Q & A
So how does all this technical analysis stuff actually work?
Technical analysis is the study of share price charts in an attempt to predict the future direction of
But how on earth can you predict such a thing by looking at a chart, which just shows you the past movements of the share price?
Sometimes you can’t. Sometimes a chart tells you nothing either because there is no discernable trend or you can see from its history that the most commonly used techniques in technical analysis would not have worked for that stock. However, there are many occasions when a chart can provide very strong indicators as to the likely future direction of the share price...
The best example that I can think of is when there is a resistance level for the shares. That means that there is a certain price level on the upside that the shares have attempted to ‘break through’ (i.e. rise above) on several occasions but have failed to do so.
And how does that work?
You basically assume that the resistance level will hold until such time as the stock manages to break through that level. If it does break out higher than the resistance level, you then make the assumption that it will follow a strong upward trend...
So what you are saying is that when the shares break through a resistance level, you should then buy them as they are likely to rise further?
OK. It there any evidence of that type of strategy working?
Plenty of evidence! Just have a look at any share price charts at random – you can get these on any of the free charting sites on the internet such as Yahoo Finance or Google Finance – and you will be able to spot previous resistance levels on most of them...
But surely it can’t always work, otherwise everyone would know about it and we would all be multi millionaires by buying stocks when they have broken through resistance levels?
It does not always work. And that is the tricky bit. When it does not work, you should sell the shares immediately and be prepared to suffer a small loss.
OK. So what you are saying is that when this strategy does not work, I will make a small loss but when it does work, I should make a much high profit?
Yes, exactly that.
OK. But why are so few people actually doing this?
For one very simple reason!
Lack of discipline!
In other words, investors are very reluctant to take a loss and move on...
Exactly. In my years as a broker, I dealt with thousands of clients and I could count on the fingers of one hand the number that would countenance selling out at a loss...
But what about the so called professionals, fund managers and the like...surely they have the discipline to cut losses quickly?
Fund managers have a lot of competing demands to cope with...they must sell their funds to the public, and the investing public is notorious for piling in at the top. So your typical fund manager is managing a lot of money at the top of the market and very little at the bottom...
I guess it is difficult for stockbrokers to sell the concept of technical analysis to their clients, especially when it means saying things like: ‘Sell that stock! It is trading at $49 and there is a resistance level at $50.’ Then if it breaks through the resistance level at $50, and trades at $51, they should say: ‘Buy that stock! It has broken through the resistance level at $50.’
The client is likely to say: ‘What! Are you crazy! You told me to sell it at $49! Now you are telling
me to buy back in at $51!’
I think you’ve answered your own question there!
OK. So why do resistance levels happen? In other words, why do stocks have resistance levels?
There are a few possible reasons...One, is that a major shareholder could be selling out. For example, if a stock is trading at say $48.75 and a large shareholder wants to sell. He or she would often give their broker the following order: ‘Whenever the stock goes up to $50, sell as much as you can of my holding’. So a big sell order hits the market every time the stock trades at $50.
The reason why a big sell order is often done like that, is because if all of the shares were sold in one trade, it would push the price down against the seller. Let’s say the large shareholder in the above example, told his or her stockbroker to sell their entire holding ‘at best’, (also known as ‘at market’), the broker might only get something like $47.90 per share. The reason being that the $48.75 bid price you see on the screen is only available for a limited number of shares, maybe 1,000 or so. A sell order for 10,000 shares would be placed by the broker with a market maker, who would then bid a lower price for that quantity (and gradually offload these on the market during the remainder of the day, at a higher price if possible).
And what are the other reasons?
The other principal reason is investor psychology. Investors have an obsession with even numbers. For example, if a stock is trading at $85, many investors will say to themselves: ‘I will sell it if it reaches $100.’ So there will be a very large amount of stock for sale at $100, but very little stock for sale at $99, $101, $102 etc. Therefore if the stock trades at $101, it means that all of the sell orders at $100 have been taken out. There is very little stock offered for sale at $101, $102, $103 etc and
the share price then climbs rapidly when it has broken through the $100 level...
But surely that is irrational! Why would someone sell just because the price reaches $100?
Yes, it is irrational. But have a look at a chart for any share you care to mention...You will usually find resistance levels at even figures such as $50, $100 etc.
OK, the ‘resistance level’ concept might have some merit. What are the other strategies used in technical analysis?
