What is Fundamental Analysis?

Fundamental analysis examines the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements.

At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.

To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either overvalued or undervalued and the market price will ultimately gravitate towards fair value.

Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

General Steps to Fundamental Evaluation

Even though there is no clear-cut method, a breakdown is presented below in the order an investor might proceed. This method employs a top-down approach that starts with the overall economy and works down from industry groups to specific companies.

As part of the analyzing process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. For example, a telecom operator such as Verizon Communications (VZ) would be compared to another telecom operator such as AT&T, Inc. (T), not to an oil company like Chevron Corp. (CVX).

Economic Forecast

The first step in a top-down investment approach would be an overall evaluation of the general economy. Think of the economy as the tide and the various industry groups and individual companies as boats. When the economy expands, most industry groups and companies benefit and grow. When the economy contracts, most sectors and companies usually suffer.

Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market.

Below is a chart of the S&P 500 ($SPX) and the yield on the 10-year note over the last 30 years. Although not exact, there's a correlation between stock prices and interest rates.

When you have identified whether the overall economy is expanding or contracting, the next step would be to break down the economy into its various industry groups.

Group Selection

If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor, and cyclical stocks.

If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities, and energy-related stocks.

To assess an industry group's potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock!

The chart below shows that relative performance of five sectors over a seven-month timeframe. As the chart illustrates, being in the right sector can make all the difference.

Narrow Within the Group

Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group.

The first task is to identify the current business and competitive environment within a group and future trends. How do the companies rank according to market share, product position, and competitive advantage? Who is the current leader, and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on having an edge, be it marketing, technology, market share, or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge and those most likely to keep it.

Company Analysis

With a shortlist of companies, an investor might analyze the resources and capabilities within each company to identify companies capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management, and sound financials.

Business Plan

The business plan, model, or concept forms the bedrock upon which all else is built. If the plan, model, or concepts are subpar, a business lacks hope. For a new business, you may want to look for answers to questions like: Does its business make sense? Is it feasible? Is there a market? Can a profit be made?

For an established business, the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership?

Management

To execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths, and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management. Alternatively, even in a mature industry, strong management can make for increased success. Some of the questions to ask might include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best to move on.

Financial Analysis

The final step in this analysis process would be to take apart the financial statements and devise a valuation method. Below is a list of potential inputs into a financial analysis.

The list can seem quite long and intimidating. However, an investor will learn what works best after a while and develop a set of preferred analysis techniques. There are many valuation metrics, and much depends on the industry and stage of the economic cycle. A complete financial model can be built to forecast future revenues, expenses, and profits, or an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.

This methodology assumes a company will sell at a specific multiple of its earnings, revenues, or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value.

Putting it All Together

After all is said and done, an investor will be left with a handful of companies that stand out from the pack. Over the course of the analysis process, an understanding will develop of which companies stand out as potential leaders and innovators. In addition, other companies would be considered laggards and unpredictable. The final step of the fundamental analysis process is to synthesize all data, analysis, and understanding into selecting individual stock or securities.

Strengths of Fundamental Analysis

Long-term Trends

Fundamental analysis is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Value Spotting

Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett, and John Neff are considered champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen

One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technical analysts will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver.

In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth-oriented (computer), value-driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Knowing Who's Who

Stocks move as a group. By understanding a company's business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations.

Weaknesses of Fundamental Analysis

Time Constraints

Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it seems quite brash to imply that the market price, and hence Wall Street, is wrong.

Industry/Company Specific

Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.

Subjectivity

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation, and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. The chart below shows how stubbornly bullish many fundamental analysts can be.

Analyst Bias

Most of the information in the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “There are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals.

Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers. These brokers are also involved in underwriting and investment banking for the companies.

Even though there are restrictions to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to consider any biases a sell-side analyst may have. On the other hand, the buy-side analyst analyzes the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases, this may be as a large shareholder.

Definition of Fair Value

When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions?

It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

The Takeaway

Fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don't happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.

Table of Contents

What is Technical Analysis?

John Murphy defines Technical Analysis as “the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.” Market action refers to price, volume, and open interest data. While analysis of this data can't make absolute predictions about the future, studying the past price movements on a chart can help technical analysts anticipate what is “likely” to happen to prices going forward.

Introduction to Investing

"Must-Read" Technical Analysis Articles

The Psychology of Investing

Technical Analysis Rules and Guidelines

StockCharts.com's Chief Technical Analyst, John Murphy, is a popular author, columnist, and speaker on the subject of Technical Analysis. John's essay, “Ten Laws of Technical Trading,” is a collection of recommendations John frequently offers to those who are new to Technical Analysis. They are based on questions and comments he has received over the years after speaking to various audiences. If you are confused about how to use Technical Analysis at a practical day-to-day level, these suggestions should help.

Introduction

Which way is the market moving? How far up or down will it go? And when will it go the other way? These are the basic concerns of the technical analyst. Behind the charts and graphs and mathematical formulas used to analyze market trends are some basic concepts that apply to most of the theories employed by today's technical analysts.

John Murphy, StockCharts.com's Chief Technical Analyst, has drawn upon his thirty years of experience in the field to develop ten basic laws of technical trading: rules that are designed to help explain the whole idea of technical trading for the beginner and to streamline the trading methodology for the more experienced practitioner. These precepts define the key tools of technical analysis and how to use them to identify buying and selling opportunities.

In The Visual Investor, John demonstrates the essential visual elements of technical analysis. The fundamentals of John's approach to technical analysis illustrate that it is more important to determine where a market is going (up or down) rather than the reason behind its direction.

The following are John's ten most important rules of technical trading:

1. Map the Trends

Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale map of the market provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the short term, you will do better if you're trading in the same direction as the intermediate- and longer-term trends.

2. Spot the Trend and Go With It

Determine the trend and follow it. Market trends come in many sizes – long-term, intermediate-term and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing.

3. Find the Low and High of It

Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old “high” becomes the new low. In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies – the old “low” can become the new “high.”

4. Know How Far to Backtrack

Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the previous trend. The maximum retracement is usually two-thirds. Fibonacci Retracements (1) of 38% and 62% are also worth watching. Therefore, during a pullback in an uptrend, initial buy points are in the 33–38% retracement area.

5. Draw the Line

Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Uptrend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect and the more times it has been tested, the more critical it becomes.

6. Follow that Average

Follow moving averages. Price moves above or below moving averages provide objective buy and sell signals. They tell you if the existing trend is still in motion, and they help confirm trend changes. However, moving averages do not tell you in advance that a trend change is imminent. In stock trading, the three most important ones are the 20-day average for short-term trends, 50-day for intermediate trends, and 200-day for major trends. Crossings of two moving averages also provide trading signals. Three popular combinations are 5–20 days, 20–50 days, and 50–200 days. Exponential moving averages (EMAs) are usually more suitable for spotting moving average crossings.

7. Learn the Turns

8. Know the Warning Signs

9. Trend or Not a Trend

10. Know the Confirming Signs

Don't ignore volume. Volume is a very important confirming indicator. Volume precedes price. It's important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising volume confirms that new money is supporting the prevailing trend. Declining volume is often a warning that the trend is near completion. A solid price uptrend should always be accompanied by rising volume.

"11." Keep at it.

Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.

- John Murphy

1) Leonardo Fibonacci was a thirteenth-century mathematician who “rediscovered” a precise and almost constant relationship between Hindu-Arabic numbers in a sequence (1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. to infinity). The sum of any two consecutive numbers in this sequence equals the next higher number. After the first four, the ratio of any number in the sequence to its next higher number approaches .618. That ratio was known to the ancient Greek and Egyptian mathematicians as the “Golden Mean” which had critical applications in art, architecture and in nature.

What is Technical Analysis?

Technical analysis has to do with forecasting future financial price movements based on past price movements. Think of technical analysis like weather forecasting—it doesn't result in absolute predictions. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time.

Applying Technical Analysis

Technical analysis can be applied to stocks, indexes, commodities, futures, or any tradable instrument where the price is influenced by supply and demand. Price data (or, as John Murphy calls it, “market action”) refers to any combination of the open, high, low, close, volume, or open interest for a given security over a specific timeframe. The timeframe can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes, or hourly), daily, weekly, or monthly price data, lasting a few hours or many years.

Technical analysis can be applied to charts that show price action over time. The chart below shows a weekly chart of Alphabet Inc. (GOOGL). A weekly chart provides a long-term view of price movement. In the chart of GOOGL, you can see an uptrend and downtrend.

Below is a daily chart of GOOGL, which shows a shorter-term view of the stock's price action.

Key Assumptions of Technical Analysis

Technical analysis can be applied to securities where the price is influenced by the forces of supply and demand. When other forces influence the price of a security, technical analysis may not work well. To be successful, technical analysis makes three key assumptions about the securities that are being analyzed:

• Liquidity. Heavily-traded stocks allow investors to trade quickly because there are many buyers and sellers. Thinly-traded stocks are more difficult to trade because there are few buyers or sellers. So, if you're trying to trade a thinly traded stock, you may have to change your entry or exit price considerably to make a trade. In addition, low-liquidity stocks often trade at a low price (sometimes less than a penny per share), which means that their prices are easier to manipulate. These outside forces acting on thinly-traded stocks make them unsuitable for technical analysis.

• No Artificial Price Changes. Splits, dividends, and distributions are the most common “culprits” for artificial price changes. Though there's no difference in the value of the investment, artificial price changes can dramatically affect the price chart and make technical analysis difficult to apply. This kind of price influence from outside sources can be easily addressed by adjusting the historical data before the price change.

• No Extreme News. Technical analysis cannot predict extreme events, such as a change in management, regulatory changes, and geopolitical events. When the forces of “extreme news” influence price, technicians have to wait patiently until the chart settles down and starts to reflect the “new normal” that results from such news.

