore the rest.

Many widely known indicators and trading patterns exist, but personally, we use only a handful of the simplest ones. Your results will differ from ours. You may trade in a different time frame than we do, or you may choose a different set of tools altogether. As long as your tools improve your trading, continue using them. Ultimately, your trading system should be like a fine suit, custom tailored to fit one specific person: you.

Using StockCharts.com

Before you can read charts, you need to create them. To help you get started creating and reading financial charts, we have partnered with StockCharts.com, one of the web’s premier charting platforms. We’ve even arranged a 20 percent discount especially for Trading For Dummies readers toward a subscription on the website. Sign up today and a get a free one‐month trial of their advanced charting tools, resources, and more. The coupon code is SCC‐DUMMIES‐17. Access that trial as a Trading For Dummies reader at http://stockcharts.com/sales/index.html. If you’re already a StockCharts member, use the discount code to renew your existing subscription.

Where you see charts throughout this book, you also find explanations of how to create them on StockCharts.com.

Creating a stock chart involves picking many variables and customizing it to fit your specific trading profile. Figure 8‐1 shows you the interface below a chart that enables you to customize it to your individual needs.

Chart courtesy of StockCharts.com
FIGURE 8‐1: To create charts, you set numerous chart attributes, overlays, and indicators.

Among the most valuable data points for your chart are these variables:

Periods: You can choose daily, weekly, or monthly depending on the time frame of your trading. For shorter time frames, intraday charts are also available in multiple periods, including one‐minute, five‐minute, and one‐hour increments.
Range: You can set the range as one, three, or six months; one, two, or three years; or year‐to‐date. Or you can customize your charts using a specific date range of your choosing.
Type: The type pictured in Figure 8‐1 is candlesticks, which is a common option that we use in this book, but you can also use various types of bars, lines, dots, and others.
Size: You can set the size as well as choose between portrait and landscape.
Overlays: You can pick numerous types of overlays. The most commonly used are shown in Figure 8‐1: 50‐day and 200‐day moving averages. We talk about other options traders use as we discuss charting techniques.
Indicators: StockCharts.com allows you to create charts using over 50 different indicators. We discuss them as we discuss trading techniques.

Knowing which settings or indicators to use to produce charts that meet your needs is a key part of technical analysis. So practice charting as you read about each technique.

We tell you throughout this book about the overlays and indicators that we use regularly, but StockCharts.com also provides an excellent educational resource, ChartSchool, that goes into careful detail about each type of charting tool, overlay, and indicator the site offers and how to use them successfully. To explore ChartSchool, go to StockCharts.com and click the tab labeled ChartSchool at the top of any web page.