StockCharts Blogs - ChartWatchers

TECHNICAL ANALYSIS 101 - PART 15

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the entire series.)

Price charts often have blank spaces known as gaps. They represent times when no shares were traded within a particular price range. Gaps result from extraordinary buying or selling interest developing when the market is closed. When the market opens, the price is raised or lowered enough to satisfy all of the buying or selling orders.

For an up gap to form, the low price after market close on the day of the up gap must be higher than the high price of the previous day. Up gaps are generally considered bullish.

A down gap is just the opposite of an up gap; the high price of the down gap day after market close must be lower than the low price of the previous day. Down gaps are usually considered bearish.

Up and down gaps can form on daily, weekly or monthly charts and are considered a significant when accompanied with higher than average volume.

A price chart with gaps almost every day is typical for very lightly traded securities and should be avoided. Prices often gap up or down at market open and then close the gap before market close. Such temporary intraday gaps should not be considered as having anything more significance than normal market volatility.

Many investors mistakenly believe that gaps influence future prices to the point of eventually filling the gap. Instances where gaps close within a few days of forming can be significant. However, gaps have little to no influence on price action weeks or months after forming.

Breakaway gaps signal a change in market psychology about the future prospect of a security, especially when accompanied by above average volume. A bullish breakaway gap forms when a security gaps up after an extended decline, extended base or a consolidation period. A bearish breakaway gap forms when a security gaps down after an extended advance, an extended top or a consolidation period.

Common gaps occur within a trading range or shortly after a sharp move as a reaction. These gaps do not reflect a change in market psychology, but rather represent price volatility or temporary imbalance of supply and demand. For instance, if a security has declined 20% in a week and gaps up, it would be considered a common gap and not likely to signify a change in trend. Or, if a trading range develops between $20 and $30, and a gap forms in the middle, it is probably a common gap.

Continuation gaps form near the middle of a short or intermediate trend in the same direction. These gaps signal a continuation of the preceding trend. Continuation gaps are also known as measuring or runaway gaps. These gaps can be triggered by news events that bring more market attention to a security.

Exhaustion gaps occur in the direction of extended trends. For an exhaustion gap to be considered valid, prices should reverse soon after the gap and close the gap. In the later stages of a trend, the extent of the trend becomes widely reported; eventually causing a surge in trading that cannot be sustained. These events often mark the end of the trend.

Next time, we'll start looking at Candlestick Chart Patterns.

TECHNICAL ANALYSIS 101 - PART 14

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the entire series.)

Fibonacci Lines

How high is "too high?" How low is "too low?" Think back to any time that you've owned a stock and think about when you started to get worried about it's performance. At what point did "your gut" start to tell you that you needed to sell? Chances are your gut started talking to you after the stock had moved up (or down) by 38.2%.

Wow, that's a really specific number - "38.2." It seems kind of arbitrary also. There's no way that could be correct, right? I mean, without knowing anything about the stock you were trading, or the amount of money involved, or the overall market conditions, or anything else - how can we stand here and tell you that you got nervous right at 38.2%?

The reason is because 38.2 appears to be programmed into the human psyche (as well as many other parts of nature). 38.2 is one of a set of numbers called "Fibonacci Percentages." They are derived from the "Fibonacci Sequence" which is a list of numbers where each number equals the sum of the previous two. i.e.,

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 etc.

The branching in trees, arrangement of leaves on a stem, the flowering of artichoke, an uncurling fern and the arrangement of a pine cone - all these things exhibit Fibonacci characteristics . In addition, if you take any large Fibonacci number and divide it by the previous number, you'll get something very close to 1.6180339887 (the larger the number, the closer you'll get). Now, 1.6180... has been known for centuries as "The Golden Ratio" - mostly because we humans tend to prefer things - art, sculptor, architecture, etc. - that have proportions that equal the Golden Ratio.

Which of these picture looks the most "natural" to you? The middle one has Golden Ratio proportions.

Getting back to stock charting, R.N. Elliott made the first well-known connection between price movements and the Golden Ratio. He noted that many reversals occurred around 61.8% or its compliment 38.2% (i.e., 100 - 61.8). Combined with 50% and 100%, they make up the standard set of Fibonacci Percentages.

Regardless of how the numbers were arrived at, chart analysts have observed that prices often will reverse after moving up (or down) by one of those percentages. Basically, those percentages are where something tells many people that it is time to take action - and thus prices reverse. Strange but true. Check it out:

The Fibonacci Lines on this chart were created based on the move from Feb. 9th to May 30th - so just focus on the shaded blue area of the chart. Like a weatherman, the lines "forecast" that support for IBM would occur around 118.35 essentially because lots of people would probably feel that IBM had "fallen enough" and would start buying it again. That is precisely what happened at the end of June (red arrows).