It's important to determine whether or not a security meets these three requirements before applying technical analysis. That's not to say that analysis of any stock whose price is influenced by one of these outside forces is useless, but it will affect the accuracy of that analysis.

The Basis of Technical Analysis

• Price discounts everything

• Price movements are not random

• “What” is more important than “Why.”

Let's look at each of these.

Price Discounts Everything

This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants—investors, portfolio managers, buy-side analysts, sell-side analysts, market strategists, technical analysts, fundamental analysts, and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view of the future.

Price Movements Are Not Totally Random

Most technicians agree that prices trend. Yet, most technicians also acknowledge that there are times when prices don't trend. If prices were always random, it would be difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:

“One way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior… The goal of the chart analyst is to identify those periods (i.e. major trends).” (p. 12)

A technical analyst believes that it's possible to identify a trend, invest, or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to different timeframes, it's possible to spot short- and long-term trends.

The chart of ORCL illustrates Schwager's view on the nature of the trend. The broad trend is up, but it's also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. When the stock price breaks above the trading range, the uptrend is renewed. When the stock price breaks below the low of the trading range, a downtrend begins. In the chart above, price broke below the trading range, but it was a short-lived downtrend. The uptrend resumed until the next trading range.

"What" Is More Important Than "Why"

1. What is the current price?

2. What is the history of the price movement?

The price of a security is the end result of the battle between the forces of supply and demand. The objective of the analysis is to forecast the direction of the future price. By focusing on price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it's best to concentrate on what and never mind why. Why did the price go up? There were simply more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?

Technical Analysis: General Steps

Many technicians apply a top-down approach that begins with broad-based market analysis, then narrows down to specific sectors/industries, and ultimately analyzes individual stocks.

The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of these levels of analysis can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It doesn't matter if the timeframe is two days or two years. It doesn't matter whether you're looking at a stock, market index, or commodity. The technical principles of support, resistance, trend, trading range, and other aspects can be applied to any chart. As simple as this may sound, technical analysis is far from easy. Success requires serious study, dedication, and an open mind.

Chart Analysis Basics

Technical analysis can be complex or straightforward. It depends on how you use it. The example below shows some basic principles of chart analysis. Since you're probably interested in buying stocks, the focus will be on spotting bullish situations in this chart.

The final step is to synthesize the above analysis to ascertain the following:

• Strength of the current trend.

• Maturity or stage of the current trend.

• Reward-to-risk ratio of a new position.

• Potential entry levels for a new long position.

The example above analyzed the chart for an individual stock, but these techniques can be applied to sectors or broad market indexes.

Top-Down Technical Analysis

Many technicians employ a top-down approach to technical analysis, starting with broad-based macro analysis and ending with a more focused/micro perspective:

1. Broad market analysis using major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.

2. Sector analysis to identify the strongest and weakest groups within the broader market.

3. Individual stock analysis to identify the strongest and weakest stocks within select groups.

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 that are the strongest of the strong.

Strengths of Technical Analysis

Focus on Price

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 the buyers and sellers agreed upon. 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, forcing the price back down. Even after this selling pressure, the close remained above the open. Looking at price action over an extended period, you 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.

Weaknesses of Technical Analysis

Analyst Bias

Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled perma-bear, then the analysis will probably have a bearish tilt.

Open to Interpretation

Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, akin to economics. Is the cup half-empty or half-full? It is all in the eye of the beholder.

Too Late

Always Another Level

Even after a new trend has been identified, there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.

Trader's Remorse

Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.

Final Thoughts

Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but when it comes to the price of a security, there's nothing to question. It's available for all to see. Nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants. We're not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?

Even though there are some universal principles and rules that can be applied, remember that technical analysis is more of an art form than a science. As an art form, it's subject to interpretation. However, it's also flexible in its approach, and each investor should use only that which suits his or her style. Developing a style takes time, effort, and dedication, but the rewards can be significant.

FAQs Technical Analysis

Introduction

The great debate continues to rage between random walkers and non-random walkers. Two competing books best represent these theories. Originally written by Burton Malkiel in 1973, A Random Walk Down Wall Street has become a classic in investment literature. Malkiel, a Princeton Economist, argues that price movements are largely random and investors cannot outperform the major indices.

Random Walk Theory

With “random walk”, Malkiel asserts that price movements in securities are unpredictable. Because of this random walk, investors cannot consistently outperform the market as a whole. Applying fundamental analysis or technical analysis to time the market is a waste of time that will simply lead to underperformance. Investors would be better off buying and holding an index fund.

Malkiel offers two popular investment theories that correspond to fundamental analysis and technical analysis. On the fundamental side, the “Firm-Foundation Theory” argues that stocks have an intrinsic value that can be ascertained by discounting future cash flows (earnings). Investors can also use valuation techniques to ascertain the true value of a security or market. Investors decide when to buy or sell based on these valuations.

On the technical side, the “Castle-in-the-Air Theory” assumes that successful investing depends on behavioral finance. Investors must determine the mood of the market - bull or bear. Valuations are not important because a security is only worth what someone is willing to pay for it.

Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis. This theory argues that stock prices are efficient because they reflect all known information (earnings, expectations, dividends). Prices quickly adjust to new information and it is virtually impossible to act on this information. Furthermore, price moves only with the advent of new information and this information is random and unpredictable.

In short, Malkiel attributes any outperformance success to lady luck. If enough people try, some are bound to outperform the market, but most are still likely to underperform.

Non-Random Walk Theory

A Non-Random Walk Down Wall Street is a collection of essays offering empirical evidence that valuable information can be extracted from security prices. Lo and MacKinlay used powerful computers and advanced econometric analysis to test the randomness of security prices. Although this book is a heavy read, the findings should be of interest to technical analysts and chartists. In short, this book documents the presence of predictable components in stock prices.

Just prior to this book, Andrew Lo wrote a paper for the Journal of Finance in 2000: Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation. Harry Mamaysky and Jiang Wang also contributed. The paper's opening remarks say it all:

Dow Theory

Fat Tails and Trends

Historic stock returns are not normally distributed. What does this mean? If one were to measure the height of 1000 people and plot the distribution, this distribution would form the classic bell curve. The most recurring height (value) would be in the middle and the remaining heights would be equally distributed on either side. Furthermore, 68.5% of all values would fall within ±1 standard deviation of the mean, 95.4% would fall within ±2 standard deviations and 99.7% would fall within ±3 standard deviations. The solid black line shows a typical bell curve with a normal distribution.

Statisticians have found that a distribution of stock returns forms a curve with “fat tails”. In a normal distribution, 99.7% of all these returns would be within ±3 standard deviations of the mean. This, however, is not the case for stock returns. Instead, the distribution has fat tails, shown in the dotted lines on the graphic above. This means a relatively high number of returns fall outside the normal distribution. Some are lower and some are higher. These abnormal returns provide evidence of extended moves, outsized moves or trends. Note that the image above is just a hypothetical example to illustrate a point.

Visual Evidence

Anyone who has followed the stock market for any length of time realizes that trends can and will take hold. To be fair, not all stocks trend and trends do not last forever. However, there are enough asset classes, major indices, sectors, industry groups or stocks out there to ensure that something is trending at some point. The challenge, as always, is to find that trend and ride it. The next three charts show some individual stocks with clear signals and trends. Identifying a simple double top and getting out of Citigroup (C) would have avoided a whole lot of pain. The same can be said for Enron, Worldcom and the few other debacles.

ExxonMobil (XOM) was choppy in 2009, down the first half of 2010 and then up sharply from July 2010 to February 2011. Catching this one big trend would have made up for quite a few losses.

Pfizer (PFE) shows an example of three sizable trends emerging over a two year period. The stock was up over 50% in 2009, down about 25% in the first half of 2010 and up around 50% from July 2010 to March 2011.

Conclusion

To be perfectly fair, the financial markets have random and non-random aspects. Stocks sometimes trend and react well to patterns or indicators. Stocks sometimes trade choppy and ignore pattern setups or indicator signals. It is the job of the technical analyst or chartist to separate the wheat from the chaff. Chartists must also be able to adapt to ever-changing conditions.

“The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas.”

Further Study

Security Analysis: Does it Matter?

Wall Street has tons of analysts, strategists, and portfolio managers hired to do one thing: beat the market. Analysts are hired to find undervalued stocks. Strategists are hired to predict the direction of the market and various sectors. Portfolio managers are hired to put it all together and outperform their benchmark, usually the S&P 500 index. Granted, there are many studies and disputes raging on the performance of equity mutual funds, but it's safe to assume that about 75% of equity mutual funds underperform the S&P 500. With these kinds of stats, wouldn't individual investors be better off simply investing in an index fund rather than attempting to beat the market?

There are different ways to analyze the market. The added value of analysis is in the eye of the beholder:

So whom do you believe? Is fundamental analysis worth the time and effort? Are technicians a bunch of quacks? Or is it all a lesson in random futility? We can begin to answer these questions by looking at the efficient market hypothesis and seeing where the fundamentalists, technicians, and random walkers stand regarding market efficiency. After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis, and technical analysis.

Are Markets Efficient?

The debate concerning the value of analysis begins with the question of market efficiency. What does the price of a stock or security represent? Is a security's current price an accurate reflection of its fair value? Do anomalies exist that allow traders and investors the opportunity to beat the market by finding undervalued or overvalued securities?

There are different definitions of an efficient market. Aswath Damodaran, of the Stern Business School at New York University defines an efficient market as one in which the market price is an unbiased estimate of the true value of the investment. That's true, but it's also an oversimplification. In an efficient market, the current security price fully reflects all available information and is the fair value.

In this ideal scenario, the price is the sum value of all views (bullish, bearish, or otherwise) held by market participants. As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling). So, the price is the fair value because the market agreed on a price to buy and sell the security. In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random. Over the long run, the price should accurately reflect fair value.

