Chapter 7 Technical Analysis and Charting Part II Having an education is one thing, being educated is another. Technical analysis is a very broad topic in trading. There are many methods, indicators, and terminology to learn to better help you understand how to analyze price and use all the information to forecast markets. In the first module we discussed the basic elements of technical analysis; chart types, trends, trendlines, channels, and support and resistance. In this chapter we ll move forward into more advanced topics such as technical indicators, gaps, and Fibonacci patterns. Trendline Breakouts Having discussed trendlines in the prior module, we ll move into the topic of Trendline Breakouts. Breakouts are important developments to track, as they provide volume and liquidity, as well as sharp moves in price. Trendline breakouts such as the one below in the NASDAQ composite are the simplest forms of a trend reversal. Like most trend reversal patterns, higher volume statistics are needed for confirmation of a trend reversal. Timing Triggers Moving Averages Figure 1: A Trendline Breakout in the NASDAQ Composite Moving averages are used to smooth trends and typically use closing prices exclusively. To construct a 10-day moving average, take the last 10 closes and divide them by 10. However, the most common moving averages used in stock trading are the 50=day, 100-day, and 200-day moving averages. The moving average is a trend-following device that has a lag. It can filter out noise associated with volatile trends but is slow to react. A shorter term moving average works better when prices have been in a trading range. Once prices begin to trend, however, a longer term moving average becomes advantageous to identify if prevailing trend remains intact. The moving average crossover (for example the 50-day moving average rises above the 100-day moving average) shouldn t be used as an entry or exit signal for position but should be used instead as a confirmation of strength or weakness in the underlying trend. Technical Analysis Part II Page 1
The moving average crossover works during a trending market but does poorly when prices aren t trending. Look at the two examples of IBM (IBM) below to see an example of the 50-day (red), 100-day (blue), and 200-day (green) moving averages performing well and performing poorly. Figure 2: Moving Average Crossovers in IBM Moving averages crossovers were mostly profitable in the chart above. Moving averages crossovers were mostly unprofitable in the chart below. Gaps Figure 3: Moving Average Crossovers in IBM Simply defined, a gap day in which the low is above the previous day s high or the high is below the previous day s low. There are four types of gaps: 1) Common gap, 2) Breakaway gap, 3) Measuring or Runaway gap, 4) Exhaustion gap. Technical Analysis Part II Page 2
The common gap always occurs within the confines of a trading range and is always filled. The breakaway, measuring, and exhaustion gaps occur in conjunction with one another at various stages of the trend. A breakaway gap usually occurs at the beginning of a new trend and typically occurs on higher than average volume. The breakaway gap is never filled and provides an excellent risk point for stop-loss orders. The measuring or runaway gap occurs near the midpoint of the trend and provides target price estimate of where the trend might end. The measuring gap is also never filled and provides a good point for a trader to raise his stop-loss orders. An example below illustrates exactly how this is done. The exhaustion gap provides an early warning that the existing trend is coming to end and is always filled. The example below is of a series of gaps in Microsoft (MSFT). The first blue dot shows a breakaway gap on higher than average volume. Breakaway gaps often occur in conjunction with trendline breakouts or rectangle breakouts. The second blue dot illustrates the measuring gap near the midpoint of the rally. Both of these gaps were never filled. The third dot highlights an exhaustion gap. Notice how volume begins to wane and that shortly after the exhaustion gap, prices check back to close the exhaustion gap, extend slightly higher on light volume again prior to a deeper correction. Figure 4: Price Gaps in MSFT An example of downside gaps in Tenet Healthcare (THC) illustrates how a series of gaps provides a target price for the existing trend. The low limit of the breakaway gap to the high limit of the measuring gap provides a measuring yardstick. In the example below, the bottom of the breakaway gap and the top of the measuring gap witness a price decline from $47 to $23 (a 49% drop in price). From the top of the measuring gap, another 49% decline to $11.73 is expected. Several months later an exhaustion gap occurs and downtrend finally bottoms at $11.32 before a rally to close the exhaustion gap occurs. Technical Analysis Part II Page 3
Figure 4: Price Gaps in THC Reversal Patterns- patterns that signal an end of the existing trend and signal a new trend is underway Key Reversal/Outside Reversal The key reversal and the outside reversal describe similar price action but occur in different stages of a trend. A key reversal or outside reversal day both have lows below the previous day s low, highs greater than the previous day s high or (bearish key reversal) a close below the previous day s close. The key reversal occurs at a trend extreme high or low. An outside reversal occurs within an existing trend. The chart below exhibits a bullish key reversal in the ishares Russell 2000 ETF (IWM). Figure 5: Key Reversal in IWM The Google (GOOG) chart below shows an example of a bearish outside reversal. Technical Analysis Part II Page 4