Unfortunately many people have gone on to claim that Fibonacci lines (and their variants) have almost "magical powers" to predict price movements. Like most Technical Analysis tools, we think Fibonacci Lines are useful forecasting tools - but not magical.

You can add Fibonacci Lines to your charts using our ChartNotes annotation tool. To get started, simply click on the "Annotation" link below any SharpCharts.

Power Tip:  If you hold down "CTRL" while drawing Fibonacci lines, we'll add the 23.6% and 161.8% lines as well.

Next time: Gaps!

TECHNICAL ANALYSIS 101 - PART 13

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the entire series.)

The Infamous Head and Shoulders Reversal Pattern

One of the most common reversal patterns is the Head and Shoulders pattern. 

This pattern forms in an uptrend and its completion marks a trend reversal.  The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being lower.  The reaction lows of each peak can be connected to form line of support called a neckline. The top reversal pattern is completed when price breaks below the neckline.

While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights.

It's important to realize that up until the point where prices move back below the level of the left shoulder, things look like a normal, ongoing uptrend.  It is only when the left shoulder's price level is violated that the bulls become fearful and the bears start to smell blood.  The right shoulder forms as the bulls try to reestablish the uptrend and then fail - usually because many of the more skittish investors will take profits at that point.

As the Head and Shoulders top reversal pattern unfolds, volume plays an important role in confirmation.  Buying volume (volume on up days) will slowly translate into selling volume (volume on down days) as the pattern develops.  This is seen when volume that previously expanded on rallies begins to expand on declines and contract on rallies. 

The Head and Shoulders bottom reversal pattern is just the reverse of the top reversal pattern with volume acting as a confirmation. 

As with the Head and Shoulders top reversal pattern, volume action is helpful in confirming the trend reversal.  Volume that was previously expanding on declines begins to expand on rallies and contract on declines as the trend reversal develops.

Traders begin noticing lighter selling volume on the declines and heavier buying volume on the rallies.  This kind of price and volume action is quickly noticed by the market which results in additional buying volume supporting the trend reversal.

A couple of other comments about this pattern:

• Sometimes several left shoulders will form before a true head appears.  Sometimes several right shoulders appear before a true neckline break occurs.
• When a neckline break occurs, the stock will often fall at least as much as the distance from the neckline to the top of the head.
• Head and Shoulder patterns are easy to find but hard to confirm.  Make sure that the pattern is based on real fear/greed and confirmed by volume before acting on it.

Other Reversal Patterns

Many of the technical analysis books out there will go on to talk about several other kinds of reversal patterns - the rounding bottom, the V-reversal, double tops, triple bottoms, and others.  (We have many of them cataloged in our ChartSchool area.)  I'm going to tell you a secret - most of those are just variations of the Head and Shoulders reversal which didn't form "perfectly" for some reason.  For example, the triple top is a Head and Shoulders pattern where the head didn't go above the left shoulder.

The key point here is this - don't worry about what type of reversal is occurring.  Knowing that it's a triple top instead of a H&S top won't make you more money.  Focus on the fact that the chart is telling you that the fear/greed ratio is changing and react accordingly.

Next time, we'll look at the question "how much is too much?"

TECHNICAL ANALYSIS 101 - PART 12

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Volume Confirmation of Price Patterns

When identifying potential price patterns on a chart, it is crucial to try and verify that the market psychology behind the price pattern is really happening at that point on the chart.  One of the best ways to do that is to use volume to confirm things.

In the case of a rectangle pattern, volume should be decreasing while the rectangle is forming.  There may be volume spikes whenever prices get near the top or bottom of the pattern, but in general, as a rectangle pattern continues to develop, volume should decrease.  Volume will probably spike up heavily immediately after the breakout as people realize that the support or resistance line has been broken.

Triangle patterns should have a similar volume pattern - decreasing volume while the triangle is forming with a sharp increase in volume once a breakout is achieved.

Again, the diagrams above are idealized - the real-world is much messier.   Consider this example:

Notice that ARST didn't have a smooth decrease in volume but instead had several "mini-spikes" that corresponded to each change in direction of the "coil."  The key however is that each mini-spike was smaller than the previous one (with the exception of July 21st, but that was early in the coil's formation).  Once that downward volume trend was well established, a big spike above that trendline would signal the breakout - just like on September 1st.

Consolidation / Continuation Patterns vs. Reversal Patterns

So far, the two price patterns we've looked at - Rectangles and Triangles - are examples of "Consolidation Patterns" also known as "Continuation Patterns."  They are called that because, in general, after the pattern completes prices will usually continue whatever trend they were in prior to the pattern forming.  In order words, if prices were in an uptrend prior to a rectangle pattern forming, prices will usually resume the uptrend once the rectangle pattern finishes.  Basically, consolidation patterns are places where the bulls and the bears have another short-term "argument" about the stock, but it is a half-hearted one.  The "bigger picture" situation doesn't really change.