The hypothesis also asserts that if markets are efficient, then it should be virtually impossible to outperform the market on a sustained basis. Even though deviations will occur and there will be periods when securities are overvalued or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them.

From experience, most investors would agree that the market isn't perfectly efficient: anomalies exist, and some investors and traders outperform the market. There are varying degrees of market efficiency which have been broken down into three levels. These three levels also happen to correspond to the beliefs of fundamentalists, technicians, and random walkers.

Strong Form: Technicians

The Strong Form of market efficiency theorizes that the current price reflects all information available. It doesn't matter if this information is available to the public or privy to top management; if it exists, it's reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are Strong Form efficient and all information is reflected in the price.

Semi-Strong Form: Random Walkers

The Semi-Strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements, and other relevant information that can be readily gathered. Yet, all information isn't readily available to the public which means that all information isn't fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers, or regulators, among others. Anomalies exist when information is withheld from the public, and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously, making it virtually impossible to profit from such news. The Random Walk theory is an example of the Semi-Strong Form of market efficiency.

Weak Form: Fundamentalists

The Weak Form of market efficiency theorizes that the current price doesn't reflect the fair value and is only a reflection of past prices. In addition, the future price can't be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of Weak Form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value; these models will help identify anomalies.

Which Form Exists in the Market Today?

Many in academia believe that security prices are semi-strong efficient. Recall that "semi-strong efficient" implies that all public knowledge is reflected in the price, and it's virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price.

Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster and new developments are factored in instantly. A surprise, positive or negative, can violently move the price of a security. A few examples include:

After Reporting Earnings Below Expectations

After announcing weak guidance during its earnings call on February 9, 2023 (after the close), Lyft shares fell from $16.22 to close at $10.31 the following trading day.

After Positive Guidance

Even though NVDA reported slightly higher revenue and net income in their Q4 earnings report on February 22, 2023, strong guidance saw NVDA stock gap up from $207.50 to close at $236.60 the following trading day.

These are just a few examples but they demonstrate how new information can move the price of a security in non-random ways.

Below, you'll find a series of articles about the basics of technical analysis. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't strayed too far from the basics. Enjoy!

Part 1 – What exactly is Technical Analysis?

Part 2 – Why does TA work and how it is commonly misused?

Part 3 – The important assumptions that TA makes about financial data

Part 4 – All about Line and OHLC bar charts

Part 5 – The basics of candlestick charts

Part 6 – How charts are scaled, how volume works, and how to create CandleVolume charts

Part 7 – Support and Resistance

Part 8 – Trend line analysis

Part 9 – Price channels

Part 10 – Using volume to confirm trend-changing signals

Part 11 – Basics of Price Patterns

Part 12 – Using volume to confirm Price patterns

Part 13 – The (infamous) Head and Shoulders Reversal pattern

Part 14 – Using Fibonacci percentages to find Support and Resistance levels

Part 15 – Price gap analysis

Part 16 – Candlestick chart pattern basics

Part 17 – Comparison charting

This is the first part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Defining Technical Analysis

Technical analysis is the study of price and volume changes over time. Technical analysis usually involves using financial charts to help study these changes. Any person who analyzes financial charts can be called a Technical Analyst.

Despite being surrounded by data, charts, raw numbers, mathematical formulas, etc., technical analysts study human behavior, specifically the crowd's reaction to fear and greed. Investors who have any interest in a particular stock are considered to be “the market” for that particular stock, and the emotional state of those investors determines the price of that stock. If more investors feel the stock will rise, it will! If more feel that the stock will fall, then it will. Thus, a stock's price change over time is the most accurate record of the emotional state — fear and greed — of the market for that stock, and thus, technical analysis is, at its core, a study of crowd behavior.

"Weathering" the Market

When was the last time you saw a 100% accurate weather forecast for your area? Chances are that at least some of the weather predictions your local weather person tells you won't come to pass. In many cases, most of the predictions are wrong. So why do we keep listening to weather forecasts?

Weather forecasts are helpful because they help us prepare for what is likely. If the forecast calls for rain, we bring our umbrellas when we go out. If sunshine is predicted, we bring our sunglasses. We know that we might not need these things, but more than likely we will and we like to be prepared.

Technical analysis is very similar to weather forecasting. Good technical analysts know that T/A can prepare you for what is likely to happen but, just like many weather forecasts, things can change in unpredictable ways. Here are some other ways that technical analysis is like weather forecasting:

• Weather forecasters measure temperature and air pressure and then use that data to determine more about the factors that cause weather changes - i.e., fronts, high pressure, low pressure, etc. Technical analysts use price and volume to determine more about the factors that cause market changes - i.e., fear and greed, trends, reversals, support, etc.

• Despite huge quantities of weather data at their disposal, weather forecasters still use their experience and intuition when creating each forecast. Technical analysis also draws heavily from the experience and intuition of the person doing the analysis (you!).

• Accurate weather forecasting requires local knowledge and experience. A forecaster from Florida that moves to Alaska will need time to become familiar with Alaska's weather patterns. Similarly, technical analysis requires experience and knowledge about the kinds of markets being charted - stocks are different from commodities, which are different from mutual funds, large stocks are different from small stocks, etc.

• In the early days of weather forecasting, charlatans tried to convince people that they could somehow control the weather or that their predictions were always accurate. Unfortunately, even today, people are making similar claims about technical analysis.

• Weather forecasts tend to be most accurate when things aren't changing. If it has been sunny for the past three days and no big weather systems are approaching, chances are it will be sunny again today. Technical analysis also works well when conditions aren't changing dramatically. Both disciplines have more trouble with predicting exactly when big changes will occur.

• Both weather forecasting and technical analysis work well for the “mid-sized view.” While predicting the weather for a large city is possible, predicting things for a city block is very hard. Similarly, second-by-second technical analysis can be extremely tricky; daily and weekly analysis is more reliable. Conversely, predicting weather for the country as a whole (i.e., “It will be sunny in the US today”) and predicting the market as a whole (i.e., “This year stocks will go up”) are too broad to be useful.

It is easy to lose perspective on what technical analysis can and cannot do. Remember this comparison with weather forecasting to keep yourself aware of its benefits and limitations.

This is the second part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

The Value of Technical Analysis

The reason technical analysis has value is that directional price moves are often sustained for a period of time, allowing analysts to detect and profit from the change in price. Even though a technical analyst has many math-based tools to analyze price and volume movement, the process is ultimately an art in the study of human behavior.

Just as a meteorologist can never guarantee a weather forecast, a technical analyst can never be perfectly certain of future price movements since human behavior is involved.

Figuring out the what and when...

All investors are faced with three basic questions about their investments. What to invest in, when to buy, and when to sell. Technical analysis provides a framework for investors to methodically select equities and pick times to buy and sell. Emotion, the investor's nemesis, is greatly reduced in these decisions since the investor can develop a list of “what and when” rules to follow. Rather than “buying and hoping for the best”, technical analysts always know how much risk they are taking and know when to “get out while the getting is good”.

Only price and volume only...

Only historical price and volume data is used for technical analysis. The underlying premise of technical analysis is that all known information such as what a company does, its financial results, analyst's ratings, management performance, politics, news, etc. are reflected in the historical price and volume data. This is a powerful concept since it is impossible to gauge how these factors may influence future price separately.

It is important to understand that technical analysis can only be used to determine the likely direction of future prices. It cannot anticipate news events or how investors will respond to them.

The Goal of Technical Analysis

The chart below displays a historical price chart for Analog Devices, Inc. (ADI) for one year.

Notice how the stock price can move up, down, or sideways for months. Technical analysis uses methodologies to help indicate when prices are beginning to change direction. The goal of a technical analyst is to buy an equity when the price chart indicates prices are beginning to move up and then sell when the price chart indicates prices are beginning to move sideways or down.

Why Technical Analysis Works

Technical analysis works because price and volume often reveal the collective psychology (the “fear/greed balance”) of a market's participants. Technical charts can reveal changes in the fear/greed balance soon after those changes occur and that provides opportunities for profitable trades. Technical analysts work to identify charts where the fear/greed balance has recently changed in a predictable manner. They then place trades to try and profit from that change. Once they have bought a stock, technical analysts monitor price and volume for sell signals. Done correctly, trades based on technical analysis carry a higher-than-average chance of success; however, disciplined money management techniques must still be used to guard against unforeseen price movements.

Misuse of Technical Analysis

While the basics of technical analysis are easy to learn, applying them correctly and successfully isn't easy. Because of this many people have lost money using technical analysis techniques and then concluded that chart analysis has no value. In addition, unfortunately, many unsuspecting investors have purchased technical “systems” that promise outlandish returns for little effort. By the time the buyer figures out that the system doesn't work, their money is long gone.

Technical analysis is just like any other money-making occupation - it takes time and energy and it involves risk. Anybody who says otherwise shouldn't be trusted. Here are ways technical analysis has been misused in the past:

The Holy Grail mentality...

One of the most common misconceptions about technical analysis is that a trading system (a set of buy and sell rules) can be devised that provides consistent profits with little to no risk.

There are several reasons that a “perfect system” cannot be sustained. Firstly, the market is made up of people with free will and guided by fear and greed. A perfect system requires prices to consistently move in predictable patterns. This will never be possible when people are involved. Secondly, many financial institutions monitor the market for patterns of systematic trading. Once detected, the financial institution can take advantage of the system (investing with or against it) which eventually compromises and defeats the “perfect system”. And finally, what motivation could someone have to share a “perfect system” at any price? Such a system would be invaluable to one person but worthless (for the second reason) if too many people or even one institution discovered it.

Just tell me what to buy...

Investment charlatans and gurus have always been offering advice on how to profit in the market. These are the people who take financial advantage of new and uninformed investors by promising quick and profitable investment success. Claims of ultra-high rates of return or knowledge of future events for substantial fees are the best ways to identify such schemers.

