Tag Archives: technical analysis

Support & Resistance

Posted on 29. Jul, 2011 by .

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Support and Resistance are two of the most closely watched and utilized technical indicators. Although difficult at times, identification of these key indicators is an essential ingredient to succesful technical analysis and even being aware of their existence and location can greatly improve your forecasting and analyzing abilities. Both are price levels at which either supply or demand for a security is often perceived greater than the other and this in turn can affect the movement of that security.

Support: is the price level at which demand is thought to be great enough to prevent the price from declining any further because as the price of the sock is getting cheaper buyers are more inclined to buy and sellers are less inclined to sell.  Support is determined by drawing a line connecting the low points (the valleys) on a stock chart.  As a stock price declines, investors are mindful of these prior price reversals.  It’s almost as if there was some kind of price memory inherent in a stock.  Perhaps there is.  Human behavior follows certain predictable patterns much like memory metal.

Resistance: is the price level at which supply is thought to be strong enough to keep the price from rising any further because as the stock gets more expensive buyers are less inclined to buy and sellers are more inclined to sell.  It’s the reverse of the phenomenon noted above.   Resistance is determined by drawing a line connecting the high points (the peaks) of the stock price.  Stock price action exhibits common behavior of struggling to exceed the peak price.  Often times this market action is interpreted as unhappy buyers who bought near the top are waiting to get even and shed the stock. 

 

When the price of the security is approaching an important support level, it can be an alert to watch for extra buying power and potential reversal. And when the price is approaching an important resistance level you need to watch for extra selling. Keep in mind that the price may briefly go beyond your established support and resistance levels so it is a good idea to have a price “zone” rather than a specific level. Once these “zones” are broken than you will need to set a new one because the relationship between supply and demand has been altered. Broken support levels often times become the new resistance levels and vice-versa.

Often times stocks will exaggerate their movement at these key junctions.  In fact you can make a logical argument that buying a stock after it makes new highs is the best time.  After all the great winners of the past ALL made many new highs by definition.  This style of investing is often associated with “momentum investing”.  You will often see a sudden spurt in volume and quick price appreciation when stocks “break out”.  There are numerous stock screens designed to rapidly pick out in real-time this price behavior although it may be a better strategy to trade against this behavior and short them.  Following crowd behavior is usually the wrong thing to do.

 

Moving Averages can also be helpful when used along with support and resistance. The moving average is simply a line chart that shows the average value of a security over a series of periods. They do not predict the price direction, rather they define the current direction with a lag, because they are based off of past prices.

Moving averages can act as both support and resistance when price approaches them. But unlike regular support and resistance levels, they do not remain at one stationary level and can also move on your chart. Simple averages help form the building blocks to many other technical indicators and are great for helping define potential stationary support and resistance levels as well because they act as a barrier where prices have already been tested.

I often compare moving averages to sign posts along the road.  If you are driving at 55 mph and you enter a speed zone marked 20-mph, traffic comes to a sudden crawl. Why is this?  Of course the answer is simple. Predictable crowd behavior.   Technical analysis is as much about human behavior as price patterns.  There are many well-known technical indicators that Chartists follow but most of them are too esoteric and practiced by few traders.  The two that are universal are moving averages and support/resistance.  These are the sign posts everyone is seeing.

But a moving average can be any number of days, months, weeks, etc that fit into your formula.  If you are asking how do you know which one works, you are missing the point.  None of these integers work.  Just because you divined some price pattern that held up to backtesting doesn’t mean anything.   It’s not the predictive nature of your moving chart that is important.  It’s just the simple fact that others are looking at the sign posts along the way.  And the signs that most people are looking at are the 50 and 200 day moving averages.  So that’s what we watch.

So just like support and resistance that we talked about earlier, stock price exhibit short-term predictable responses at the 50 day and 200 day moving average lines.   These lines drawn by the computer become support and resistance lines just like the lines drawn from peak to peaks and valley to valleys.