Next, we are going to start looking at "Reversal Patterns."  These are where the fireworks occur.  If consolidation patterns are skirmishes, reversal patterns are the big battles.  When reversal patterns start to appear, the current trend is in real danger and lots of people start to pay attention.

Next time, we'll look at the granddaddy of all reversal patterns - the Head and Shoulders reversal.

TECHNICAL ANALYSIS 101 - PART 11

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Price Patterns

Price Patterns result when the market is not in agreement on the value of a stock.  Essentially, they are the “visual remains” of a big battle between Bulls and Bears.  In many ways, they are like weather patterns that you see on the nightly news.  Often today’s weather can be forecast by looking at yesterday’s atmospheric data but occasionally (frequently?) the forecast is wrong.  Similarly, chart patterns often but not always indicate future price movements.

At their core, most price patterns are combinations of several trendlines.  The simplest pattern is the Rectangle Pattern.

In a rectangle pattern, price moves between two horizontal lines of support and resistance.  In order to qualify as a rectangle pattern, both support and resistance lines must be touched at least twice.  Rectangle patterns have a narrow or wide price range and last from days to months.  The pattern ends once the line of support or resistance is broken. 

A price break through resistance may be anticipated if volume expands when prices rise and contracts when prices fall within the rectangle pattern.  An imminent price break above resistance may exist if prices don’t fall to the support line before rising again.

A price break through support may be anticipated if volume expands when prices fall and contracts when prices rise within the rectangle pattern.  An imminent price break below support may exist if prices don’t rise to the resistance line before falling again.

As illustrated above, as soon as the pattern breaks down, the top (or bottom) of the rectangle changes into a support (or resistance) line for the stock.

Rectangle patterns clearly show the battle between bulls and bears with the bulls repeatedly buying when prices hit the support level and bears repeatedly selling when prices hit the resistance level.  At some point, one of those groups will “win” and prices will breakout of the pattern.  The longer prices have been in the pattern then the larger the “breakout move” will be and the more significant the new support/resistance line becomes.

Another common price pattern is the Triangle Pattern.   The triangle pattern is very similar to the rectangle, except that the upper and/or lower trendlines that define the pattern are sloped instead of horizontal.

Go back to the rectangle diagram above and imagine that bearish sentiment about the stock was growing over time.  What would that look like?   Well, in that case, more and more sellers would not wait for prices to return to the level of the red resistance line before selling.  Instead, they would sell sooner.  That would cause the red resistance line to become a downward trendline forming a Descending Triangle Pattern.

Alternately, what if buyers started getting impatient and started buying before the stock got back to its green support line?  Then a Rising Triangle Pattern would form.

And what if both the bulls became more bullish while at the same time, the bears became more bearish?  Then both the red and green lines would be slanted and we’d have a Symmetric Triangle Pattern.

By the way, triangle patterns are also referred to as “coils.”  Can you see why?  As the upper and lower parts of the triangle get closer together, the battle between the bulls and the bears gets more intense and the suspense builds.  Obviously, at some point, prices are going to move outside of the triangle’s boundaries – but will they move higher or lower?  Psychological energy coils up like a spring inside of the triangle and the closer the lines get, the bigger the inevitable breakout will be.

As you probably guessed, the diagrams above are not realistic.  Typically, triangle patterns have a breakout well before the apex of the triangle is reached.  It is the direction of the breakout that is the key question when watching a triangle form. Will the bulls win?  Will the bears win?

A couple of clues can be found in the price action that precedes the triangle.  If the stock was in an uptrend prior to the triangle, there is a good chance it will break out of the triangle pattern on the upside and continue the uptrend.  In addition, rising triangles tend to breakout to the upside while descending triangles often break lower.  Symmetric triangles are usually not completely “even” – i.e., the support side may be stronger than the resistance side making the triangle “point up” or, if the support side is weaker, “point down.”  In that case, the triangle often breaks in the direction it is “pointing.”

Next time, we'll look at how to confirm these patterns with volume and examine some real-world examples.

TECHNICAL ANALYSIS 101 - PART 10

This is the tenth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Volume Confirmation

In an uptrend, volume should expand as the prices move higher and contract as the prices pull back.  As long as this pattern continues, volume is confirming the uptrend.  The opposite is true for downtrends.  Volume should expand as prices decline and contract during rallies to confirm a downtrend.

Negative divergences can occur if new price highs in an uptrend take place on declining volume.  This type of volume activity is an indication of diminishing buying pressure.  If the volume also begins to pick up on price pull backs, prices may begin consolidating or reversing into a downtrend. 

The same concept is true for positive divergences in downtrends.  If volume begins to contract on new price lows but expands during rallies, prices may begin consolidating or reversing into an uptrend.

 

This is the end of our section on Trends and trendlines.  Next time, we'll dive into some of the fundamental price patterns that result from when two trendlines are in effect at the same time.

