
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.
Table 11-1
Volume and Price Movements That Indicate Market Mood
Volume |
Price |
Market Mood |
Increasing |
Increasing |
Bullish |
Increasing |
Decreasing |
Bearish |
Decreasing |
Decreasing |
Somewhat bullish |
Decreasing |
Increasing |
Somewhat bearish |
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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