Although a real guru is a spiritual guide or teacher, the title “Market Guru” is gladly accepted by advisers who have developed notoriety with fortuitous calls of major market changes or unusual approaches to investing. Today's TV media and the Internet enthrone new market gurus on a regular basis. There are precious few true market gurus like Warren Buffet who have proven their market savvy over decades. Most market gurus can only provide profitable guidance as long as the market is favoring their investment philosophy. As the market changes, new market gurus will emerge as their philosophies' agree with the new market dynamics.

Technical Analysis lets me control the market...

While few people consciously believe that they can control a stock's price directly, subconsciously, chart analysis can give new investors a false sense of control, which will cause them to lose objectivity: “My stock just broke below my trend line today, but it will come back tomorrow since that is a really good trend line!”

The opposite response is just as damaging: “My stock broke my trend line! T/A is worthless!” Both responses are driven by emotion, something that technical analysis strives to eliminate.

In Part 3, we'll take a critical look at the assumptions that technical analysis makes about the markets.

This is the third part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Chart Data

Charts are created from data such as price data and index data.

Price Data

Exchanges record the price and number of shares for each stock transaction, which is called tick data. Tick data is compiled over different periods of time to construct price bar data. Price bars show the beginning, highest, lowest, and ending prices for a chosen period. Individual price bar time periods can range from one minute to one year. Daily, weekly, and 60-minute price bars are other common examples.

Price bars less than a day long are known as intraday price bars. They range from one minute to one hour and are typically used in technical analysis by day traders who hold positions for minutes or hours.

A daily price bar is constructed of all the transactions during a full trading day. Investors who hold positions for days or years most often use daily price bars in technical analysis.

The number of shares traded in each transaction is called volume. Volume is recorded as tick data just like price. Volume tick data is added together to construct volume bars and are then charted with their corresponding price bars for technical analysis.

Index Data

Data for hundreds of indices, published by financial service companies and the major exchanges, are provided to StockCharts.com through third party data providers. Indices are not tradable financial instruments. Indices represent domestic and foreign market averages, industries, commodities, currencies, bonds and many other price, volume, and breadth measurements of market activity. Examples of market indices include the Dow Jones Industrial Average ($INDU), NYSE Healthcare Index ($NYP) and the New Zealand Dollar ($NZD). The financial service companies are responsible for the accuracy of the indices they publish.

Breadth indices measure how many issues move within a particular market index. Breadth indices give analysts insight into investor sentiment. Examples of breadth indices include NASDAQ Advance-Decline Issues ($NAAD), NYSE Advance-Decline Volume ($NYUD) and AMEX Issues Unchanged ($AMADU).

Key Assumptions of Technical Analysis

There are three things that you must verify are true about a security before you can apply standard chart and/or indicator analysis to the security's chart. These three key assumptions are:

High Liquidity

Liquidity is essentially volume. It means that shares have the ability to trade quickly without dramatically affecting prices. If someone buys 100 shares of Microsoft today, that trade by itself will have almost no effect on the price of the stock. Why? Because MSFT is extremely liquid with lots of buyers and selling at any given moment.

Low Liquidity is a trap that many amateur investors can fall into. When you buy a stock with low liquidity, you probably won't get it at the price you were quoted because there are no sellers at that price. The broker has to raise the price - often significantly - before a seller can be found. Similarly, when you sell a low liquidity stock, the broker will need to lower the price significantly to find a buyer.

In addition, these thinly-traded stocks are often very low priced - often less than 1 cent - and that means that their price can be manipulated by someone with lots of resources (and lots of time).

None of this is illegal or hidden or “wrong” in any way. It is just that the principles upon which Technical Analysis is based assume that only normal market forces move a stock's price - not the manipulation or issues with trading volumes that low liquidity stocks can have.

No Artificial Price Changes

Similar to the reason for high liquidity, prices cannot be changed by forces other than the fear and greed that drives the market. Anything else that changes prices is considered “artificial” and needs to be eliminated before standard technical analysis techniques can be applied.

So what is an example of an “artificial” price change? Splits, dividends, and distributions are the most common “culprits.” When a stock splits, let's say 2-for-1, the market participants don't really care. They get double the shares at half the price - a net-zero transaction that doesn't change their opinion of the stock one way or the other.

However, consider what happens to the stock's chart. It now has a huge (50%) gap down on it. If you didn't know about the split, you'd be very worried about the stock. And, because technical indicators are dumb, they would all give bearish “sell” signals at that point.

For this reason, the effects of these “artificial” price changes must be removed from the data before standard technical analysis techniques can be used. Ironically, this is done by adjusting all of the data prior to the split downwards, thus eliminating the gap on the chart.

No Extreme News

Technical Analysis cannot predict extreme events such as, for example, a company's CEO dying unexpectedly or the huge tragedy of 9/11. When “extreme news” happens, technicians have to wait patiently until the chart settles down and starts to reflect the “new normal” that results from such news.

This is not to say that charts are useless when one or more of these three things occur. It means that the philosophical underpinnings of the signals and chart patterns that traditional technical analysis uses are gone in those cases. Standard technical signals and predictions cannot be accurately used in those circumstances.

Chart Construction

The security's price data is displayed on a price chart: a graph which shows how price and volume changes with time. This visual representation of price data is very helpful when using technical analysis techniques.

Price charts on StockCharts.com are called SharpCharts (Time-independent charting methods like Point & Figure charting will be discussed in detail later).

The example above illustrates the layout of a typical SharpChart. Price data, volume data and technical indicators are displayed on a SharpChart. A technical indicator is a mathematical expression of price and/or volume which can provide insight into future price movements. We will talk more about technical indicators later.

Price data and overlays are plotted in the Price Plot Area. Overlays are technical indicators that are normally expressed in terms of price. Non-price values of overlays are displayed on the left axis as shown above.

Technical indicators that cannot be expressed in terms of price are normally plotted in the Indicator Panels. Although only a single Indicator Panel is shown above, SharpCharts can be created with multiple Indicator Panels displayed above and below the Price Plot Area. Additional date/time axes can be added between the Indicator Panels if needed. The legend for both the Price Plot Area and Indicator Panel contain the information used to create the SharpChart.

In Part 4, we'll get into the specifics of line charts, OHLC Bar charts, and candlestick charts.

This is the fourth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Line Charts

Line charts are created by plotting a line between the closing prices for each period set on the chart. On a daily chart, a line is plotted between the daily closing prices. Line charts are useful to help visualize the direction of prices. The extent of rallies and reactions in trends can also be quickly deduced.

A five-month price SharpChart of Apple, Inc. (AAPL) is plotted above in a line format. Higher highs and lows are annotated with green dashes and lower highs and lows with red dashes. Between March and mid-May 2008, the direction of prices is readily apparent with higher highs and lows. After mid-May 2008, prices began to make lower highs and lows.

A line chart is plotted by default when only end-of-day (closing) prices are available for a symbol. Examples of such symbols include all mutual funds and some market indices. However, weekly and monthly price bars can be charted for ticker symbols with only end-of-day (EOD) quotes.

OHLC Charts

Open-High-Low-Close (OHLC) bar charts provide volatility information that line charts lack. The attributes of an OHLC bar are shown below. The chartist can evaluate volatility by the height of the bars and the conviction of the buyers and sellers by the price range between the open and close marks.

For the left price bar, the CLOSE mark is above the OPEN mark indicating price ended higher for the day, known as an up day. This price bar is considered bullish. Bullish sentiment is present when greed for gain exceeds fear of loss and prices move higher.

With the price bar on the right, the OPEN is higher than the CLOSE indicating price ended lower for the day, known as a down day. This is a bearish price bar. Bearish sentiment is present when fear of loss is greater than greed for gain and prices move lower.

The SharpChart of AAPL above illustrates the OHLC format.

Notice how intraday price swings pass through the red and green reference marks made at the closing price levels on the previous Line chart. This illustrates why line charts are useful for visualizing price direction.

OHLC Bar Colors

When the 'Color Prices' option is selected on the Chart Attributes workbench, the price bars will be colored black or red, depending on how a price bar's closing price relates to the previous day's closing price. If the closing price is higher than the previous day's closing price, the price bar will be black. If the closing price is lower than the previous day's, the price bar will be red. With this convention, it is possible to have a black price bar with the close being lower than the open.

Colored OHLC price bars are shown in the AAPL SharpChart above. As discussed earlier, the color of the price bar is only based on the previous day's closing price, not the current day's opening price. Up day and down day price bars are usually black and red respectively, but that is not always the case as shown in the chart above.

In part 5 we'll get into the specifics of candlestick charts.

This is the sixth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Chart Scaling

Charts are created with one of two different kinds of vertical price scales. An arithmetic scale evenly spaces price along the right side of the chart. Arithmetic chart spacing between $10 and $20 is half as tall as the spacing between $20 and $40. A log scale evenly spaces price in percentage terms. Chart spacing between $10 and $20 has the exact same chart spacing as between $20 and $40 since they represent the same percentage increase.

The SharpCharts above illustrate the differences between the two scaling methods. On the arithmetic scale, three different trend lines were required to keep pace with the price advance. On the log scale, the trend line fits the price trend during the entire rally. Log scaling should be the first scaling choice when using trend lines, especially over long timeframes.

Volume

StockCharts.com provides several ways to plot volume data on a chart. The following price and volume SharpChart of AAPL illustrates how volume is typically plotted.

Volume can be plotted in an 'indicator panel' above or below the 'price plot area' or in the price plot area as an 'overlay.'

When the 'Color Volume' option is used, the volume bars are shown as black for up days and red for down days. Color volume bars allow the chartist to quickly see where heavy or weak buying and selling activity is happening.

CandleVolume Charts

CandleVolume charts are similar to candlestick charts except that each candle's width is proportional to its corresponding volume value. This charting style allows one to visualize the volume activity “in” rather than “below” price moves. Depending on the style of analysis, volume bars could be omitted to simplify the chart.