The next strategy in technical analysis that I will explain to you, is the concept of a ‘support level’. A support level is a mirror image of a resistance level...
So if there is a support level at $50, I assume that the stock will rally every time it falls to that level. But if it breaks through that level and trades at $49, then a further fall is likely...
Yes, if it breaks through the support level at $50 and trades at $49, you should sell it.
What else have you got?
A key concept in technical analysis is that stocks often move in trends. In other words, most stocks are usually in an upward or downward trend.
So buy the stocks that are in an upward trend, and sell those that are in a downward trend?
And I guess you’re going to tell me, buy a stock that is on an upward trend and sell it when it breaks out of that upward trend. In other words, do not sell it until it goes into a downward trend...
It sounds so easy! So what’s the catch?
Sometimes it can be difficult to tell, when there is a fall in the price of a stock that has previously been on an upward trend...if that fall is merely a pull back on profit taking, which is a normal occurrence in an upward trend – or does that fall constitute the start of a downward trend...
So how do you determine that?
There are a few different techniques that you can use. Firstly, you can often draw a simple straight line upwards that connects the low points of the main pull backs in the share price. If the share price falls below that trend line, then it has broken the trend and you should sell...
And what other techniques do you have for establishing whether or not the upward trend has broken down?
By using moving averages. The most commonly used moving average is the 200 day moving average. This charts the average price level of the past 200 days and this smoothes out the price fluctuations. Most importantly, it changes direction very infrequently. So when it changes from being on an upward trend to being on a downward trend, then that is confirmation the trend has changed.
I note that you say ‘confirmation’. Is there any way of telling that the trend is about to change shortly before this actually happens?
There are a number of techniques that attempt to predict whether or not a change of trend is imminent such as the Rate of Change (ROC), Relative Strength Index (RSI), Moving Average Convergence – Divergence (MACD)...
Whoa! What are they all about?
There are different ways of calculating them. I can give you the general gist of what they indicate...Bear in mind that they are not as reliable as moving averages and one of the world’s foremost technical analysts, Martin Pring in his seminal work ‘Technical Analysis Explained’ says that one should seek confirmation that the trend has changed by using trend lines or top and bottom formations or moving averages, before you rely on such predictive indicators...
OK. Give us the gist of them anyway...
The Rate of Change (ROC) indicator assumes that a stock loses upward momentum when it is close to the top, so it seeks to indicate when the upward momentum is slowing down. The Relative Strength Index (RSI) is somewhat similar. It seeks to measure how strong the stock has performed against itself (i.e. its historical strength). Any fall in this could indicate that the price is near the top. The Moving Average Convergence-Divergence (MACD) utilises the fact that the moving averages converge when a stock has changed trend. For example, a stock that changes course from being on an upward trend to a downward trend, will have a downward sloping 50 day moving average crossing over a downward sloping 200 day moving average (known as a ‘death cross’). However, the stock will be down quite a lot from its peak by the time that happens. So the MACD attempts to predict when that will happen by indicating when the short term moving average is heading towards the long term moving average and is likely to cross it.
That all sounds fairly complicated...
You don’t really need these, in my opinion. They need to be confirmed anyway by the more basic techniques such as trend lines, top and bottom formations, and moving averages according to Pring. So if you just focus on these, you should be OK. The ROC, RSI & MACD just provide some extra evidence of a change in trend.
I understand about trend lines and moving averages. But what are top and bottom formations?
The two main top of market indicators are the ‘head and shoulders’ and the ‘double top’. The two main bottom of market indicators are the ‘reverse head and shoulders’ and the ‘double bottom’.
Head and shoulders? Good for dandruff! Sounds like you’re talking about shampoo!
How do I get started?
This web site is designed for investors seeking to start using technical analysis as a tool to assist with their decision making for buying and selling stocks.
I have used the free charts and technical analysis features that are available on Yahoo Finance and other web sites. I favour the 150 day moving average rather than the 200 day, as recommended by Stan Weinstein in his seminal work ‘Secrets for Profiting in Bull and Bear Markets’ as the former has a slightly shorter term focus than the latter. Apart from that, I have used basic trend lines and top & bottom formations, and provided a short summary of the results. Where the chart is particularly important, I have inserted a link to a copy of it for your convenience.
While I try to avoid stock market jargon as much as possible, ‘bullish’ meaning the shares are expected to rise and ‘bearish’ meaning the shares are expected to fall - are terms that are common on all articles one reads about the stock market and so are used here.