In This Chapter

What will be the share price of IBM stock on the first trading day in July two years from the day you read this? The answer is: No one has a clue. However, if you ask a short-term active trader at 10 A.M. on any trading day what IBM’s stock is going to do in the next 30 minutes, the trader would have a good shot at the correct answer. Lucky guess? No, the trader would have been looking at his charts and plotting IBM since trading opened. He would know whether the stock was trading in a narrow range or trending up or down. If the stock followed its trend, the trader would have a good idea where it would be and figure out a trading set-up to profit from it.

Many short-term traders use technical analysis to identify trading opportunities—when to buy and when to sell. Intraday prices from Level II quotes and historical prices are used to construct charts, which illustrate what prices are doing at that moment. Short-term traders learn to construct charts to provide immediate information on changes in price trends.

There is an old market cliché that the trend is your friend. For investors and traders with longer holding periods than one day, that may not always be true. However, for short-term traders, correctly identified trends are where you make money.

Technical analysis is about trends or cycles in stock prices. The premise of technical analysis is that by studying the supply and demand forces at work on a stock (or other type of security) you can see suggestions of future price direction. The supply-and- demand forces at work in the market are the emotions that drive expectations of future profits or losses. If some investors and/or traders expect a stock to be worth more in the future, they will buy now and that pressure will possibly increase the price. However, if more investors disagree with that rosy picture and predict losses in the future, they will sell and put downward pressure on the stock’s price. If there is more supply than demand, the price will keep falling until it reaches a low enough point to encourage a trader or investor to buy.

Technical analysis differs from fundamental analysis in that it does not attempt to measure a company’s value. Fundamental analysis is more appropriate for investors or traders with longer holding periods—more than six months, for example. Fundamental analysis can identify under- or overvalued stocks and suggest an appropriate price based on its intrinsic value. Buy-and-hold investors use fundamental analysis almost exclusively.

Technical analysis employs a number of tools to identify trends, cycles, or patterns in a stock’s price. The premise is that these will repeat themselves barring the intervention of an unforeseen consequence (a merger or hostile takeover, for example). By plotting historical price and volume data, a trader can spot trends as they develop and capture profits by entering the position at the earliest possible moment. Short-term traders use one-minute charts, among others, to watch a stock’s movement and to identify when it is beginning or ending a cycle or trend.

Technical analysis works, its proponents say, because the market prices all fundamental and economic factors into the price of the stock. This means the stock’s price is the best gauge of a company’s value at that particular point in time. Market pros like to talk about the market “discounting” certain factors. What they mean is those factors are already reflected in the price of the stock. If the technical analysis proponents are correct, a stock’s price is all the current information you need. Any change in a stock’s price, barring some change in circumstances, reflects the adjustment to new market conditions, specifically supply and demand.

If demand is high for the stock, the price will rise. Sellers realize that selling a sought-after commodity of limited supply will allow them to raise prices. The psychological and emotional aspects of buying and selling stocks are very much a part of technical analysis.

However, not everyone is convinced that the premise of limited supply and known price is correct. Value investors who look for stocks that are languishing, but have no serious fundamental flaws, do not hold the idea that all stocks are correctly priced by the market. Their strategy is to buy the underpriced shares and hold them until the market gets around to correcting the price upward. This process could take a long time, however.

Technical analysts believe everything has already been factored into the price and all that is left to do is to discover the trend. Price trends will repeat themselves and technical analysis can identify them. By analyzing price trends, traders can profit by buying or selling with the trend.

Can you be a successful active trader without using technical analysis? Yes, you can, and a number of traders use other tools or don’t rely on technical analysis exclusively. It is possible to be a scalper—a very short-term trader—without using technical analysis. You can also be successful as a momentum trader without technical analysis. Swing and position traders most definitely can do well without technical analysis.

However, many active traders find technical analysis an extremely helpful tool that provides an objective way to determine entry and exit points. You can succeed by trading on Level II quotes alone, although for very active stocks, this can be challenging. Scalping and momentum trading are all done in a single trading day. The market and market information moves quite rapidly.

Using technical analysis to help you decide where to get into and out of a position is important to many active traders.

Some traders use charts exclusively for their short-term trading decisions. They follow a stock through charts, which they set up in advance to have the right parameters. Some of these traders use nothing but their charts for trading guidance and don’t want or need any fundamental analysis.

