Technicals Revisited [BRIEFING.COM - Jim Schroeder] Have we begun a new bull market or have the gains been merely corrective in nature? If we haven't transitioned from bear to bull yet, at what levels can we finally proclaim an end to the bear market? Do I buy XYZ stock as it approaches key resistance, or wait for a confirmed break out? In order to answer these questions, it helps to have an understanding of technical analysis. Consequently, today we provide a Brief refresher course on how to use technical tools in your day-to-day trading.
Trends
The objective of technical analysis is not to replace fundament research. Instead, it is best put to use once you have completed your due diligence. This type of analysis can increase your confidence by confirming your fundamental opinion of a stock as well as assit you in determining timely enter and exit points. The first step is to determine the overall trend. While this sounds simple enough, fact is that the long-term investor (holding for years), position trader (for several weeks or months) and short-term trader (day trader looking for quick hits), are likely to interpret trends differently. Nevertheless, basic methods for determining the underlying trend include the MACD (Moving Average Convergence Divergence), trendlines/channels and moving averages. We will spare you the detailed explanation of calculating the indicators as technical packages are readily available. There are simple and exponential moving averages with the latter helping to smooth the particular average. Trends are established when your short, intermediate and longer term averages are moving in the same direction. The 10, 50, 100 and 200 day averages are often used. MACD is the interaction between two moving averages and can vacillate above or below its zero line. A bullish signal occurs when the shorter averages crosses above the longer while both are above the zero line and headed higher together. Trendlines are drawn off a series of highs or lows (usually 3 to be considered valid) that contains all the action. A channel is formed by merely taking a line parallel to the trendline so that all the highs or lows are within.
Indicators
Once you are comfortable with your trend, indicators such as a stochastic, RSI or ROC (rate of change) can be used to help determine if the current trend has legs or is running out of steam. The first two compare the current price of a stock over a specific period of time. The indicators move between 0 and 100 with overbought typically marked by a reading above 70 or 80 (trader preference), while oversold territory is considered below 30 or 20. These indicators can give early warning that the longer term trend is in trouble. The best signals are generated when a divergence develops. This occurs when the stock price moves to a higher high while the indicator establishes a lower high while in overbought territory (or the opposite in a downtrend) and it then moves below the overbought level. As long as the underlying trend is still intact (trendlines not broken, MACD still headed in the same direction) the indicators can be used to time your trade in the direction of the trend once they would reach the opposite extreme reading (oversold on an uptrend). Penetration of your trendline or a bear signal from the MACD suggests that patience and further research are needed to determine if the underlying trend will resume. ROC studies are a way to measure the strength of the move. A slowing or a decline in the rate of change of the moves from day to day implies that the move is weakening. While a stock may be in a firm uptrend, an overbought stochastic and a weakening ROC suggests that a shorter term top may be nearing which could present a better buying opportunity while your trend indications are intact.
Support & Resistance
These are simply levels that a stock or index may have trouble penetrating. In an uptrend it would be where the demand for a stock overcomes supply. Supports can be found at a rising trendline, moving average or a previous low before the advance resumed. Retracements are also popular and represent a percentage reversal of a specific move. Some prefer using 66%, 50% and 33%, others use Fibonacci retracements which are 62%, 50% and 38%. The best levels are typically a combination of several of the above. An ideal situation in an uptrend would be to see a stock stymied by a support level while the stochastic or RSI indicators begin to rotate higher out of oversold territory.
Breakouts
Assuming that you have a good feel for a particular stock in terms of the overall trend, how can technical analysis be used to help enter, add to or exit a position? As an example, XYZ has begun to consolidate within a limited range after an extended advance. No damage has been done to the underlying bias so an investor is looking for an opportunity to enter on the long side. Three options are available. The first is to enter in anticipation of breakout. The investor is able get a lower point of entry but there is a higher probability of a loss being sustained even if the trend is not altered as a more extensive correction could be underway. The second option is to enter on a breakout (preferably on strong volume). While this increases the odds of a successful trade the penalty is a higher entry price. The third option is to watch for a pullback after the breakout. The problem using this more conservative method is that the stock may run too far too fast after the break and ultimately not present a good opportunity to enter. The key is to have flexibility and not use just one method to enter but a combination of them to take your full position. In this example, if confidence is high of a short term resumption, you might consider entering prior to the break and adding on, or pyramiding, your position following the breakout.
Trendlines/Stops
Trading with the use of trendlines, whether using a daily or an intraday chart, can be very useful in establishing an early entry point for a trade based on a penetration. An important key is to have confirmation from other aspects of your technical analysis. By the same token, these lines can also be used for entry points when they hold firm (on a pullback), again with confirmation. Stops are a classic money management tool to limit losses when the market moves against your position and are best used at, or slightly beyond, a key floor or ceiling. Depending on the overall volatility of the market or if you are dealing with a stock that can move significantly on an intraday basis, looser reins will be required to prevent a premature exit. While the flexibility mentioned above can ease the pain when the trade goes against you, other technicals such as the momentum indicators, moving averages or pattern analysis can raise confidence of success.
Conclusion
This represents merely a small sample of technical analysis and the potential ways that it can be used. Understandably this type of research/analysis is not for all, as many investors prefer a purely fundamental approach. However, as with technical analysis itself, research that encompasses a broader body of complementary work will raise the probability that the investment decision is the correct one.
Jim Schroeder, Briefing.com |