TECHNICAL ANALYSIS 101 - PART 9

This is the ninth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Price Channels

Trending prices often form a channel where prices can be bounded above and below by parallel trendlines.  When trend channels form, it is helpful to draw the top and bottom trendlines and monitor how well prices stay within the channel. 

If prices in an uptrend fail to reach the upper channel line, the uptrend may be weakening and getting ready to reverse.  Also, if prices suddenly break above the upper channel line, the uptrend may be either beginning to exhaust itself and reverse direction or be starting a new, steeper trend.  Similar behavior also happens in downtrend price channels.

 

 

Trend Changes

Trending prices can only go three directions; continue in the direction of the trend, change to a trading range or reverse the direction of the trend.  Trend changes are most easily recognized by watching the price peaks and troughs.  An uptrend makes ever higher price peaks and troughs.  A downtrend makes ever lower price peaks and troughs.  And a trading range price peaks and troughs are roughly equal over time. 

A change in uptrend begins when a new price peak is similar or lower than the previous price peak.  The change is confirmed when the next price trough is similar or lower than the last price trough.

Changes in downtrends and price ranges occur the same way, new price peaks or troughs break the pattern of prior peaks and troughs with the next peak or trough confirming the change.

 

 

Price and Volume Data Adjustments

When a company declares a normal stock split, additional shares are created in a ratio to the current available shares. For a 2:1 (two-for-one) stock split, every pre-split share will be replaced with two shares.  Share prices are subsequently reduced by the split ratio (1/2 in this case) to maintain the total value (price multiplied by the total number of company shares) of the company.  In a reverse stock split, the total number of shares is reduced by some ratio, resulting in the stock price being raised by that ratio.

Price and volume data adjustments are necessary for technical indicators to be valid during the period of the stock split.  To accomplish these adjustments, pre-split prices are reduced by the split ratio and pre-split volume is increased by the split ratio.  The opposite adjustments are made for reverse stock splits.

Data adjustments are made in the same way for dividends and mutual fund distributions.

The following charts illustrate prices before and after a data adjustment for a stock split.  Notice how several strong “sell” signals on the first chart have disappeared on the adjusted chart. 

Next time, we'll look at how volume can confirm trend change signals.

TECHNICAL ANALYSIS 101 - PART 8

This is the eighth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Trend Psychology

The psychology of fear and greed of market participants ultimately determines the direction of prices in a market. Prices rise with greed (demand) and fall with fear (supply).  A price trend is simply a sustained directional price move.  It can be thought of as a “tilted” support/resistance zone.

A trend will continue as long as either fear or greed is in control of a market.  Trends fade or change direction as the balance of fear and greed changes.  The extent of fear and greed in a market can be seen by how quickly prices are trending down or up.

Trending

As stated earlier, a trend is a sustained directional price move.  Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend.  A trading range is characterized by horizontal peaks and troughs.  Trends are generally classified into major (longer than six months), intermediate (one to six months), or minor (less than a month).  Long term are most interested with identifying long term trends where short term investors are more interested in minor and intermediate trends.  The following SharpChart shows examples of the different types and categories of trends.

 

Trendlines

A trendline is a straight line that connects two or more low or high price points and then extends into the future to act as a line of support or resistance.  The first two points establish the trend line while additional points validate it.

 

The following SharpChart is a real example of how an uptrend line is drawn with a trend change.

 

An uptrend line has a positive slope and is formed by connecting two or more low points. Uptrend lines act as support.  As long as prices remain above the trend line, the uptrend is considered intact.  A break below the uptrend line indicates that demand has weakened and a change in trend could be imminent.

 

A downtrend line has a negative slope and is formed by connecting two or more high points. Downtrend lines act as resistance.   As long as prices remain below the downtrend line, the downtrend is intact.  A break above the downtrend line indicates that supply is decreasing and that a change of trend could be imminent.

Next time we'll look at Trend Channels and Trend Changes.

TECHNICAL ANALYSIS 101 - PART 7

This is the seventh part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Analysis - Support and Resistance

Prices are driven by two of humanity’s strongest emotions: Fear and Greed.  When more investors are fearful that a stock will fall, it does!  It will continue to decline until the balance between Fear and Greed is re-established.  The same is true for greed and rising prices.  This phenomenon is referred to as “Market Psychology.”

Support is the price level where “greedy” buyers enter the market to prevent prices from declining further.  Support can develop at a specific price or more commonly in a price zone.  Areas of support can exist for many months at a time.

 The diagram above illustrates how market psychology causes the previous area of price support to turn into resistance.   After breaking support, traders who bought in the zone of support are now holding losses and want to sell as soon as prices approach their original purchase prices in order to break even.  

 
The Volume by Price overlay (volume traded in incremental price ranges) in the following SharpChart of Dover Corp illustrates how strong support at 46 later became significant resistance as greed turned into fear.