For these traders, charts are everything. They have their favorite types and look for certain setups or patterns in a stock’s price trends to direct their trading activity. There is no doubt that following charts can prove valuable to traders, if the charts are set up correctly and the trader understands what they mean. However, charts aren’t perfect. Despite the notion that the price reflects everything known about a stock, charts can’t anticipate a major economic loss, a union strike, an unfortunate court ruling, or one of a hundred other events that can push a stock’s price up or down. We’ll take a more detailed look at charts in Chapter 16.

Proponents of technical analysis believe that price movements tend to repeat themselves barring the introduction of an unexpected influence. It is this tendency toward repetition of pricing patterns that technical analysis relies on to predict future price movement.

The most basic pattern of a stock’s price is the peak and valley. In simple terms, a stock creates a peak and valley pattern each day it is traded. It has a high and low for the day. It may close at the high, low, or somewhere in between. If the stock is very actively traded, there may be several points’ difference between the daily high and low. A stock that is thinly traded may have only a slight or no change in price during the day.

This same pattern can be tracked over days, weeks, months, or years. Obviously, the more periods you track, the more peaks and valleys you will observe. If, over time, the highs are higher and the lows are higher than previous lows, your chart will show an upward inclination. If you plotted a line on your chart using lows, you would see that the stock is rising in price. This would be obvious without the line, but adding the line gives you a better graphic idea of the angle of ascent. The line represents support for the uptrend or a floor.

Stocks following this pattern are in an uptrend—they are not bumping against any ceiling in their price that will hold them back. Over a long period (months), you will often see the stock rise, and then back off slightly, only to rise even higher. This three-steps-up-and-one-step-back pattern is typical of a stock on an uptrend. The periodic retreat is often caused by profit-taking, which will cause prices to drop momentarily.

Active traders want to spot uptrends early and ride them as long as possible. Some uptrends may last a very short time; if you’re trading intraday, you will want to get in and out in a hurry. These short-term traders are grabbing profits in the daily cycle of highs and lows. While it sounds simple to buy the low and sell the high, it is much more complicated than that. We’ll look at trading strategies in Chapter 17.

Trends can be down as well as up. The downtrend is defined by lower lows and lower highs. When you look at a stock over a longer period, you will often see both trends on the same chart. This trend up, then trend down, is also a pattern. It is a particularly important one for traders to understand because, with some exceptions, most stocks don’t continue up or down forever. Some companies will go bankrupt and their stock will be worthless, so it is possible to go to zero. It is rarer that a stock will continue to climb forever. However, a number of companies have uptrends that run for years.

Traders are often more comfortable with uptrends, but there is money to be made with downtrends as well and they shouldn’t be ignored. Shorting, which we discussed in Chapter 9, is a way to make money when a stock’s price is trending down.

The other trend possibility is that the stock will neither go up or down, but trade in a narrow range for a period. The sideways trend is a place where a form of swing trading can be employed under the right circumstances. If the stock is reasonably consistent in staying in the channel, the swing trader can play the stock going up and coming down.

Sideways may not be a bona fide trend, but the absence of one. When investors and traders are undecided about a stock, the stock may sit in a price range for some time until the buyers or sellers have a reason to act. This is also known as consolidation and when a stock breaks out of consolidation, traders have an opportunity to profit.

Consolidation doesn’t mean for sure that a trend is about to reverse itself, but traders should be looking for other indicators. Although some of its adherents treat it as such, technical analysis is not a precise science—there are too many influences that can change the course of a stock’s price movement.

Of course, stock prices don’t always form neat patterns on charts for us to quickly analyze. At times, prices jump up and down without seeming to establish a direction either way. This is another form of moving sideways and is usually a nasty place for traders. Such a pattern suggests a lot of indecision in the market, and that is dangerous for traders. When investors and traders are acting erratically toward a stock, it’s a good time to sit on the sidelines and wait until the stock breaks toward the buyers or sellers.

We have talked about support and resistance on several occasions, but its importance in technical analysis cannot be overstated. Identifying and understanding these two concepts is key to making profitable trades. The idea of support and resistance is there are certain price points that a stock will not easily fall through or push above.

When a stock’s price does break through either support or resistance, it signals the beginning of a trend in that direction. This involves investors’ psychology more than any fundamental or factual reason.

As a practical matter, support and resistance are often not single numbers but zones that function as roofs and floors. It is important for short-term active traders to identify support and resistance of the stock they are trading and watch for significant changes.

