Technical Analysis

Investment Snapshot: Using Technical Analysis to Determine Which Stocks to Buy and Sell

Would you make important decisions in your life based on answers provided by fortune-tellers or readers of tea leaves? Similarly, would you buy or sell stocks based on charts of stock price patterns and trading volumes? Technical analysts, who follow market and stock price movements, patterns, and trading volumes, say that technical analysis is the most reliable method for trading in the markets. Technical analysts even have names for all their chart patterns, for example, symmetrical triangles, ascending triangles, descending triangles, head and shoulders, double bottoms, and even flags and pennants. The charts also come in different varieties: line charts, bar charts, point and figure charts, and candlestick charts, which originated in Japan. The terminology used in technical analysis is creative and different from standard business and financial jargon. The terms breakout and resistance and support levels are reminiscent of terms used in war games.

The use of technical analysis to select stocks is undoubtedly easier than analyzing financial statements and crunching numbers. The conclusions to be drawn about the use and benefits are yours. However, after reading this chapter and looking at the results of using technical analysis in stock selection, you might well find some use for number crunching from fundamental and financial statement analysis.

Technical analysis is the study of market and stock variables, such as the relationships between trading volumes and price movements, to determine the supply and demand for securities and the markets. Technical analysts are not all that concerned about fundamental factors of companies and the economic environment. Rather, the focus of technical analysis is on a company’s historical stock price movements and the trading volumes of the stock in relation to those of the market. From this information, technical analysts predict future stock price behavior. The technical analyst has a shorter time horizon than the fundamental analyst. Even though many people dispute the value of technical analysis, it is a widely used method for selecting stocks. Most large brokerage firms have at least one technical analyst on staff, and many rely on the information provided by their technical analysts in the selection of stocks. In academic circles, however, technical analysis does not have very much credibility. Despite the many shortcomings of technical analysis, you should be aware of how it works.

Advocates of technical analysis feel that fundamental analysis is of minimal value, whereas advocates of fundamental analysis feel precisely the same way about technical analysis. In reality, these two approaches do not work in isolation. Generally, technicians are aware of the fundamentals of the stock they are interested in, and fundamentalists are cognizant of the volume and trading range of charts, point and figure charts, and candlestick charts, which originated in Japan. The terminology used in technical analysis is creative and different from standard business and financial jargon. The terms breakout and resistance and support levels are reminiscent of terms used in war games.

the stocks they are interested in. An awareness of the contradictions between these approaches will make it easier for you to recognize the philosophies your brokers and financial analysts follow in giving you advice.

Technical analysis focuses on past price movements of stocks, using them as a basis for predicting future stock prices. The assumption is that these price movements will be repeated. In other words, investor behavior always will be the same in similar situations, enabling technical analysts to predict future stock prices and whether stocks should be bought or sold. Technical analysts use several methods to predict future price movements, one of which is the use of charts. Charts show the patterns of stock price movements, which are the basis for interpreting future price movements. In other words, investors determine the markets for stocks, and when the same price conditions recur, investors react to them in the same way they did in the past. These repetitions of previous patterns in the stock prices then become the basis for technicians’ buy and sell recommendations.

Technicians consider trading volume, together with price, to be an important indicator of the supply and demand for a stock. For technicians, the combination of price movements and trading volume indicates the mood of the market, as summarized in Table 11–1. When both volume and stock prices are increasing, investors are bullish because the increasing trading volume will continue to push prices up. However, the opposite situation occurs when trading volume is increasing and stock prices are decreasing. This situation indicates bearish sentiment because more people are selling than buying, which depresses stock prices.

Decreasing price and decreasing volume indicate a mixed mood in the market. Decreasing volume shows that the market for a stock is bottoming out. When the price reaches a low enough point, more investors will start buying, which pushes the price up.

Although decreasing volume and increasing price also describes a mixed market, this combination has a somewhat bearish tone because the increasing price will not be supported by the declining volume. The price will “top out” and start to fall.

You can easily see why technical analysis is so much more appealing than fundamental analysis: Price and volume data are easy to find (they are published daily in the financial newspapers) and to use.

You can classify technical analysis into four categories:
* Charts
* Market indicators
* Trends
* Structural theories

So many technical approaches exist within each of these broad categories that only a few of the more popular examples in each category are discussed on this site.

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