 

The concept of resistance is opposite of the support as discussed above.  Resistance is the price level where “fearful” sellers suddenly come into the market and prevent prices from advancing further.  Like support, resistance can develop at a specific price or in a price zone and can be held for months at a time.

 

If resistance is broken, market psychology causes the previous area of price resistance to turn into support.  The diagram above illustrates this market behavior.  Stock holders who sold in the zone of resistance are now regretting selling and want to buy as soon as prices approach the level they sold at earlier.  Prices that seemed too high before now look like a bargain.  The following SharpChart of Parker Hannifin Corp. illustrates resistance later becoming support.  Notice how Volume by Price indicates the potential number of previous sellers willing to buy again if given the opportunity.

Next time we'll discuss trendline analysis and trend channels.

TECHNICAL ANALYSIS 101 - PART 6

This is the sixth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Scaling

Charts are created with one of two different kinds of vertical price scales.  An arithmetic scale evenly spaces price along the right side of the chart.  Arithmetic chart spacing between $10 and $20 is half as tall as the spacing between $20 and $40.  A log scale evenly spaces price in percentage terms.  Chart spacing between $10 and $20 has the exact same chart spacing as between $20 and $40 since they represent the same percentage increase. 

  

The SharpCharts above illustrate the differences between the two scaling methods.  On the arithmetic scale, three different trend lines were required to keep pace with the price advance.  On the log scale, the trend line fits the price trend during the entire rally.  Log scaling should be the first scaling choice when using trend lines, especially over long time frames.
 
 

Volume

StockCharts.com provides several ways to plot volume data on a chart.  The following price and volume SharpChart of AAPL illustrates how volume is typically plotted.

Volume can be plotted in an ‘indicator panel’ above or below the ‘price plot area’ or in the price plot area as an ‘overlay’.

 

   
When the ‘Color Volume’ option is used, the volume bars are shown as black for up days and red for down days.  Color volume bars allow the chartist to quickly see where heavy or weak buying and selling activity is happening.

 

CandleVolume Charts

CandleVolume charts are similar to candlestick charts except that each candle's width is proportional to its corresponding volume value.  This charting style allows one to visualize the volume activity ‘in’ rather than ‘below’ price moves.  Depending on the style of analysis, volume bars could be omitted to simplify the chart.

The time axis for these charts is not uniformly spaced since the candlestick bar widths vary with volume values.  As a result, trendline analysis using CandleVolume charts should always be confirmed with a standard candlestick or OHLC chart.  The SharpChart above of AAPL shows how volume bars correlate to the candlestick widths.

That wraps up our look at how charts are constructed.  Next time, we're going to start to talk about how charts are analyzed - starting with Support and Resistance analysis.

TECHNICAL ANALYSIS 101 - PART 5

This is the fifth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Candlestick Charts

Compared to traditional OHLC bar charts, many traders consider candlestick charts more visually appealing and easier to interpret.  Each candlestick provides an easy-to-decipher picture of price action.  An analyst can quickly see compare the relationship between the opening and closing price as well as the high and low price. 

The graphic above shows how candlesticks are constructed.

Candlesticks with hollow bodies indicate buying pressure and filled bodies indicate selling pressure.  Long upper or lower shadows form when the market moves significantly in a particular direction during the day and then reverses before the end of the day.  As a result, long lower shadows can infer bullishness while long upper shadows can infer a bearish market.

 

Candlestick Colors

When the ‘Color Prices’ option is selected on the Chart Attributes workbench, the Candlestick’s outline and  body be colored black or red, depending on the candlestick’s opening and closing prices and the previous day’s closing price. 

If the closing price is higher than the opening price, the body will be displayed hollow.  If the closing price is lower than the opening price, the body will be filled red with the following exception; if the closing price is higher than the previous day’s closing price, the body will then be filled black.

The candlestick’s shadows and body outline are colored black or red depending on the closing price compared to the previous day’s closing price.  If the closing price is higher than the previous day’s, the candlestick’s shadows and body outline will be colored black.  And the candlestick’s shadows and body outline will be red if the closing price is lower than the previous day’s closing price.

Market psychology is reflected in each of these candlestick formations in the following ways.

Up Day, Higher Close; typically results from expectations of higher prices (greed) out weighing expectations of lower prices (fear).  The length of the candlestick body shown indicates especially strong buying.

Down Day, Lower Close; expectations of lower prices (fear) are stronger than those of higher prices (greed).  As with the first candlestick, a longer candlestick body infers greater urgency of investors to sell their shares.

Down Day, Higher Close; a rare candlestick, this one begins with an opening gap up in price from the previous day’s closing price but closes down for the day.  A gap is defined as a price range where no trading takes place and is the result of a significant change in demand (gap up) or supply (gap down) before trading begins for the day.  In this case, heavy buying at the beginning of the day reversed but still closed higher than the previous day.  This is a bearish sign when it occurs well into an upward price move.