For example, investors seem reluctant to broach round numbers. As the price approaches a round number, investors tend to sell shares, causing the price to fall back—making the round number a difficult resistance level to crack. Likewise, when the share price falls close to a round number, buyers will step in and purchase large amounts of stock, raising the price. This keeps the round number at the support level. Active traders use support and resistance knowledge to enter trades. We’ll discuss this strategy in Chapter 17.

Round numbers aren’t made of iron and are breached when buyers or sellers see a compelling reason to move. When this happens, and support or resistance is broken, the volatility of a stock can increase and traders may find interesting profit opportunities.

Frequently, when support or resistance barriers are breached, they take on the opposite role. For example, if a stock bursts through resistance, the old resistance level may become the new support level.

Breaking the support or resistance barrier by itself is not enough to confirm a breakout or reversal. The breakthrough must be on strong volume, meaning a significant number of shares traded. If the price pokes through resistance, but volume is below the stock’s normal daily volume, assume that it is a fluke and wait for more confirmation.

The importance of strong volume is obvious—buyers or sellers are making a move and traders should always pay attention when that happens.

It is easy to track volume, so there is no excuse for being fooled by a price change that breaches either support or resistance on weak volume. Many charts feature a volume bar across the bottom, which will show you whether this is a legitimate breakthrough or an aberration that won’t hold.

We discussed moving averages in Chapter 4, but need to expand on them in this chapter because they are an important part of technical analysis.

Moving averages are a way of looking at prices over a period and smoothing out the peaks and valleys. A moving average takes the closing stock prices for the stated period and averages them (simple moving average). As a new period is added, the oldest period is dropped and the average is recalculated. Thus a 20-day moving average would take 20 days of closing prices and average them. The next trading day, the oldest price is dropped, the newest closing price is added, and the average recalculated. These data points are plotted on charts to help traders see price trends over time more clearly.

The longer period you use, the flatter the line becomes since more numbers are used in calculating the average. A 50-day moving average would look flatter than a 10-day moving average, for example. Sharp price changes can skew a short moving average to be misleading. Longer-term moving averages help traders verify the strength of a trend and its direction.

There is value to giving more weight to recent data than older data, especially in longer moving averages. Exponential moving averages use a weighed calculation to give more importance to recent prices.

All major charting software will place these averages on charts for you so you don’t have to learn the math or dig up historical price quotes.

Moving averages are more than decoration for your charts. They represent key information that can tip you to important trading opportunities. How moving averages display with current prices and how they display with other moving averages of different time periods tell you much about price movement.

You should expect shorter term moving averages to more closely reflect current prices. This just makes mathematical sense. As noted above, the longer the term, the flatter or less reflective of current prices the moving average will be. When current prices are above the long-term moving average (50 days or more), you have a confirmed uptrend. When prices are below the long-term moving average, it’s a downtrend.

It gets more interesting when you add a short-term moving average to a chart with a long-term moving average. For example, if you have a 15-day and a 50-day moving average plotted on your chart and the 15-day average is above the 50-day average, which signals an uptrend. If the longer average is above the shorter average, that signals a downtrend.

When prices cut through an important average, such as the 50-day average, traders should take that as a signal that a trend is reversing. For example, a stock on the uptrend suddenly drops through the 50-day moving average—this is a reversal of the uptrend and traders should look for the price to fall farther.

Crossovers are when moving averages intersect and change places—the one below becomes the one on top. For example, if you see the 10-day average crossover from under the 50-day average to above, that is a strong signal of an upturn. The longer the averages, the longer the trend is likely to last.

Moving averages can also be strong support or resistance areas, especially the longer-term averages. The 200-day, which is considered a trading year, is the strongest moving average. A stock that falls through that support may be on its way to a serious downward trend. Likewise, popping through a 200-day average on strong volume is a definite statement toward an uptrend.

Technical analysis is a powerful tool, especially for the short-term trader, as we’ll see in Chapter 17. Those who practice technical analysis can’t imagine trading without their charts. Some skeptics are not sure technical analysis is any more effective than reading tea leaves. The truth is probably somewhere in between.

While technical analysis does offer some insight into short-term price movements, it is not particularly suited for picking long-term investments. Buy-and-hold investors are probably better off sticking with fundamental analysis, which does offer some hope of playing out over a longer period. On the other hand, technical analysis has been around for a long time and is used by the most respected brokerage houses.

Short-term active traders would do themselves a favor to learn more about technical analysis than room permits in this book. Only you can ultimately decide if it is a tool you can use effectively in trading.

The Least You Need to Know