Although you should never make a call simply on what a technical indicator is telling you, having an understanding of these simple concepts can greatly improve your analysis of a security. To learn more about technical analysis please review our Investment Survival Guide, or click here:

http://saxangle.com/help-menu-aka-the-investment-survival-guide/technical-analysis-that-works/

Coles and Hawkins, MIDAS Technical Analysis

Posted on 18. Jun, 2011 by .

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Coles and Hawkins, MIDAS Technical Analysis

Anyone who trades using technical analysis would do well to read MIDAS Technical Analysis: A VWAP Approach to Trading and Investing in Today’s Markets (Bloomberg/Wiley, 2011) by Andrew Coles and David G. Hawkins. It’s not that the MIDAS method, pioneered by Paul Levine in 1995, is the holy grail. I recommend the book because the authors have done such a thorough job of explaining and, after extensive research, expanding on the notion of volume-weighted support and resistance curves. In the process they touch on a wide range of technical approaches to the market, some of which I suspect will be unfamiliar to the majority of readers. 

Coles and Hawkins, like so many who end up in technical analysis and trading, have academic backgrounds. Coles earned a Ph.D. from the University of London with a dissertation on biological themes in philosophy and medicine in ancient Greece. Hawkins has an M.S. in physics from Brown and taught at the university level. And the original developer of MIDAS was a theoretical physicist with a Ph.D. from Caltech. “Overeducation” can sometimes result in overthinking a problem. Midas Technical Analysis exhibits its fair share of overthinking, but that doesn’t mean that it’s merely a theoretical study. Far from it.

The MIDAS method was a development of or variation on VWAP (volume weighted average price). First, Levine modified the original VWAP formula. Second, he thought it important to anchor his support and resistance curves at a point where there was a change in the underlying psychology. That is, “instead of ‘moving’ averages, one should take fixed or ‘anchored’ averages, where the anchoring point is the point of trend reversal.” (p. 11) And third, he believed the markets to be fractal.

Coles and Hawkins start from the basic MIDAS premises, but they set out to develop a full trading system, not just a forecasting method. The two authors work on different time horizons: whereas Coles trades intraday, Hawkins focuses on longer-term charts. And they presumably have different interests as well. So each chapter in the book has a single author.

The chapters cover a broad range of topics. For example, MIDAS curves and day trading; applying the topfinder/bottomfinder to investor timeframes; equivolume, MIDAS, and float analysis; standard and calibrated curves; MIDAS and FX; MIDAS and the Commitments of Traders report; a MIDAS displacement channel for congested markets; and MIDAS and standard deviation bands. Appendixed to the text is MetaStock code for the standard MIDAS S/R curves and TradeStation code for the MIDAS topfinder/bottomfinder curves.

The trading plan the authors present is discretionary. There are no hard-and-fast buy and sell rules, though Hawkins offers a set of directions. Judgment is required throughout: for instance, where to anchor a curve, how to interpret multiple timeframe curves, and what kinds of market data to consider in addition to what’s on the chart.

In this more than 400-page book Coles and Hawkins take the reader down highways and byways, describing the scenery all along the way. Some of scenery is Kansanian (with due apologies to any readers from Kansas), but much is intriguing. The book is, to shift metaphors, definitely several cuts above the standard technical analysis fare.

 

Divergence- the best technical indicator

Posted on 26. May, 2011 by .

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Divergence

A divergence is a move in the price of an asset not confirmed by a comparable move in the applied technical indicator. For example, a bullish divergence exists when a market reaches a new low without the indicator reaching a corresponding new low. Conversely, a bearish divergence exists when a market reaches a new high without the indicator reaching a corresponding new high.

In my opinion, divergence is the most predictive of all the indicators. It will be early more often than not. Early can be very painful. A popular stock market tidbit of wisdom reads like this: “What’s the difference between being early and wrong? None.”

That being said let me show you how I interpret divergence. First of all I only look at a version of Wilder’s relative strength index when I’m examining divergence. Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. Before we get too far into this, let’s rehash the popular version of what this indicator does because I dont’ use it in the way most people do.