The time axis for these charts is not uniformly spaced as candlestick bar widths vary with volume values. As a result, trend line analysis using CandleVolume charts should always be confirmed with a standard candlestick or OHLC chart. The SharpChart of AAPL above shows how volume bars correlate to the candlestick widths.

That wraps up our look at how charts are constructed. In part 7 we're going to start to talk about how charts are analyzed - starting with Support and Resistance analysis.

This is the seventh part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Chart Analysis - Support and Resistance

Prices are driven by two of humanity's strongest emotions: Fear and Greed. When more investors are fearful that a stock will fall, it does! It will continue to decline until the balance between Fear and Greed is re-established. The same is true for greed and rising prices. This phenomenon is referred to as Market Psychology.

Support is the price level where “greedy” buyers enter the market to prevent prices from declining further. Support can develop at a specific price or, more commonly, in a price zone. Areas of support can exist for many months at a time.

The diagram above illustrates how market psychology causes the previous area of price support to turn into resistance. After breaking support, traders who bought in the zone of support are now holding losses and, in order to break even, want to sell as soon as prices approach their original purchase prices.

The Volume by Price overlay (volume traded in incremental price ranges) in the following SharpChart of Dover Corp. illustrates how strong support at 24 later became significant resistance as greed turned into fear.

The concept of resistance is opposite of the support as discussed above. Resistance is the price level where “fearful” sellers suddenly come into the market and prevent prices from advancing further. Like support, resistance can develop at a specific price or in a price zone and can be held for months at a time.

If resistance is broken, market psychology causes the previous area of price resistance to turn into support. The diagram above illustrates this market behavior. Stock holders who sold in the zone of resistance are now regretting selling and want to buy as soon as prices approach the level they sold at earlier. Prices that seemed too high before now look like a bargain. The following SharpChart of Parker Hannifin Corp. illustrates resistance later becoming support. Notice how Volume by Price indicates the potential number of previous sellers willing to buy again if given the opportunity.

In part 8 we'll discuss trend line analysis and trend channels.

This is the ninth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Price Channels

Trending prices often form a channel where prices can be bounded above and below by parallel trend lines. When trend channels form, it is helpful to draw the top and bottom trend lines and monitor how well prices stay within the channel.

If prices in an uptrend fail to reach the upper channel line, the uptrend may be weakening and getting ready to reverse. Also, if prices suddenly break above the upper channel line, the uptrend may be either beginning to exhaust itself and reverse direction or be starting a new, steeper trend. Similar behavior also happens in downtrend price channels.

Trend Changes

Trending prices can only go three directions: continue in the direction of the trend, change to a trading range, or reverse the direction of the trend. Trend changes are most easily recognized by watching the price peaks and troughs. An uptrend makes higher price peaks and troughs. A downtrend makes lower price peaks and troughs. In a trading range, price peaks and troughs are roughly equal over time.

A change in uptrend begins when a new price peak is similar to or lower than the previous price peak. The change is confirmed when the next price trough is similar to or lower than the last price trough.

Changes in downtrends and price ranges occur in the same way. New price peaks or troughs break the pattern of prior ones, with the next peak or trough confirming the change.

Price and Volume Data Adjustments

When a company pays out a dividend or a fund makes a distribution, it can affect the price of the underlying security. For example, after a company pays out dividends (ex-dividend date), the price of the stock drops by the dividend amount. Because of the change, price and volume data adjustments are necessary for technical indicators to be valid.

Technical analysts generally view charts with adjusted price data. In the Classic SharpCharts Workbench, if you'd like to view unadjusted price data, type an underscore symbol before the ticker symbol, i.e. _TSLA.

If you're using the New SharpCharts Workbench, and you want to view unadjusted price data on your chart, uncheck the Adjust For Dividends box (click the settings icon).

In part 10 we'll look at how volume can confirm trend-change signals.

This is the fifth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Candlestick Charts

Compared to traditional OHLC bar charts, many traders consider candlestick charts more visually appealing and easier to interpret. Each candlestick provides an easy-to-decipher picture of price action. An analyst can quickly understand the relationship between the opening and closing price as well as the high and low price.

The graphic above shows how candlesticks are constructed.

Candlesticks with hollow bodies indicate buying pressure and filled bodies indicate selling pressure. Long upper or lower shadows form when the market moves significantly in a particular direction during the day and then reverses before the end of the day. As a result, long lower shadows can infer bullishness while long upper shadows can infer a bearish market.

Candlestick Colors

When the 'Color Prices' option is selected on the Chart Attributes workbench, the Candlestick's outline and body will be colored black or red, depending on the candlestick's opening and closing prices and the previous day's closing price.

If the closing price is higher than the opening price, the body will be displayed hollow. If the closing price is lower than the opening price, the body will be filled red with the following exception; if the closing price is higher than the previous day's closing price, the body will then be filled black.

The candlestick's shadows and body outline are colored black or red depending on the closing price compared to the previous day's closing price. If the closing price is higher than the previous day's, the candlestick's shadows and body outline will be colored black. If the closing price is lower than the previous day's, however, the candlestick's shadows and body outline will be red.

Market psychology is reflected in each of these candlestick formations in the following ways.

Up Day, Higher Close: Typically results from expectations of higher prices (greed) out weighing expectations of lower prices (fear). The length of the candlestick body shown indicates especially strong buying.

Down Day, Lower Close: Expectations of lower prices (fear) are stronger than those of higher prices (greed). As with the first candlestick, a longer candlestick body infers greater urgency of investors to sell their shares.

Down Day, Higher Close: A rare candlestick, this one begins with an opening gap up in price from the previous day's closing price but closes down for the day. A gap is defined as a price range where no trading takes place and is the result of a significant change in demand (gap up) or supply (gap down) before trading begins for the day. In this case, heavy buying at the beginning of the day reversed but still closed higher than the previous day. This is a bearish sign when it occurs well into an upward price move.

Up Day, Lower Close: Another rare candlestick, this one begins with an opening gap down in price from the previous day's closing price but closes up for the day. This price action can be considered bullish during a downward price move since initial strong selling in the day becomes exhausted and buyers push the price higher at close.

The SharpChart AAPL above illustrates the candlestick format. The up and down days are readily apparent with the use of candlestick charting. When the balance between buyers and sellers change, candlesticks often form recognizable patterns signaling the change. These candlestick patterns will be discussed in a later article.

Below, you can see how the three types of charts compare visually:

In part 6, we'll get into chart scaling, volume, and CandleVolume charts.

This is the eighth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Trend Psychology

The psychology of fear and greed of market participants ultimately determines the direction of prices in a market. Prices rise with greed (demand) and fall with fear (supply). A price trend is simply a sustained directional price move. It can be thought of as a tilted support/resistance zone.

A trend will continue as long as either fear or greed is in control of a market. Trends fade or change direction as the balance of fear and greed changes. The extent of fear and greed in a market can be seen by how quickly prices are trending down or up.

Trending

As stated earlier, a trend is a sustained, directional price move. Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend. A trading range is characterized by horizontal peaks and troughs. Trends are generally classified into major (longer than six months), intermediate (one to six months), or minor (less than a month). Long term investors are most interested with identifying long-term trends where short-term investors are more interested in minor and intermediate trends. The following SharpChart shows examples of the different types and categories of trends.

Trend lines

A trend line is a straight line that connects two or more low or high price points and then extends into the future to act as a line of support or resistance. The first two points establish the trend line while additional points validate it.

The following SharpChart contains a real example of how an uptrend line is drawn with a trend change.

An uptrend line has a positive slope and is formed by connecting two or more low points. Uptrend lines act as support. As long as prices remain above the trend line, the uptrend is considered intact. A break below the uptrend line indicates that demand has weakened and a change in trend could be imminent.

A downtrend line has a negative slope and is formed by connecting two or more high points. Downtrend lines act as resistance. As long as prices remain below the downtrend line, the downtrend is intact. A break above the downtrend line indicates that supply is decreasing and that a change of trend could be imminent.

In part 9 we'll look at trend channels and trend changes.

Introduction

Chart analysis has become more popular than ever. One of the reasons for that is the availability of highly sophisticated, yet inexpensive, charting software. The average trader today has greater computer power than the major institutions had just a couple of decades ago. Another reason for the popularity of charting is the Internet. Easy access to Internet charting has produced a great democratization of technical information. Anyone can log onto the Internet today and see a dazzling array of visual market information. Much of that information is freely available at very low cost.

Another revolutionary development for traders is the availability of live market data. With the increased speed of market trends in recent years, and the popularity of short-term trading methods, easy access to live market data has become an indispensable weapon in the hands of technically oriented traders. Day-traders live and die with that minute-by-minute price data. And, it goes without saying, that the ability to spot and profit from those short-term market swings is one of the strong points of chart analysis.

Sector rotation has been especially important in recent years. More than ever, it's important to be in the right sectors at the right time. During the second half of 1999, technology was the place to be and that was reflected in enormous gains in the Nasdaq market. Biotech and high-tech stocks were the clear market leaders. If you were in those groups, you did great. If you were anywhere else, you probably lost money.

During the spring of 2000, however, a sharp sell off of biotech and technology stocks pushed the Nasdaq into a steep correction and caused a sudden rotation into previously ignored sectors of the blue chip market - like drugs, financials, and basic industry stocks - as money moved out of “new economy” stocks into “old economy” stocks. While the fundamental reasons for those sudden shifts in trends weren't clear at the time, they were easily spotted on the charts by traders who had access to live market information - and know how to chart and interpret it correctly.

That last point is especially important because having access to charts and data is only helpful if the trader knows what to do with them. And that's the purpose of this booklet. It will introduce to you the more important aspects of chart analysis.