Up Day, Lower Close: another rare candlestick, this one begins with an opening gap down in price from the previous day’s closing price but closes up for the day.  This price action can be considered bullish during a downward price move since initial strong selling in the day becomes exhausted and buyers push the price higher at close.

 

The SharpChart AAPL above illustrates the candlestick format.  The up and down days are readily apparent with the use of candlestick charting.  When the balance between buyers and sellers change, candlesticks often form recognizable patterns signaling the change.  These candlestick patterns will be discussed in a later article.

Below, you can see how the three types of charts compare visually:

 




 

Next time, we'll get into Chart Scaling, Volume, and CandleVolume charts.

TECHNICAL ANALYSIS 101 - PART 4

This is the fourth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Line Charts

Line charts are created by plotting a line between the closing prices for each period set on the chart.  On a daily chart, a line is plotted between the daily closing prices.  Line charts are useful to help visualize the direction of prices.  The extent of rallies and reactions in trends can also be quickly deduced. 

 

A five month price SharpChart of Apple, Inc. (AAPL) is plotted above in a line format.  Higher highs and lows are annotated with green dashes and lower highs and lows with red dashes.  Between March and mid-May 2008, the direction of prices is readily apparent with higher highs and lows.  After mid-May 2008, prices began to make lower highs and lows.

A line chart is plotted by default when only end-of-day (closing) prices are available for a symbol.  Examples of such symbols include all mutual funds and some market indices.  However, weekly and monthly price bars can be charted for ticker symbols with only end-of-day (EOD) quotes.

OHLC Charts

Open-High-Low-Close (OHLC) bar charts provide volatility information that line charts lack.  The attributes of an OHLC bar are shown below.  The chartist can evaluate volatility by the height of the bars and the conviction of the buyers and sellers by the price range between the open and close marks. 

 

For the left price bar, the CLOSE mark is above the OPEN mark indicating price ended higher for the day, known as an up day.  This price bar is considered bullish.  Bullish sentiment is present when greed for gain exceeds fear of loss and prices move higher.

With the price bar on the right, the OPEN is higher than the CLOSE indicating price ended lower for the day, known as a down day.   This is a bearish price bar.  Bearish sentiment is present when fear of loss is greater than greed for gain and prices move lower.

The SharpChart of AAPL above illustrates the OHLC format.

Notice how intraday price swings pass through the red and green reference marks made at the closing price levels on the previous Line chart.  This illustrates why line charts are useful for visualizing price direction.

OHLC Bar Colors

 

When the ‘Color Prices’ option is selected on the Chart Attributes workbench, the price bars will be colored black or red, depending on how a price bar’s closing price relates to the previous day’s closing price.  If the closing price is higher than the previous day’s closing price, the price bar will be black.  If the closing price is lower than the previous day’s, the price bar will be red.  With this convention, it is possible to have a black price bar with the close being lower than the open.

 

Colored OHLC price bars are shown in the AAPL SharpChart above.  As discussed earlier, the color of the price bar is only based on the previous day’s closing price, not the current day’s opening price.  ‘Up day’ and ‘down day’ price bars are usually black and red respectively, but that is not always the case as shown in the chart above.

Next time, we'll get into the specifics of Candlestick charts.

TECHNICAL ANALYSIS 101 - PART 3

This is the third part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Construction

Charts are created from data - Price data and Index data.  After discussing the various types of data used, we’ll look at how charts are constructed.

Price Data

Exchanges record the price and number of shares for each stock transaction.  These individual transactions are called tick data.   Tick data is compiled over different periods of time to construct price bar data.  Price bars show the beginning, highest, lowest and ending prices for a chosen time period.  Individual price bar time periods can range from one minute to one year.  Daily, weekly and 60-minute price bars are other common examples.

Price bars less than a day long are known as intraday price bars. Intraday price bars range from one minute to one hour and are typically used in technical analysis by day traders who hold positions for a matter of minutes or hours.

A daily price bar is constructed of all the transactions during a full day of trading.  Daily price bars are most often used in technical analysis by investors who hold positions from days to years. 

The number of shares traded in each transaction is called volume.  Volume is recorded as tick data just like price.  Volume tick data is added together to construct volume bars and are then charted with their corresponding price bars for technical analysis.

Index Data

Data for hundreds of indices, published by financial service companies and the major exchanges, are provided to StockCharts.com through third party data providers.  Indices are not tradable financial instruments.  Indices represent domestic and foreign market averages, industries, commodities, currencies, bonds and many other price, volume and breadth measurements of market activity.  Examples of market indices include the Dow Jones Industrial Average ($INDU), NYSE Healthcare Index ($NYP) and the New Zealand Dollar ($NZD).  The financial service companies are responsible for the accuracy of the indices they publish.