Figure 5: Outside Reversal in GOOG Oscillators Stochastics, Relative Strength Index (RSI) and Rate of Change (ROC) fall into the category of market oscillators. Oscillators are most helpful in three instances: Stochastics 1) When they reach extreme readings near the upper or lower boundaries. A low reading suggests that the market has become oversold (i.e. that it has fallen too far, too fast) and is die for a rebound. A high reading indicates an overbought condition (i.e. that prices have risen too far, too fast.) 2) A divergence between the oscillator and the price action when the oscillator has reached an overbought or oversold reading. 3) The oscillator crosses either a zero line or a 50% reading (midpoint of the oscillator s range). The Stochastic Oscillator compares where a security s price closed relative to its price range over a given time period. Interpretation The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a moving average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line. There are several ways to interpret a Stochastic Oscillator. Popular methods include: Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level, or buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. Technical Analysis Part II Page 5
Figure 6: Stochastic Signals on MCD Calculation The Stochastic Oscillator has four variables: 1. %K Periods This is the number of time periods used in the stochastic calculation. 2. %K Slowing Periods This value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic; a value of 3 is considered a slow stochastic. 3. %D Periods. This is the number of time periods used when calculating a moving average of %K. The moving average is called %D and is usually displayed as a dotted line on top of %K. 4. %D Method The method (i.e., Exponential, Simple, Time Series, Triangular, Variable, or Weighted) that is used to calculate %D. The formula for %K is: For example, to calculate a 10-day %K, first find the security s highest-high and lowest-low over the last 10 days. As an example, let s assume that during the last 10 days the highest-high was 46 and the lowest-low was 38 a range of 8 points. If today s closing price was 41, %K would be calculated as: The 37.5% in this example shows that today s close was at the level of 37.5% relative to the security s trading range over the last 10 days. If today s close was 42, the Stochastic Oscillator would be %50. This would mean that the security closed today at 50%, or the mid-point of its 10-day trading range. Technical Analysis Part II Page 6
The above example used a %K Slowing Period of 1-day (no slowing). If you use a value greater than one, you average the highest-high and the lowest-low over the number of %K Slowing Periods before performing the division. A moving average of %K is then calculated using the number of time periods specified in the %D periods. This moving average is called %D. The Stochastic Oscillator always ranges between 0% and 100%. A reading of 0% shows that the security s close was the lowest price that the security has traded during the preceding x-time periods. A reading of 100% shows that the security s close was the highest price that the security has traded during the preceding x-time periods. When prices are not trending, oscillators will be reliable indicators but unreliable during trending markets like this example of Goldman Sachs in a downtrend. Relative Strength Index (RSI) Figure 7: Stochastic Signals on GS The name Relative Strength Index is slightly misleading as the RSI does not compare the relative strength of two securities, but rather the internal strength of a single security. A more appropriate name might be Internal Strength Index. Interpretation When Wilder, (the author of the concept) introduced the RSI, he recommended using a 14-day RSI. Since then, the 9-day and 25-day RSIs have also gained popularity. Because you can vary the number of time periods in the RSI calculation, you should experiment to find the period that works best for you. (The fewer days used to calculate the RSI, the more volatile the indicator.) The RSI is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the RSI then turns down and falls below its most recent trough, it is said to have completed a failure swing. The failure swing is considered a confirmation of the impending reversal. Tops and Bottoms The RSI usually tops above 70 and bottoms below 30. IT usually forms these tops and bottoms before the underlying price chart. Technical Analysis Part II Page 7
Support and Resistance The RSI shows, sometimes some clearly than prices themselves, levels of support and resistance. Divergences Figure 8: Trendline Breakouts in QQQ As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction RSI. Rate of Change (ROC) Figure 9: Divergences in AAPL The rate of change oscillator measures the rate of ascent or rate of descent in a market. It is not indexed to 0 to 100; it has readings that are either positive or negative. Technical Analysis Part II Page 8
