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Technical Analysis
Last week we gave you a peek at your own risk tolerance. Remember, there is no correct, or optimum level of risk tolerance. It's a very individual issue. What is important is to understand where we actually are in the mix. Further, as we gain new insights and understandings, our risk tolerance will change.
It has always been our contention that we are comfortable with what we understand. There is little comfort with the unknown. It is in this regard that we begin a series of Guideposts on Technical Analysis; what it is, what it can do for us, and how to use it. If we are to find any value in technical analysis, we must understand technical analysis. Is that a dumb & obvious statement? I hope not. Much of what passes for magic bullets in the form of some chart pattern by itself does not bring the comfort of understanding. The intent of this series will be to add understanding to the tools of the technical analyst.
Let's start with what technical analysis is. Graphics - Pictures - How we all love to see concepts. And with seeing, feel the principle involved. This could get us side-tracked into a right-brain/left-brain dialog but let it suffice that technical analysis can provide new dimensions to our understanding. Our intent then is to strengthen understanding, and with that understanding, bring greater comfort because of the reduced investment risk.
Technical analysts are lovingly called "chartists." Their most basic tool is a price chart which visibly displays price movements with respect to time. The value of a chart is that it can tell us at a glance how a stock has performed over any period of time. If it did no more than this, it would still be a top choice. But it does more, much more.
The price chart reveals buying and selling patterns found in no other way. Consider the difficulty in trying to "see" a trend, or a trend reversal, simply by reading the stock quotes in the daily financial page.
The second tool in the chartist's bag of tricks is the companion chart of the trading volume, usually plotted below the price chart. If we could boil the market down to a single phrase, it would be "supply-demand." Basic economics explains that when demand increases, relative to the supply, the price will rise. Likewise, when the supply is greater than the demand, prices will fall.
The relationship between supply and demand plays an important role in our study of rolling stocks. In fact, the channel that defines the support and resistance levels in our rollers is nothing more than an expression of the supply-demand relationship. For instance, in the figure below, we have two diagonal lines, supply and demand. The supply line shows the number of sellers willing to sell at a given price.
The demand line shows the number of buyers willing to buy at a given price. Quite simply, as the price increases, the number of buyers willing to buy at the higher prices decreases. In the chart below, resistance occurs where the price bumps the ceiling because there are no buyers willing to pay the higher price. Support occurs on the left side of the supply line where sellers are no longer willing to sell at the low prices. The position of these lines changes continually during market action, reflecting the changing opinions and expectations of investors. The chartist looks for signals in the price and volume relationships to discern the direction of the changes.
In this figure, when the price equals $23, there would be about 5 willing buyers and 17 willing sellers. Which direction do you suppose the price will move? The dynamic of free market activity is profoundly evident in this example.
Trading volume is the primary indicator of supply and demand. Used with the price charts, volume data can help us look ahead to where the price is going. If the volume is heavy when the price is rising, the rise is likely to continue. However, if the price is rising on declining volume, it will probably not continue its rise for long. It is from the combination of price and volume that all technical indicators derive their value. We must add timing to this duo since the charts are all plotted with respect to time.
Fundamental analysis tells us what a stock should be doing. Stock charts tell us what the stock is doing. This means technical analysis can be viewed as a short-cut. The chartist can analyze a stock without plowing through all the fundamental data. It is enough to say, when a price is rising, the market considers its fundamentals bullish. The chartist does not care what those fundamentals are.
The chartist utilizes Price, Volume and Time to look at three basic patterns:
- Correlation between price and volume activity.
- The direction of price movement (rising or falling).
- Support and resistance levels (the prices where the pattern changes direction).
A group of technical indicators tell us the status of these three patterns. This series of Guideposts will cover these important indicators.
The most important principle that guides this study of market activity is termed momentum. We were taught the principle of inertia early, first defined by Sir Isaac Newton over 300 years ago, which says that a body will continue in its present state of motion unless acted upon by some external force. As we drive down the road and turn to the left, the force of inertia will move us to the right. We'll turn with the car because the force of the turning auto becomes that external force to change our direction. This is Newton's first law of motion.
In the market this principle remains valid and is termed momentum. Each indicator utilizes the principle of momentum to help explain both what the price movement has been and what it is likely to be.
April 23 - Trends [Moving averages, Lagging indicators]
April 30 - Trading bands, Bollinger Bands, Dow Theory
May 7 - Oscillators [Leading indicators] A price chart tells us whether prices are rising or falling. An oscillator tells us more about the momentum, or pace, of the stock or market. An oscillator also tells us the rate (also called rate of change) at which a market is rising or falling. This tells us if the current trend is gaining or losing momentum. The slowing of momentum may not show up in the price chart.
May 14 - Wilder's relative strength index (RSI) Divergences, Convergences
May 21 - Stochastics, MACD, On Balance Volume (OBV)
May 28 - TC-2000 proprietary indicators (BOP, MS, TSV)
We believe you will enjoy and understand this series.
Understanding :
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