Charts can be used by themselves or in combination with fundamental analysis. Charts can be used to time entry and exit points by themselves or in the implementation of fundamental strategies. Charts can also be used as an alerting device to warn the trader that something may be changing in the market's underlying fundamentals. Whichever way you choose to employ them, charts can be an extremely valuable tool - if you know how to use them. This booklet is a good place to start learning how.

– John J. Murphy

Why is Chart Analysis So Important?

Successful participation in the financial markets virtually demands some mastery of chart analysis. Consider the fact that all decisions in various markets are based, in one form or another, on a market forecast. Whether the market participant is a short-term trader or long-term investor, price forecasting is usually the first, most important step in the decision-making process. To accomplish that task, there are two methods of forecasting available to the market analyst - the fundamental and the technical.

Fundamental analysis is based on the traditional study of supply and demand factors that cause market prices to rise or fall. In financial markets, the fundamentalist would look at such things as corporate earnings, trade deficits, and changes in the money supply. The intention of this approach is to arrive at an estimate of the intrinsic value of a market in order to determine if the market is over- or under-valued.

Technical or chart analysis, by contrast, is based on the study of the market action itself. While fundamental analysis studies the reasons or causes for prices going up or down, technical analysis studies the effect, the price movement itself. That's where the study of price charts comes in. Chart analysis is extremely useful in the price-forecasting process. Charting can be used by itself with no fundamental input, or in conjunction with fundamental information. Price forecasting, however, is only the first step in the decision-making process.

Market Timing

The second, and often the more difficult, step is market timing. For short-term traders, minor price moves can have a dramatic impact on trading performance. Therefore, the precise timing of entry and exit points is an indispensable aspect of any market commitment. To put it bluntly, timing is everything in the stock market. For reasons that will soon become apparent, timing is almost purely technical in nature. This being the case, it can be seen that the application of charting principles becomes absolutely essential at some point in the decision-making process. Having established its value, let's take a look at charting theory itself.

What is Chart Analysis?

Chart analysis (also called technical analysis) is the study of market action, using price charts, to forecast future price direction. The cornerstone of the technical philosophy is the belief that all of the factors that influence market price - fundamental information, political events, natural disasters, and psychological factors - are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down. Chart analysis, therefore, is simply a short-cut form of fundamental analysis.

Consider the following: A rising price reflects bullish fundamentals, where demand exceeds supply; falling prices would mean that supply exceeds demand, identifying a bearish fundamental situation. These shifts in the fundamental equation cause price changes, which are readily apparent on a price chart. The chartist is quickly able to profit from these price changes without necessarily knowing the specific reasons causing them. The chartist simply reasons that rising prices are indicative of a bullish fundamental situation and that falling prices reflect bearish fundamentals.

Another advantage of chart analysis is that the market price itself is usually a leading indicator of the know fundamentals. Chart action, therefore, can alert a fundamental analyst to the fact that something important is happening beneath the surface and encourage closer market analysis.

Charts Reveal Price Trends

Markets move in trends. The major value of price charts is that they reveal the existence of market trends and greatly facilitate the study of those trends. Most of the techniques used by chartists are for the purpose of identifying significant trends, to help determine the probable extent of those trends, and to identify as early as possible when they are changing direction.

Figure 2-1: Daily Bar Chart This daily chart of Intel is a good example of an uptrend over a six-month period. Charts facilitate the study of trends. Important trends persist once they are established.

Click here for a live version of the chart.

Figure 2-2: Candlestick Chart A candlestick chart of Intel covering two months. The narrow wick is the day's range. The fatter portion is the area between the open and close. Open candles are positive; darker ones are negative. Click here for a live version of the chart.

Types of Charts Available

The most popular type of chart used by technical analysts is the daily bar chart. Each bar represents one day of trading. Japanese candlestick charts have become popular in recent years. Candlestick charts are used in the same way as bar charts, but present a more visual representation of the day's trading. Line Charts can also be employed (see Figure 2-3). The line chart simply connects each successive day's closing prices and is the simplest form of charting.

A line chart of Intel for an entire year. A single line connecting successive closing prices is the simplest form of charting. Click here for a live version of the chart.

Any Time Dimension

All of the above chart types can be employed for any time dimension. The daily chart, which is the most popular time period, is used to study price trends for the past year. For longer range trend analysis going back five or ten years, weekly and monthly charts can be employed. For short-term (or day-trading) purposes, intraday charts are most useful. [Intraday charts can be plotted for periods as short as 1-minute, 5-minute or 15-minute time periods.]

How to Plot the Daily Bar Chart

Price plotting is an extremely simple task. The daily bar chart has both a vertical and horizontal axis. The vertical axis (along the side of the chart) shows the price scale, while the horizontal axis (along the bottom of the chart) records calendar time. The first step in plotting a given day's price data is to locate the correct calendar day. This is accomplished simply by looking at the calendar dates along the bottom of the chart. Plot the high, low, and closing (settlement) prices for the market. A vertical bar connects the high and low (the range). The closing price is recorded with a horizontal tic to the right of the bar. (Chartists mark the opening price with a tic to the left of the bar.) Each day simply move one step to the right. Volume is recorded with a vertical bar along the bottom of the chart.

Figure 3-1: Construction of a Daily Bar Chart The construction of a daily bar chart is simple. The vertical bar is drawn from the day's high to the low. The tic to the left is the open; the tic to the right is the close. Volume bars are drawn along the bottom of the chart. Click here for a live version of the chart.

Two basic premises of chart analysis are that markets trends and that trends tend to persist. Trend analysis is really what chart analysis is all about. Trends are characterized by a series of peaks and troughs. An uptrend is a series of rising peaks and troughs. A downtrend shows descending peaks and troughs. Finally, trends are usually classified into three major categories: major, secondary, and minor. A major trend lasts more than a year; a secondary trend, from one to three months; and a minor trend, usually a couple of weeks or less.

Support and Resistance Trendlines and Channels

There are two terms that define the peaks and troughs on the chart. A previous trough usually forms a support level. Support is a level below the market where buying pressure exceeds selling pressure and a decline is halted. Resistance is marked by a previous market peak. Resistance is a level above the market where selling pressure exceeds buying pressure and a rally is halted.

Figure 4-1: Support and Resistance An uptrend is marked by rising peaks and troughs. Each peak is called resistance; each trough is called support. The uptrend is continued when a resistance peak is exceeded. Click here for a live version of the chart.

Support and resistance levels reverse roles once they are decisively broken. That is to say, a broken support level under the market becomes a resistance level above the market. A broken resistance level over the market functions as support below the market. The more recently the support or resistance level has been formed, the more power it exerts on subsequent market action. This is because many of the trades that helped form those support and resistance levels have not been liquidated and are more likely to influence future trading decisions.

Figure 4-2: Role Reversal An example of role reversal. A broken resistance level usually becomes a new support level. In a downtrend, a broken support level becomes resistance. Click here for a live version of the chart.

The trendline is perhaps the simplest and most valuable tool available to the chartist. An up trendline is a straight line drawn up and to the right, connecting successive rising market bottoms. The line is drawn in such a way that all of the price action is above the trendline. A down trendline is drawn down and to the right, connecting the successive declining market highs. The line is drawn in such a way that all of the price action is below the trendline. An up trendline, for example, is drawn when at least two rising reaction lows (or troughs) are visible. However, while it takes two points to draw a trendline, a third point is necessary to identify the line as a valid trend line. If prices in an uptrend dip back down to the trendline a third time and bounce off it, a valid up trendline is confirmed.

Figure 4-3: Rising Trendline An example of a rising trendline. Up trendlines are drawn under rising lows. A valid trendline should be touched three times as shown here. Click here for a live version of the chart.

Trendlines have two major uses. They allow identification of support and resistance levels that can be used, while a market is trending, to initiate new positions. As a rule, the longer a trendline has been in effect and the more times it has been tested, the more significant it becomes. The violation of a trendline is often the best warning of a change in trend.

Channel lines are straight lines that are drawn parallel to basic trendlines. A rising channel line would be drawn above the price action and parallel to the basic trendline (which is below the price action). A declining channel line would be drawn below the price action and parallel to the down trendline (which is above the price action). Markets often trend within these channels. When this is the case, the chartist can use that knowledge to great advantage by knowing in advance where support and resistance are likely to function.

Figure 4-4: Channel Line An example of a channel line. During an uptrend, prices will often meet new selling along an upper channel line which is drawn parallel to the rising trendline. Click here for a live version of the chart.

Reversal and Continuation Price Patterns

One of the most useful features of chart analysis is the presence of price patterns, which can be classified into different categories and which have predictive value. These patterns reveal the ongoing struggle between the forces of supply and demand, as seen in the relationship between the various support and resistance levels, and allow the chart reader to gauge which side is winning. Price patterns are broken down into two groups - reversal and continuation patterns. Reversal patterns usually indicate that a trend reversal is taking place. Continuation patterns usually represent temporary pauses in the existing trend. Continuation patterns take less time to form than reversal patterns and usually result in resumption of the original trend.

Reversal Patterns

The Head and Shoulders

The head and shoulders is the best known and probably the most reliable of the reversal patterns. A head and shoulders top is characterized by three prominent market peaks. The middle peak, or the head, is higher than the two surrounding peaks (the shoulders). A trendline (the neckline) is drawn below the two intervening reaction lows. A close below the neckline completes the pattern and signals an important market reversal.

Figure 5-1: Head and Shoulders Example of a head and shoulders bottom on a daily chart of Alaska Air Group (ALK). Click here for a live version of the chart.

Price objectives or targets can be determined by measuring the shapes of the various price patterns. The measuring technique in a topping pattern is to measure the vertical distance from the top of the head to the neckline and to project the distance downward from the point where the neckline is broken. The head and shoulders bottom is the same as the top except that is turned upside down.

Double and Triple Tops and Bottoms

Another one of the reversal patterns, the triple top or bottom is a variation of the head and shoulders. The only difference is that the three peaks or troughs in this pattern occur at about the same level. Triple tops or bottoms and the head and shoulders reversal pattern are interpreted in similar fashion and mean essentially the same thing.

