General Steps to Technical Evaluation
Many technicians employ a top-down approach that begins with
broad-based macro analysis. The larger parts are then broken down to
base the final step on a more focused/micro perspective. Such an
analysis might involve three steps:
- Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
- Sector analysis to identify the strongest and weakest groups within the broader market.
- Individual stock analysis to identify the strongest and weakest stocks within select groups.
Chart Analysis
Technical analysis can be as complex or as simple as you want it. The
example below represents a simplified version. Since we are interested
in buying stocks, the focus will be on spotting bullish situations.
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.
Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.
Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
- Strength of the current trend.
- Maturity or stage of current trend.
- Reward to risk ratio of a new position.
- Potential entry levels for new long position.
Top-Down Technical Analysis
For each segment (market, sector and stock), an investor would analyze
long-term and short-term charts to find those that meet specific
criteria. Analysis will first consider the market in general, perhaps
the S&P 500. If the broader market were considered to be in bullish
mode, analysis would proceed to a selection of sector charts. Those
sectors that show the most promise would be singled out for individual
stock analysis. Once the sector list is narrowed to 3-4 industry groups,
individual stock selection can begin. With a selection of 10-20 stock
charts from each industry, a selection of 3-4 of the most promising
stocks in each group can be made. How many stocks or industry groups
make the final cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which
to choose. These stocks could even be broken down further to find the
3-4 of the strongest of the strong.
Strengths of Technical Analysis
Focus on Price
If the objective is to predict the future price, then it makes sense to
focus on price movements. Price movements usually precede fundamental
developments. By focusing on price action, technicians are automatically
focusing on the future. The market is thought of as a leading indicator
and generally leads the economy by 6 to 9 months. To keep pace with the
market, it makes sense to look directly at the price movements. More
often than not, change is a subtle beast. Even though the market is
prone to sudden knee-jerk reactions, hints usually develop before
significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, Demand, and Price Action
Many technicians use the open, high, low and close when analyzing the
price action of a security. There is information to be gleaned from each
bit of information. Separately, these will not be able to tell much.
However, taken together, the open, high, low and close reflect forces of
supply and demand.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
Support/Resistance
Simple chart analysis can help identify support and resistance levels.
These are usually marked by periods of congestion (trading range) where
the prices move within a confined range for an extended period, telling
us that the forces of supply and demand are deadlocked. When prices move
out of the trading range, it signals that either supply or demand has
started to get the upper hand. If prices move above the upper band of
the trading range, then demand is winning. If prices move below the
lower band, then supply is winning.
Pictorial Price History
Even if you are a tried and true fundamental analyst, a price chart can
offer plenty of valuable information. The price chart is an easy to
read historical account of a security's price movement over a period of
time. Charts are much easier to read than a table of numbers. On most
stock charts, volume bars are displayed at the bottom. With this
historical picture, it is easy to identify the following:
- Reactions prior to and after important events.
- Past and present volatility.
- Historical volume or trading levels.
- Relative strength of a stock versus the overall market.
Assist with Entry Point
Technical analysis can help with timing a proper entry point. Some
analysts use fundamental analysis to decide what to buy and technical
analysis to decide when to buy. It is no secret that timing can play an
important role in performance. Technical analysis can help spot demand
(support) and supply (resistance) levels as well as breakouts. Simply
waiting for a breakout above resistance or buying near support levels
can improve returns.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