Relative Strength Index 14-period

The RSI is presented on a graph above or below the price chart. The indicator has an upper line, typically at 70, a lower line at 30, and a dashed mid-line at 50. Wilder believed that when price moves up very rapidly, at some point it is considered over-bought. Likewise, when price falls very rapidly, at some point it is considered oversold. In either case, Wilder deemed a reaction or reversal imminent.

The level of the RSI is a measure of the stock’s recent trading strength. The slope of the RSI is directly proportional to the velocity of a change in the trend. The distance traveled by the RSI is proportional to the magnitude of the move.

Wilder believed that tops and bottoms are indicated when RSI goes above 70 or drops below 30. Traditionally, RSI readings greater than the 70 level are considered to be in overbought territory, and RSI readings lower than the 30 level are considered to be in oversold territory. In between the 30 and 70 level is considered neutral, with the 50 level a sign of no trend. For those of you that want a formula and further explanation of how Wilder’s RSI is calculated and graphed, please click on this excellent explanation from StockCharts.com.

So as an oscillator, I pay no attention at all to this theory. I dont’ believe very much in oscillators in general although I use popular ones like stochastic in my charts every day. More on that later but let me say you should know and recognize what other people see when they read charts. You dont’ have to believe in Christianity or Islam to know that millions do.

Divergence

What appears to work well for me is that Wilder further believed that divergence between RSI and price action is a very strong indication that a market turning point is imminent. Bearish divergence occurs when price makes a new high but the RSI makes a lower high, thus failing to confirm. Bullish divergence occurs when price makes a new low but RSI makes a higher low. Let me illustrate how this works with this chart of Apple Computer. I use TradeStation’s popular charting software and a proprietary version of Wilder’s RSI that I had coded in their programming language, Easy Language.

An eighty point move foretold somewhat by divergence
Wilder’s RSI divergence on Apple

As you can see, in this screen capture and the accompanying video,Apple Computer stock appears to be range bound for several months between April 2010 and August 2010. Then on August 25, and then again on August 27th my indicator fired off a green dot indicating divergence. It fired off a very early green paint sign a month earlier that created brief profits before being reversed. As you can see from the chart, there is a very dramatic divergence between the price action which is still trending down or flat and Wilder’s RSI which is beginning to rocket up. This is a very clear divergence and led to a dramatic 80 point rise in the stock before exhausting itself. This is a classic bullish divergence.

Starting though around October 18th, Apple begins to show dramatic bearish divergence. This was an early warning for traders to exit or even short sell the stock. Although I wouldn’t want to short a stock with such obvious good prospects. At a minimum Apple was dead money for a month or so after this signal.

Expanding the chart to view the price action in 2011, shows two more divergences. Another bearish one and then a positive one. Actually there are several bearish red dots but like I mentioned earlier, this proprietary indicator I had coded is not perfect. Although I had it programmed to fire off buys and sells automatically, it never proved accurate enough to do that. I still have to see the chart and analyze multiple factors before I make a decision on buying or selling. I tend to only use the red and green dots (known as paints in the TradeStation platform) as a tool to grab my attention. What I really focus on is the trend of the Wilder’s RSI line. It is it diverging from the price action?

Wilder's RSI trending down
Diverging Wilder RSI line portends sell off
This video illustrates the divergence


As you can see when Apple topped out on March 7th, its RSI line had already turned down. This was a classic bearish divergence. Then for the first time on April 15th and April 18th, Apple showed clear bullish divergence both in the RSI line and on my indicator with positive green posts. In fact I blogged about this widely and Apple rewarded me with a quick 20-30 point gain depending on when you entered. And what has Apple done lately? It’s not a pretty picture if you are long at the moment. I’m not of course because my charts have taken me out.