Figure 5-2: Double Bottom Chart Example of a double bottom on the daily chart of General Electric (GE). Click here for a live version of the chart.

Double tops and bottoms (also called M's and W's because of their shape) show two prominent peaks or troughs instead of three. A double top is identified by two prominent peaks. The inability of the second peak to move above the first peak is the first sign of weakness. When prices then decline and move under the middle trough, the double top is completed. The measuring technique for the double top is also based on the height of the pattern. The height of the pattern is measured and projected downward from the point where the trough is broken. The double bottom is the image of the double top.

Figure 5-3: Double Top Reversal Pattern Two prominent peaks can be seen on the chart for LMT, forming a double top reversal pattern. Click here for a live version of the chart.

Saucers and Spikes

These two patterns aren't as common, but are seen enough to warrant discussion. The spike top (also called a V-reversal) pictures a sudden change in trend. What distinguishes the spike from the other reversal patterns is the absence of a transition period, which is sideways price action on the chart constituting topping or bottoming activity. This type of pattern marks a dramatic change in trend with little or no warning.

The saucer, by contrast, reveals an unusually slow shift in trend. Most often seen at bottoms, the saucer pattern represents a slow and more gradual change in trend from down to up. The chart picture resembles a saucer or rounding bottom - hence its name.

Figure 5-4: Spike Tops and Bottoms Two examples of a stock changing direction with little or no warning. Click here for a live version of the chart.

Figure 5-5: Saucer Bottom Some bottoms are a slow, gradual process and have a rounding shape like a saucer. This saucer bottom is Advanced Micro Devices (AMD) took almost a year to form. Click here for a live version of the chart.

Continuation Patterms

Triangles

Instead of warning of market reversals, continuation patterns are usually resolved in the direction of the original trend. Triangles are among the most reliable of the continuation patterns. There are three types of triangles that have forecasting value - symmetrical, ascending, and descending triangles. Although these patterns sometimes mark price reversals, they usually just represent pauses in the prevailing trend.

The symmetrical triangle (also called the coil) is distinguished by sideways activity with prices fluctuating between two converging trendlines. The upper line is declining and the lower line is rising. Such a pattern describes a situation where buying and selling pressure are in balance. Somewhere between the halfway and the three-quarters point in the pattern, measured in calendar time from the left of the pattern to the point where the two lines meet at the right (the apex), the pattern should be resolved by a breakout. In other words, prices will close beyond one of the two converging trendlines.

Figure 5-6: Symmetrical Triangle An example of a symmetrical triangle during the 1999 advance in Citigroup. The two lines converge, with the upper line falling and the lower line rising. Since this is a continuation pattern, the odds favored resumption of the bull trend. Click here for a live version of the chart.

The ascending triangle has a flat upper line and a rising lower line. Since buyers are more aggressive than sellers, this is usually a bullish pattern.

Figure 5-7: Ascending Triangle An example of an ascending triangle. The upper line is flat, while the lower line is rising. This is usually a bullish pattern and is completed when prices close above the upper line. Click here for a live version of the chart.

The descending triangle has a declining upper line and a flat lower line. Since sellers are more aggressive than buyers, this is usually a bearish pattern.

The measuring technique for all three triangles is the same. Measure the height of the triangle at the widest point to the left of the pattern and measure that vertical distance from the point where either trendline is broken. While the ascending and descending triangles have a built-in bias, the symmetrical triangle is inherently neutral. Since it is usually a continuation pattern, however, the symmetrical triangle does have a forecasting value and implies that the prior trend will be resumed.

Flags and Pennants

These two short-term continuation patterns mark brief pauses, or resting periods, during dynamic market trends. Both are usually preceded by a steep price move (called the pole). In an uptrend, the steep advance pauses to catch its breath and moves sideways for two or three weeks. Then the uptrend continues on its way. The names aptly describe their appearance. The pennant is usually horizontal with two converging trendlines (like a small symmetrical triangle) The flag resembles a parallelogram that tends to slope against the trend. In an uptrend, therefore, the bull flag has a downward slope; in a downtrend, the bear flag slopes upward. Both patterns are said to “fly at half mast,” meaning that they often occur near the middle of the trend, making the halfway point in the market move.

Figure 5-8: Pennant An example of a pennant forming during the ascent of Apple Computer during November 1999. The pennant looks like a small symmetrical triangle, but normally doesn't last for more than two or three weeks. The breaking of the upper line signals resumption of the uptrend. Click here for a live version of the chart.

Figure 5-9: Flag An example of a bullish flag forming during December 2013. Bull Flags are short-term patterns that slope against the prevailing trend. The uptrend usually resumes after the upper line is broken. Click here for a live version of the chart.

In addition to price patterns, there are several other formations that show up on the price charts and that provide the chartist with valuable insights. Among those formations are price gaps, key reversal days, and percentage retracements.

Price Gaps

Gaps are simply areas on the bar chart where no trading has taken place. An upward gap occurs when the lowest price for one day is higher than the highest price of the preceding day. A downward gap means that the highest price for one day is lower than the lowest price of the preceding day. There are different types of gaps that appear at different stages of the trend. Being able to distinguish among them can provide useful and profitable market insights. Three types of gaps have forecasting value- breakaway, runaway and exhaustion gaps.

Figure 6-1: Price Gaps Example of price gaps. Click here for a live version of the chart.

The breakaway gap usually occurs upon completion of an important price pattern and signals a significant market move. A breakout above the neckline of a head and shoulders bottom, for example, often occurs on a breakaway gap.

The runaway gap usually occurs after the trend is well underway. It often appears about halfway through the move (which is why it is also called a measuring gap since it gives some indication of how much of the move is left). During uptrends, the breakaway and runaway gaps usually provide support below the market on subsequent market dips; during downtrends, these two gaps act as resistance over the market on bounces.

The exhaustion gap occurs right at the end of the market move and represents a last gasp in the trend. Sometimes an exhaustion gap is followed within a few days by a breakaway gap in the other direction, leaving several days of price action isolation by two gaps. This market phenomenon is called the island reversal and usually signals an important market turn.

The Key Reversal Day

Another price formation is the key reversal day. This minor pattern often warns of an impending change in trend. In an uptrend, prices usually open higher, then break sharply to the downside and close below the previous day's closing price. (A bottom reversal day opens lower and closes higher).

The wider the day's range and the heavier the volume, the more significant the warning becomes and the more authority it carries. Outside reversal days (where the high and low of the current day's range are both wider than the previous day's range) are considered more potent. The key reversal day is a relatively minor pattern taken on its own merits, but can assume major importance if other technical factors suggest that an important change in trend is imminent.

Figure 7-1: Key Reversal Days Examples of key reversal days. The two downside reversal days are identified by higher openings and lower closings on heavy volume. The bigger the price range, the more significant is the reversal signal. Click here for a live version of the chart.

Percentage Retracements

Market trends seldom take place in straight lines. Most trend pictures show a series of zig-zags with several corrections against the existing trend. These corrections usually fall into certain predictable percentage parameters. The best-known example of this is the fifty-percent retracement. That is to say, a secondary, or intermediate, correction against a major uptrend often retraces about half of the prior uptrend before the bull trend is again resumed. Bear market bounces often recover about half of the prior downtrend.

A minimum retracement is usually about a third of the prior trend. The two-thirds point is considered the maximum retracement that is allowed if the prior trend is going to resume. A retracement beyond the two-thirds point usually warns of a trend reversal in progress. Chartists also place importance on retracements of 38% and 62% which are called Fibonacci retracements.

The Interpretation of Volume

Chartists employ a two-dimensional approach to market analysis that includes a study of price and volume. Of the two, price is the more important. However, volume provides important secondary confirmation of the price action on the chart and often gives advance warning of an impending shift in trend.

Figure 9-1: Price and Volume An example of price and volume moving in harmony during an uptrend. The price advance during January 2000 saw heavy trading. The February correction was on light volume. The resumption of the uptrend was on heavier volume again. That's what should happen during an uptrend. Click here for a live version of the chart.

Volume is the number of units traded during a given time period, which is usually a day. It is the number of common stock shares traded each day in the stock market. Volume can also be monitored on a weekly basis for longer-range analysis.

When used in conjunction with the price action, volume tells us something about the strength or weakness of the current price trend. Volume measures the pressure behind a given price move. As a rule, heavier volume (marked by larger vertical bars at the bottom of the chart) should be present in the direction of the prevailing price trend. During an uptrend, heavier volume should be seen during rallies, with lighter volume (smaller volume bars) during downside corrections. In downtrends, the heavier volume should occur on price selloffs. Bear market bounces should take place on a lighter volume.

Volume Is an Important Part of Price Patterns

Volume also plays an important role in the formation and resolution of price patterns. Each of the price patterns described previously has its own volume pattern. As a rule, volume tends to diminish as price patterns form. The subsequent breakout that resolves the pattern takes on added significance if the price breakout is accompanied by heavier volume. Heavier volume accompanying the breaking of trendlines and support or resistance levels lends greater weight to price activity.

Figure 9-2: Volume User in a Price Pattern An example of volume used in a price pattern. The chart shows ADM breaking a “neckline” of a head and shoulders top. The breaking of the neckline coincided with a burst in trading activity- which is usually a negative sign for the stock. Click here for a live version of the chart.

On Balance Volume (OBV)

Market analysts have several indicators to measure trading volume. One of the simplest, and most effective, is on-balance volume (OBV). OBV plots a running cumulative total of upside versus downside volume. Each day that a market closes higher, that day's volume is added to the previous total. On each down day, the volume is subtracted from the total. Over time, the on-balance volume will start to trend upward or downward. If it trends upward, that tells the trader there's more upside than downside volume, which is a good sign. A falling OBV line is usually a bearish sign.