Breadth indices measure how many issues move within a particular market index.  Breadth indices give analysts insight into investor sentiment.  Examples of breadth indices include NASDAQ Advance-Decline Issues ($NAAD), NYSE Advance-Decline Volume ($NYUD) and AMEX Issues Unchanged ($AMADU).

Price Chart

A price chart is a graph which shows how price and volume changes with time.  Price charts on StockCharts.com are called SharpCharts.  (Time-independent charting methods like Point & Figure charting will be discussed in detail later.)

 

The diagram above illustrates the layout of a typical SharpChart.  Price data, volume data and technical indicators are displayed on a SharpChart.  A technical indicator is a mathematical expression of price and/or volume which can provide insight into future price movements.  We will talk more about technical indicators later. 

Price data and overlays are plotted in the Price Plot Area.  Overlays are technical indicators that are normally expressed in terms of price.  Non-price values of overlays are displayed on the left axis as shown above.

Technical indicators that cannot be expressed in terms of price are normally plotted in the Indicator Panels.  Although only a single Indicator Panel is shown above, SharpCharts can be created with multiple Indicator Panels displayed above and below the Price Plot Area.  Additional date/time axes can be added between the Indicator Panels if needed.  The legend for both the Price Plot Area and Indicator Panel contain the information used to create the SharpChart.

Next time, we'll get into the specifics of Line charts, OHLC Bar charts, and Candlestick charts.

TECHNICAL ANALYSIS 101 - PART 2

This is the second part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the first part of this series.)

The Value of Technical Analysis

The reason technical analysis has value is that directional price moves are often sustained for a period of time allowing analysts to detect and profit from the change in price. Even though a technical analyst has many math-based tools to analyze price and volume movement, the process is ultimately an art in the study of human behavior.

Just as the meteorologist can never guarantee a weather forecast, a technical analyst can never be perfectly certain of future price movements since human behavior is involved.

Figuring out the what and when…

All investors are faced with three basic questions with their investments. What to invest in, when to buy and when to sell. Technical analysis provides a framework for investors to methodically select equities and pick times to buy and sell. Emotion, the investor’s nemesis, is greatly reduced in these decisions since the investor can develop a list of ‘what and when’ rules to follow. Rather than ‘buying and hoping for the best’, technical analysts always know how much risk they are taking and know when to ‘get out while the getting is good’.

Only price and volume only…

Only historical price and volume data is used for technical analysis. The underlying premise of technical analysis is that all known information such as what a company does, its financial results, analyst’s ratings, management performance, politics, news, etc. are reflected in the historical price and volume data. This is a powerful concept since it is impossible to gage how these factors may influence future price separately.

It is important to understand technical analysis can only be used to determine the likely direction of future prices. It cannot anticipate news events or how investors will respond to them.

The Goal of Technical Analysis

The graph above is a historical price chart for the company Analog Devices, Inc., ticker symbol ADI. The line represents the price of ADI over a period of a year. The price chart illustrates how prices can move up, down or sideways for months at a time. Technical analysis uses methodologies to help indicate when prices are beginning to change direction. The goal of a technical analyst is to buy an equity when the price chart indicates prices are beginning to move up and then sell when the price chart indicates prices are beginning to move sideways or down.

Why Technical Analysis Works

Technical analysis works because price and volume often reveal the collective psychology (the “fear/greed balance”) of a market’s participants. Technical charts can reveal changes in the fear/greed balance soon after those changes occur and that provides opportunities for profitable trades. Technical analysts work to identify charts where the fear/greed balance has recently changed in a predictable manner. They then place trades to try and profit from that change. Once they have bought a stock, technical analysts monitor price and volume for sell signals. Done correctly, trades based on technical analysis carry a higher than average chance of success but disciplined money management techniques must still be used to guard against unforeseen price movements.

Misuse of Technical Analysis

While the basics of technical analysis are easy to learn, applying them correctly and successfully isn’t easy. Because of this many people have lost money using technical analysis techniques and then concluded that chart analysis has no value. In addition, unfortunately, many unsuspecting investors have purchased technical “systems” that promise outlandish returns for little effort. By the time the buyer figures out that the system doesn’t work, their money is long gone.

Technical analysis is just like any other money making occupation – it takes time and energy and it involves risk. Anybody who says otherwise shouldn’t be trusted. Here are ways technical analysis has been misused in the past:

The Holy Grail mentality…

One of the most common misconceptions about technical analysis is that a trading system (a set of buy and sell rules) can be devised that provides consistent profits with little to no risk.

There are several reasons that a ‘perfect system’ cannot be sustained. Firstly, the market is made up of people with free will and guided by fear and greed. A perfect system requires prices to consistently move in predictable patterns. This will never be possible when people are involved. Secondly, many financial institutions monitor the market for patterns of systematic trading. Once detected, the financial institution can take advantage of the system (investing with or against it) which eventually compromises and defeats the ‘perfect system’. And finally, what motivation could someone have to share a ‘perfect system’ at any price? Such a system would be invaluable to one person but worthless (for the second reason) if too many people or even one institution discovered it.

