Series 7

Portfolio Management - Technical Analysis

Technical analysis is all about trends. Before reading on, we strongly recommend a review of the Technical Analysis tutorial for a quick primer:

Here is a simplified chart showing the movement of a stock price over 18 months, as well as a trend line:

Figure 12.2

Trends
Figure 12.2 is not intended to be a particularly useful chart for analytical purposes; however, it demonstrates what a trend line looks like against the day-to-day changes in a stock price. Specifically, it shows a downtrend; if the stock had started the period at $18 then risen to $22, it would show an uptrend.

One reason the trend line above is not especially useful from an analytical standpoint is that it is simply a linear, straight-arrow bullet path. In technical analysis, trend lines have to be far subtler than that. Technical analysis searches not only for trends, but also for reversals of trends.

Learn how to recognize the direction of the market within the article Short-, Intermediate- and Long-Term Trends.

Using a polynomial trend curve, a technician may see a different pattern emerge, as shown on Figure 3:

Figure 12.3

Saucer
As you can see above, the data line is exactly the same, but at this point a technician might see a saucer shape, which suggests a trend reversal. A saucer bottom indicates the stock price has reached its support level, the lowest price at which it is likely to trade, and it has nowhere to go but up. A saucer top signals exactly the opposite: the stock has reached its resistance level, the highest price at which it is likely to trade. The band between the support and resistance levels is called the trading channel.

Head and Shoulders
Another sign of a trend reversal is the head-and-shoulders pattern:

Figure 12.4

You do not need a trend line for this: the data line tells the story. The stock price glided up until it formed its first shoulder in May 2001, then it dropped off; then it surged to form a higher peak - its head - in December. It then fell off again and surged one more time - weakly - to form the second shoulder in March 2002. Technicians consider this a bearish chart. An inverted head-and-shoulders would be bullish.

Take a closer look at the head and shoulders pattern, how to spot it and when to buy in the article Price Patterns - Part 2.

Breakout
Technicians have an old saying: "The trend is your friend - 'til it comes to an end." That end is signaled by a breakout, which happens when a stock penetrates through a support or resistance level. If a stock price breaks out through a resistance level and is accompanied by higher-than-usual trading volumes, technicians consider this a bullish indicator. It means, according to technical analysis, that the stock is now looking for a new resistance level, and it may be able to continue climbing on momentum for quite some time.

Moving Average
One other type of trend line that technicians consider is the moving average, which shows changes in the average share price over a given period. Technicians believe that a stock price is likely to regress back to that average - good news to anyone who bought the stock below that line:

Figure 12.5

In this example, anyone who bought the stock in July 2001, when it was trading below its four-month moving average, would have been amply rewarded later on.

Accumulation/Distribution Line
Stock price is just one component of technical analysis. Volume is also important because, according to technicians, changes in volume precede changes in price. Right before a stock price gains, there may be a period of increased volume. One key volume indicator is the accumulation/distribution line, which identifies divergences between stock price and volume flow.
  • If the price is declining but the volume is increasing, it is a bullish sign.
  • When price gains while volumes decrease, it is bearish.
Overbought and Oversold
Technical analysis is as much an art as a science. Sometimes a stock will be trading higher than technicians can account for using their price and volume charts. They will then call the stock "overbought" rather than say "I'm wrong."

The theory is that if all investors who want to buy the stock have already bought it, then there are only sellers left in the market, and so the price must drop. Similarly, a stock that is trading lower than can be accounted for by technical analysis is said to be oversold and is expected to rise in price.


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