Rate of Change (ROC) indicator (percent method) is calculated by dividing the price change over the last x-periods by the closing price of the security x-periods ago. The result is the percentage that the security s price has changed in the last x-periods. If the security s price is higher today than x-periods ago, the ROC will be a positive number. If the security s price is lower today than x-periods ago, the ROC will be a negative number. Interpretation When the ROC crosses the zero line, it is an early warning of a new trend and therefore a buy or sell signal. Below is an example of a 14-day ROC in General Electric. Figure 10: 14-day ROC on General Electric (GE) Bollinger Bands Developed by John Bollinger, Bollinger Bands are a type of envelope. However, where envelopes are plotted at a fixed percentage above and below a moving average, Bollinger Bands are plotted at standard deviation levels above and below a moving average. Center Line=p-period moving average (no less than a 20-day moving average) Upper Band=Center Line + 2 x standard deviations Lower Band= Center Line 2 x standard deviations Because the spacing between Bollinger Bands is based on the standard deviation of the security, the bands widen when the security becomes more volatile and contract when the security becomes less volatile. The following are characteristics of Bollinger Bands. Sharp price changes tend to occur after the bands tighten, as volatility lessens. When prices move outside the bands, a continuation of the trend is implied. Bottoms/tops made outside the bands followed by bottoms/tops made inside the bands call for reversals in the trend. A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets. Technical Analysis Part II Page 9
The chart below shows BAC with a 20-day, 2 standard deviation Bollinger band. If the market establishes a bottom at the low band, look for a rally to challenge the high band and vice-versa. Fibonacci Retracements Figure 10: Bollinger Bands on BAC Leonardo Fibonacci was a 13 th century mathematician who, among other things, noted that there are certain ratios that tend to reoccur in nature. The common ones that he identified were 38.2%, 50% and 61.8%. For example, the distance from your fingertips to your wrist is 38.2% of the distance from your fingertips to your elbow. Of you have heard of the golden mean, or the golden ratio, then you probably already know that Fibonacci was the name of one of the greatest European mathematicians of the Middle Ages. His fame, as related to the stock market, comes from a series of numbers that he is associated with. The series looks like this: 0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 and on to infinity. This series of numbers is formed by taking the previous number and adding it to the current number to get the next number in the series. For instance: 3, 5, 8, 13, 21, 34, 55, 89, 144,. Add 8 and 13 to arrive at 21, and then add 13 to 21 to get the next number of 34. Now take the current number and divide by the next number. 21/34=0.6176 or 34/55=0.6182 or 144/233=0.618 0.618 is 62%this is one of the key Fibonacci retracement levels. You can get the 38% retracement level by taking the previous number and dividing by the next number. 21/55=0.382 or 34/89=0.382, etc. Another way is simply to multiply 0.618 by itself. 0.618*0.618=0.382 One other number to be aware of is the square root of 0.618, which is 0.786 (or 79%) Technical Analysis Part II Page 10
And finally, the 50% level is a prime level to be reckoned with, even if it doesn t have its roots in the Fibonacci series. Fibonacci ratios are applied to the stock market in the forms of retracements. After a rally loses its upward momentum, a wave of profit-taking will trigger a countertrend break called to a correction. It is remarkable how often these retracements coincide with the Fibonacci percentages of 38.2%, 50% and 61.8%. The depth of the retracement tells a lot about the strength of the underlying trend. A relatively shallow retracement suggests the underlying trend is bullish and further gains are extremely likely. The 50% retracement indicates normal strength in the underlying trend and a retest or recent highs is likely further out. A deep retracement of 61.8% or greater signals underlying weakness in the trend and suggests that the current high will remain a ceiling and further weakness is possible longer term. Look at the charts below of Caterpillar (CAT). Although the retracements didn t perfectly contain the counter-trend retracement, it is clear that the market is respecting these levels as support. The first chart is an example of a shallow retracement (38.2%), and the second chart is an example of a deep retracement (61.8%). Review Figure 11: Fibonacci Retracements on CAT Technical analysis is an important skill set to develop in your trading approach. The more comfortable you are analyzing charts, the more productive you ll be in trading. Through both chapters on technical analysis we ve discussed many topics that you ll find helpful in analyzing past price to predict future movements. Take time to practice each of these topics. To determine whether or not you ll find any of them helpful in your trading approach, you ll need to apply them to your paper trading routine. This way, you ll have enough experience to know which indicators and processes fit your trading style. Notes: Technical Analysis Part II Page 11