A couple important points to remember:

  1. The period you set your indicators too will have a tremendous impact on your outcomes.   I for one use a short period on the Wilder’s RSI indicator (just seven days).  I’ve found that’s what works best for me with my style of investing.  Others may find better results with different periods.  Wilder himself suggested a 14 day average to begin the calculations.   Also I use daily charts.  Weekly charts, monthly charts or even 2 minute charts will all likely have very different results.
  2. RSI divergence as do most oscillator type indicators work best in markets that are going up and down or range bound.  Stocks that are breaking out or breaking down can trend in a particular direction for longer periods of time and make these types of indicators less useful.  Technical analysis when used for profitable gain,  is just one piece of the picture.  A slight edge in investing can yield enormous results.   Dont’ fall victim to the dogma that all known and future expectations are already revealed by the stock’s chart.  One piece of news can often blow apart the prettiest of chart patterns.

Technical Analysis that Works

Posted on 25. May, 2011 by .

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“You see I can predict this stock went down!”

 

I’ve read a great deal on technical analysis and spent a great deal more time testing various indicators, programs, backtesting, and attending seminars on the subject.  At first I thought I would write a piece with a top down view and summarize the major indicators in use today.  I’ve hesitated and even anguished over doing that for a couple of reasons:  But first let’s set the discussion by quoting Wikipedia’s succinct definition:

“Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.[1] Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands in contradiction to much of modern portfolio theory. The efficacy of technical analysis is disputed by efficient-market hypothesis since stock market prices are essentially unpredictable.”

I decided against writing a summary of technical analysis.  First of all-others have already done it.  And far better than I could.   Check out John Murphy’s Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications.  TradeStation’s own dictionary of technical analysis technical indicators is an incredible online help platform that provides a brief explanation of each indicator. It doesn’t go into the formulas that calculate them but provides illustrations of how they look and work in their particular platform.    One of the true marvels of computing is that complex math formulas can review years of daily data of the high, low, close prices of stocks and render instant plots of whatever you can dream of.  This was one of the first incredible usages of personal computers probably right behind spreadsheets, word processors, and data bases.  But the bigger question is does technical analysis work?

Technical Analysis is Always Right until its Wrong

Does it predict future price movement?  Does technical analysis work? You would think that a discipline so heavily dependent on math and computers would have a simple answer to this question.  For several months I routinely and religiously ran a program that optimized dozens of technical indicators against the universe of S&P 500 stocks.  I was trying to determine which indicators tracked better.  Do some technical indicators work better than others?  I think most technicians would say yes without hesitation.  But if you believe that,  rephrasing the question is another way of asking if technical analysis works at all?  After all if some indicators dont’ work better than others, perhaps none of them work at all.  If some indicators can predict future price movement better than others, then technical analysis works, right?

Not exactly.

So for the sake of argument, let’s say that some indicators work better than others.  If you believe that then there are lots of shelf software out there that can scan historic price action, backtest an indicator, and provide you with comparison reports. I know of only one though that can backtest dozens of indicators against a common stock or index.   For example, I know Metastock can do that.  I used it for quite some time, religiously running the entire S&P 500 against their universe of technical indicators and many third-party add-ons.  Astoundingly enough many stocks showed reliable patterns. Some indicators DID work better than others.  There was no doubt about it.  It was quantifiable, repeatable, and visible right in front of your face.

But really what does that mean?  As I found out the hard way, just because an indicator worked well for some period of time, there was no assurance that it would continue to work well.  If you are using raw computer power to find patterns, you will.  There is no doubt about that.  Life is full of patterns.  But I found no real evidence that running Metastock’s indicators would work in the future.  Some indicators worked better than others on certain stocks until they didn’t.  My proof was my money line.  It wasn’t growing.   If you could go back in the past and buy or sell securities, I would be all over it but you can’t. You can only buy or sell now or sometime in the future. When someone comes up with a future testing solution, I’ll listen. I don’t buy the premise that backtesting is any kind of reliable indicator of the accuracy of a technical indicator or strategy for the future.

A broken clock is right twice per day and we all know that’s worthless.   But I do believe completely in technical analysis.  It’s just that most of the indicators are worthless in my opinion.    So instead I’ve come up with a preferable solution.  I’m only going to talk about the ones that  either have some predictive ability or provide some trading advantage.  The ones that work.