Just tell me what to buy…

Investment charlatans and gurus have always been offering advice how to profit in the market. These are the people who take financial advantage of new and uninformed investors by promising quick and profitable investment success. Claims of ultra-high rates of return or knowledge of future events for substantial fees are the best ways to identify such schemers.

Although a real guru is a spiritual guide or teacher, the title ‘Market Guru’ is gladly accepted by advisors who have developed notoriety with fortuitous calls of major market changes or unusual approaches to investing. Today’s TV media and Internet enthrone new market gurus on a regular basis. There are precious few true market gurus like Warren Buffet who have proven their market savvy over decades. Most market gurus can only provide profitable guidance as long as the market is favoring their investment philosophy. As the market changes, new market gurus will emerge as their philosophies’ agree with the new market dynamics.

Technical Analysis lets me control the market…

While few people consciously believe that they can control a stock’s price directly, subconsciously, chart analysis can give new investors a false sense of control which will cause them to lose objectivity. “My stock just broke below my trendline today, but it will come back tomorrow since that is a really good trendline!”

The opposite response is just as damaging – “My stock broke my trendline! T/A is worthless!” Both responses are driven by emotion, something that technical analysis strives to eliminate.

Next time, we'll take a critical look at the assumptions that Technical Analysis makes about the markets.

TECHNICAL ANALYSIS 101 - PART 1

This is the first part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy!

Defining Technical Analysis

Technical analysis is the study of price and volume changes over time. Technical analysis usually involves the use of financial charts to help study these changes. Any person who analyzes financial charts can be called a Technical Analyst.

Despite being surrounded with data, charts, raw numbers, mathematical formulas, etc., technical analysts are really studying human behavior - specifically the behavior of crowds with respect to fear and greed. All of the investors that have any kind of interest in a particular stock can be considered to be "the market" for that particular stock and the emotional state of those investors is what determines the price for that stock. If more investors feel the stock will rise, it will! If more feel that the stock will fall, then fall it will. Thus, a stock's price change over time is the most accurate record of the emotional state - the fear and the greed - of the market for that stock and thus, technical analysis is, at its core, a study of crowd behavior.

"Weathering" the Market

When was the last time you saw a 100% accurate weather forecast for your area? Chances are that at least some of the weather predictions your local weather person tells you won't come to pass. In many cases, most of the predictions are wrong. So why do we keep listening to weather forecasts?

Weather forecasts are useful because they help us prepare for what is likely. If the forecast calls for rain, we bring our umbrellas with us when we go out. If sunshine is predicted, we bring our sunglasses. We know that we might not need these things, but more than likely we will and we like to be prepared.

Technical analysis is very similar to weather forecasting. Good technical analysts know that T/A can prepare you for what is likely to happen but, just like many weather forecasts, things can change in unpredictable ways. Here are some other ways that technical analysis is like weather forecasting:

• Weather forecasters measure temperature and air pressure and then use that data to determine more about the factors that cause weather changes - i.e., fronts, high pressure, low pressure, etc. Technical analysts use price and volume to determine more about the factors that cause market changes - i.e. fear and greed, trends, reversals, support, etc.
• Despite huge quantities of weather data at their disposal, weather forecasters still use their experience and intuition when creating each forecast. Technical analysis also draws heavily from the experience and intuition of the person doing the analysis (you!).
• Accurate weather forecasting requires local knowledge and experience. A forecaster from Florida that moves to Alaska will need time to become familiar with Alaska's weather patterns. Similarly, technical analysis requires experience and knowledge about the kinds of markets being charted - stocks are different from commodities which are different from mutual funds, large stocks are different from small stocks, etc.
• In the early days of weather forecasting, charlatans tried to convince people that they could somehow control the weather or that their predictions where always accurate. Unfortunately, even today, you can find people making similar claims about technical analysis.
• Weather forecasts tend to be most accurate when things aren't changing. If it has been sunny for the past three days and no big weather systems are approaching, chances are it will be sunny again today. Technical analysis also works well when conditions aren't changing dramatically. Both disciplines have more trouble with predicting exactly when big changes will occur.
• Both weather forecasting and technical analysis work well for the "mid-sized view." While predicting the weather for a large city is possible, predicting things for a city block is very hard. Similarly, second-by-second technical analysis can be extremely tricky; daily and weekly analysis is more reliable. Conversely, predicting weather for the country as a whole (i.e., "It will be sunny in the US today") and predicting the market as a whole (i.e., "This year stocks will go up") are too broad to be useful.

It is easy to lose perspective on what technical analysis can and cannot do. Try to remember this comparison with weather forecasting to keep yourself aware of its benefits and limitations.

Next time, we'll look at the real goal of Technical Analysis, why it works, and how it can be misused.