Understand Dow's theories behind technical analysis. Three of Dow's theories about investments form the underpinnings of technical analysis and serve to guide the technical analyst's approach to financial markets. Those theories are described below with an explanation of how technical analysts interpret them. Market fluctuations reflect all known information. Technical analysts believe that changes in the price of a security and how well it trades in the market reflect all the available information about that security as garnered from all pertinent sources. Price listings are therefore thought of as fair value. Sudden changes in how a stock trades often precedes major news about the company that issued the stock. Technical analysts don't concern themselves with the price-to-earnings ratio, shareholder equity, return on equity or other factors that fundamental analysts consider. Price movements can often be charted and predicted. Technical analysts acknowledge that there are periods when prices move randomly, but there are also times when they move in an identifiable trend. Once a trend is identified, it is possible to make money from it, either by buying low and selling high during an upward trend (bull market) or by selling short during a downward trend (bear market). By adjusting the length of time the market is being analyzed, it is possible to spot both short- and long-term trends. History repeats itself. People don't change their motivations overnight; traders can be expected to react the same way to current conditions as they did in the past when those same conditions occurred. Because people react predictably, technical analysts can use their knowledge of how other traders reacted in the past to profit each time conditions repeat themselves. In this respect, technical analysis differs from "efficient market theory," which ignores the effect that human actions and reactions have on the market.
Look for quick results. Unlike fundamental analysis, which looks at balance sheets and other financial data over relatively long periods of time, technical analysis focuses on periods no longer than a month and sometimes as short as a few minutes. It is suited to people who seek to make money from securities by repeatedly buying and selling them rather than those who invest for the long term.
Read charts to spot price trends. Technical analysts look at charts and graphs of security prices to spot the general direction in which prices are headed, overlooking individual fluctuations. Trends are classified by type and duration: Up trends, characterized by highs and lows that become progressively higher. Down trends are seen when successive highs and lows are progressively lower. Horizontal trends in which successive highs and lows fail to change much from previous highs and lows. Trend lines are drawn to connect successive highs to each other and successive lows to each other. This makes spotting trends easy. Such trend lines are often called channel lines. Trends are classified as major trends when they last longer than a year, as intermediate trends when they last at least a month but less than a year, and as near-term trends when they last less than a month. Intermediate trends are made up of near-term trends, and major trends are made up of near-term and intermediate trends, which may not go in the same direction as the larger trend they are part of. (An example of this would be a month-long downward price correction in a year-long bull market. The bull market is a major trend, while the price correction is an intermediate trend within it.) Technical analysts use four kinds of charts. They use line charts to plot closing stock prices over a period of time, bar and candlestick charts to show the high and low prices for the trading period (and gaps between trading periods if there are any), and point and figure charts to show significant price movements over a period of time. Technical analysts have coined certain phrases for patterns that appear on the charts they analyze. A pattern resembling a head and shoulders indicates that a trend is about to reverse itself. A pattern resembling a cup and handle indicates that an upward trend will continue after pausing for a short downward correction. A rounding bottom, or saucer bottom pattern indicates a long-term bottoming out of a downward trend before an upswing. A double top or double bottom pattern indicates two failed attempts to exceed a high or low price, which will be followed by a reversal of the trend. (Similarly, a triple top or bottom shows three failed attempts that precede a trend reversal.) Other patterns include triangles, wedges, pennants and flags.
Understand the concepts of support and resistance. Support refers to the lowest price a security reaches before more buyers come in and drive the price up. Resistance refers to the highest price a security reaches before owners sell their shares and cause the price to fall again. These levels are not fixed, but fluctuate. On a chart depicting channel lines, the bottom line is the support line (floor price for the security), while the top line is the resistance line (ceiling price). Support and resistance levels are used to confirm the existence of a trend and to identify when the trend reverses itself. Because people tend to think in round numbers (10, 20, 25, 50, 100, 500, 1,000, and so on), support and resistance prices are often given in round numbers. It is possible for stock prices to rise above resistance levels or fall below support levels. In such cases, the resistance level may become a support level for a new, higher resistance level; or the support level may become a resistance level for a new, lower support level. For this to happen, the price has to make a strong, sustained change. Such reversals may be common in the short term. Generally, when securities are trading near a support level, technical analysts tend to avoid buying because of concern for price volatility. They may, however, buy within a few points of that level. Those who sell short use the support price as their trading point.
Pay attention to the volume of trades. How much buying and selling goes on indicates the validity of a trend or whether it's reversing itself. If the trading volume increases substantially even as the price rises substantially, the trend is probably valid. If the trading volume increases only slightly (or even falls) as the price goes up, the trend is probably due to reverse itself.
Use moving averages to filter out minor price fluctuations. A moving average is a series of calculated averages measured over successive, equal periods of time. Moving averages remove unrepresentative highs and lows, making it easier to see overall trends. Plotting prices against moving averages, or short-term averages against long-term averages, makes it easier to spot trend reversals. There are several averaging methods used: The simple moving average (SMA) is found by adding together all the closing prices during the time period and dividing that sum by the number of prices included. The linear weighted average takes each price and multiplies it by its position on the chart before adding the prices together and dividing by the number of prices. Thus, over a five-day period, the first price would be multiplied by 1, the second by 2, the third by 3, the fourth by 4 and the fifth by 5. An exponential moving average (EMA) is similar to the linear moving average, except that it weighs only the most recent prices used in computing the average, making it more responsive to the latest information than a simple moving average.
Use indicators and oscillators to support what the price movements are telling you. Indicators are calculations that support the trend information gleaned from price movements and add another factor into your decision to buy or sell securities. (The moving averages described above are an example of an indicator.) Some indicators can have any value, while others are restricted to a particular range of values, such as 0 to 100. The latter indicators are termed oscillators. Indicators may be either leading or lagging. Leading indicators predict price movements and are most useful during horizontal trends to signal uptrends or downtrends. Lagging indicators confirm price movements and are most useful during uptrends and downtrends. Trend indicators include the average directional index (ADX) and the Aroon indicator. The ADX uses positive and negative directional indicators to determine how strong an uptrend or downtrend is on a scale of 0 to 100. Values below 20 indicate a weak trend and over 40 a strong one. The Aroon indicator plots the lengths of time since the highest and lowest trading prices were reached, using that data to determine the nature and strength of the trend or the onset of a new trend. The best known volume indicator is the moving average convergence-divergence (MACD) indicator. It is the difference between two exponential moving averages, one short-term and the other long-term, as plotted against a center line that represents where the two averages equal each other. A positive MACD value shows that the short-term average is above the long-term average and the market should move upward. A negative MACD value shows that the short-term average is below the long-term average and that the market is moving downward. When the MACD is plotted on a chart, and its line crosses the centerline, it shows when the moving averages that make it up cross over. Another volume-related indicator, the on-balance volume (OBV) indicator, is the total trading volume for a given period, a positive number when the price is up and a negative number when the price is down. Unlike the MACD, the actual value of the number has less meaning than whether the number is positive or negative. How frequently securities are being traded is tracked by both the relative strength index (RSI) and the stochastic oscillator. The RSI ranges from 0 to 100; a value over 70 suggests that the security being evaluated is being bought too frequently, while a value under 30 suggests it is being sold too frequently. RSI is normally used for 14-day periods but may be used for shorter periods, making it more volatile. The stochastic oscillator also runs from 0 to 100. It signals too frequent buying at values over 80 and too frequent selling at values under 20.
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