Next - Divergence My Favorite Technical Indicator

13 Stock Chart Patterns That You Can’t Afford To Forget

Posted on 23. May, 2011 by .

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By Kirk Du Plessis

Chart patterns play a critical role in usefulness technical analysis. Chart patterns are a result of human nature and trading psychology. If you can learn to recognize patterns early you can also learn to profit from breakouts and reversals.

As you all know I’m a big fan of technical analysis and chart patterns are very powerful for any trader.

Why Are They So Important?

Simply put, chart patterns are just a series of price action that occurs in a stocks trading. These can happen on any time frame really; monthly, weekly, daily and intra-day. The great thing about chart patterns is that they repeat themselves over and over again. Human psychology and investor emotional cycles never fade. The markets change but human emotion does not!

So if you can learn to recognize these patterns early, you will gain a real competitive advantage in the markets. Just as volume, support and resistance levels, RSI, and Fibonacci Retracements can help your technical analysis trading, chart patterns can help identify trend reversals and continuations.

Print This Out So You Won’t Forget!

Click the print button right now and keep this article by your desk. I promise it will be a huge help in the coming weeks and months. Just having them in your face each and every day will subconsciously help you learn to recognize them in live trading.

1. Pennant

2. Cup And Handle

3. Ascending Triangle

4. Triple Bottom

5. Descending Triangle

6. Inverse Head And Shoulders

7. Bullish Symmetric Triangle

8. Rounding Bottom

9. Flag Continuation

10. Double Top

11. Bearish Symmetric Triangle

12. Falling Wedge

13. Head And Shoulders Top

14. Did I Forget Your Favorite Pattern?

Add your comments below and let me know what patterns you like to trade besides the 13 above. There are many more stock chart patterns out there, but these will just get you started

*Kirk only reads comments posted on his blog*

By Kirk Du Plessis

The Stop-Loss Myth

Posted on 23. May, 2011 by .

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I’m sure everyone has been presented with the following logic: put in a ‘stop-loss’ at some arbitrary amount, say losing 1%. Then, your payoff distribution is tilted towards infinity, as shown above. It’s like the idea of going to Vegas, and saying you will stop when you lose $500, so you think that you still have an equal chance of generating those +$500 and up numbers, and the bad outcomes are just truncated at -$500. Alas, it doesn’t work like the graphs above. Instead, it generates the graph below, with a lot of probability mass at the stop-loss point:


From a nice little paper by Detko, Ma and Morito (2008).

 By EFalken

Stock Price Gaps – Why They Happen And How To Trade Them

Posted on 17. May, 2011 by .

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By Kirk Du Plessis

Beginning traders were probably shocked the first time they experienced a stock price gap. I guess even the most experienced traders still get taken back when there is an unexpected stock price gap in a stock they are trading. Either way I wanted to cover once again why they happen and what you can do (if anything) to trade them.

It Happens When The Market Is Closed

Nearly all stock price gaps happen in pre market trading or during after hours trading. Call them Black Swans if you want since they seemingly come when you least expect it.

Generally speaking gaps are rare for the normal stock. Most mutual funds, ETF’s, and other illiquid assets actually gap more frequently which make the gaps less important.

How The Actual Price Gap Is Created

A price gap is created when a stock closes at say $91.50 (as AAPL did below) for the day which is at 4:00 PM EST and then the next day opens dramatically higher or lower than it’s previous closing price of $91.50.

(more…)

One piece of news trumps charts

Posted on 04. Feb, 2011 by .

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Some chartists believe that all known events are already reflected in the price patterns in the chart. They spend a lot of time trying to divine MA crossovers, MACD, Stochastics, Resistance Support lines and many more technical indicators. I too believe strongly in technical analysis but of course equally strongly that one piece of news trumps charts. This chart of Dolby is a a perfect example of this. The company looked like it was poised for a bounce. It was oversold, the RSI was diverging clearly heading in a positive direction while the price action was settling out. Then came the earnings. Chart patterns were blown apart.