Plotting OBV

The OBV line is usually plotted along the bottom of the price chart. The idea is to make sure the price line and the OBV line are trending in the same direction. If prices are rising, but the OBV line is flat or falling, that means there may not be enough volume to support higher prices. In that case, the divergence between a rising price line and a flat or falling OBV line is a negative warning.

Figure 9-3: Price and OBV Lines An example of price and OBV lines not confirming each other. The March 2000 move to new highs by JDS Uniphase was accompanied by a flat OBV line. That was an early warning of a possible top. Click here for a live version of the chart.

OBV Breakouts

During periods of sideways price movement, when the market trend is in doubt, the OBV line will sometimes break out first and give an early hint of future price direction. An upside breakout in the OBV line should catch the trader's eye and cause him or her to take a closer look at the market or stock in question. At market bottoms, an upside breakout in on-balance volume is sometimes an early warning of an emerging uptrend.

Figure 9-4: On-Balance Volume (OBV) Line An example of the OBV line giving a bullish warning. During the decline in the price of GE during the 1st quarter of 2000, the rising On-Balance Volume line hinted at the bottom. Click here for a live version of the chart.

Other Volume Indicators

There are many other indicators that measure the trend of volume - with names like Accumulation Distribution, Chaikin Oscillator, Market Facilitation Index, and Money Flow. While they're more complex in their calculations, they all the same intent- to determine if the volume trend is confirming, or diverging from, the price trend.

Using Different Timeframes for Short- and Long-Term Views

Bar chart analysis is not limited to daily bar charts. Weekly and monthly charts provide a valuable long-term perspective on market history that cannot be obtained by using daily charts alone. The daily bar chart usually shows up to twelve months of price history for each market. Weekly charts show almost five years of data, while the monthly charts go back over 20 years.

Figure 10-1: Weekly Bar Chart A demonstration of the importance of long-term perspective achieved by a weekly chart going back several years. The 1st upside breakout exceeded highs set a year earlier, which might have been spotted on a daily chart. The 2nd breakout, however, exceeded a peak set three years earlier- and would have been missed on a daily chart. Click here for a live version of the chart.

By studying these charts, the chartist gets a better idea of long-term trends, where historic support and resistance levels are located, and is able to obtain a clearer perspective on the more recent action revealed in the daily charts. These weekly and monthly charts lend themselves quite well to standard chart analysis described in the preceding pages. The view held by some market observers that chart analysis is useful only for short-term analysis and timing is simply not true. The principles of chart analysis can be used in any time dimension.

Using Intraday Charts

Daily and weekly charts are useful for intermediate- and long-term analysis. For short-term trading, however, intraday charts are extremely valuable. Intraday charts usually show only a few days of trading activity. A 15-minute bar chart, for example, might show only three or four days of trading. A 1-minute or a 5- minute chart usually shows only one or two days of trading respectively, and is generally used for day-trading purposes. Fortunately, all of the chart principles described herein can also be applied to intraday charts.

Figure 10-2: Intraday Chart Example of a 60-minute bar chart. Charting principles (like gaps, trendlines, and price formation) can be seen on these intraday charts and are extremely helpful for short-term trading. Click here for a live version of the chart.

Going From the Long Term to the Short Term

As indispensable as the daily bar charts are to market timing and analysis, a thorough chart analysis should begin with the monthly and weekly charts- and in that order. The purpose of that approach is to provide the analyst with the necessary long-term view as a starting point. Once that is obtained on the 20- year monthly chart, the 5-year weekly chart should be consulted. Only then should the daily chart be studied. In other words, the proper order to follow is to begin with a solid overview and then gradually shorten the time horizon. (For even more microscopic market analysis, the study of the daily chart can be followed by the scrutiny of intraday charts).

Using a Top-Down Market Approach

The idea of beginning one's analysis with a broader view and gradually narrowing one's focus has another important application in the field of market analysis. That has to do with utilizing a “top-down” approach to analyzing the stock market. This approach utilizes a three-step approach to finding winning stocks. It starts with an overall market view to determine whether the stock market is moving up or down, and whether this is a good time to be investing in the market. It then breaks the stock market down into market sectors and industry groups to determine which parts of the stock market look the strongest. Finally, it seeks out leading stocks in those leading sectors and groups.

THE FIRST STEP: The Major Market Averages

The intent of the first step in the “top-down” approach is to determine the trend of the overall market. The presence of a bull market (a rising trend) is considered a good time to invest funds in the stock market. The presence of a bear market (a falling trend) might suggest a more cautious approach to the stock market. In the past, it was possible to look at one of several major market averages to gauge the market's trend. That was because most major averages usually trended in the same direction. That hasn't always been the case in recent history, however. For that reason, it's important to have some familiarity with the major market averages, and to know what each one actually measures.

Different Averages Measure Different Things

The traditional blue chip averages- like the Dow Jones Industrial Average, the NYSE Composite Index, and the S&P 500- generally give the best measure of the major market trend. The Nasdaq Composite Index, by contrast, is heavily influenced by technology stocks. While the Nasdaq is a good barometer of trends in the technology sector, it's less useful as a measure of the overall market trend. The Russell 2000 Index measures the performance of smaller stocks. For that reason, it's used mainly to gauge the performance of that sector of the market. The Russell is less useful as a measure of the broader markets which is comprised of larger stocks.

Since most of these markets are readily available in the financial press and on the Internet, it's usually a good idea to keep an eye on all of them. The strongest signals about market directions are given when all or most of the major market averages are trending in the same direction.

Figure 11-1: Major Market Average The best way to determine the trend of the stock market is to chart one of the major market averages. This example shows that the NYSE Composite Index has been rising several years. Click here for a live version of the chart.

THE SECOND STEP: Sectors and Industry Groups

The stock market is divided into market sectors which are sub-divided further into industry groups. There are ten market sectors, which include Basic Materials, Consumer Cyclicals, Consumer Non-Cyclicals, Energy, Financial, Healthcare, Industrial, Technology, Telecommunications, and Utilities. Each of those sectors can have as many as a dozen or more industry groups. For example, some groups in the Technology sector are Computers, the Internet, Networkers, Office Equipment, and Semiconductors. The Financial sector includes Banks, Insurance, and Securities Brokers.

The recommended way to approach this group is to start with the smaller number of market sectors. Look for the ones that seem to be the strongest. During most of 1999 and into the early part of 2000, for example, technology stocks represented the strongest market sector. Once you've isolated the preferred sector, you can then look for the strongest industry groups in that sector. Two leading candidates during the period of time just described were Internet and Semiconductor stocks. The idea is to be in the strongest industry groups within the strongest market sectors.

Figure 11-2: Strong Industry Group An example of a strong industry group. During the first quarter of 2000, semiconductor stocks were the strongest group in a strong technology sector. Click here for a live version of the chart.

For many investors, the search can stop there. The choice to be in a market sector or industry group can easily be implemented through the use of mutual funds that specialize in specific market sectors or industry groups. A wide range of Exchange Traded Funds (ETFs) that trade throughout the trading day are even more suitable for sector rotation purposes

THE THIRD STEP: Individual Stocks

For those investors who deal in individual stocks, this is the third step in the “top-down” market approach. Having isolated an industry group that has strong upside potential, the trader can then look within that group for winning stocks. It's been estimated that as much as 50% of a stock's direction is determined by the direction of its industry group. If you've already found a winning group, your work is half done.

Another advantage of limiting your stock search to winning sectors and groups is that it narrows the search considerably. There are as many as 5,000 stocks that an investor can choose from. It's pretty tough doing a market analysis of so many markets. Some sort of screening process is required. That's where the three-step process comes in. By narrowing your stock search to a small number of industry groups, the number of stocks you have to study is dramatically reduced. You also have the added comfort of knowing that each stock you look at is already part of a winning group.

Figure 11-3: Individual Stocks Intel was one of the strongest semiconductor stocks during the first three months of 2000. Having started the search in a strong semiconductor group, the search for a winning stock is made a lot easier. Click here for a live version of the chart.

Moving Averages

In the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason. Moving averages smooth the price action and make it easier to spot the underlying trends. Precise trend signals can be obtained from the interaction between a price and an average or between two or more averages themselves. Since the moving average is constructed by averaging several days' closing prices, however, it tends to lag behind the price action. The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action. A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes. The moving average is easily quantified and lends itself especially well to historical testing. Mainly for those reasons, it is the mainstay of most mechanical trend-following systems.

Popular Moving Averages

In stock market analysis, the most popular moving average lengths are 50 and 200 days. [On weekly charts, those daily values are converted into 10- and 40-week averages.] During an uptrend, prices should stay above the 50-day average. Minor pullbacks often bounce off that average, which acts as a support level. A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe correction.

In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average. If a market is in a normal bull market correction, it should find new support around its 200-day average. [For short-term trading purposes, traders will employ a 20-day average to spot short-term trend changes].

Bollinger Bands

These are trading bands plotted two standard deviations above and below a 20-day moving average. When a market touches (or exceeds) one of the trading bands, the market is considered to be over-extended. Prices will often pull back to the moving average line.

Moving Average Convergence Divergence (MACD)

The MACD is a popular trading system. On your computer screen, you'll see two weighted moving averages (weighted moving averages give greater weight to the more recent price action). Trading signals are given when the two lines cross.

Oscillators

Oscillators are used to identify overbought and oversold market conditions. The oscillator is plotted on the bottom of the price chart and fluctuates within a horizontal band. When the oscillator line reaches the upper limit of the band, a market is said to be overbought and vulnerable to a short-term setback. When the line is at the bottom of the range, the market is oversold and probably due for a rally. The oscillator helps to measure market extremes and tells the chartists when a market advance or decline has become over-extended.

Relative Strength Index (RSI)

This is one of the most popular oscillators used by technical traders. The RSI scale is plotted from 0 to 100 with horizontal lines drawn at the 70 and 30 levels. An RSI reading above 70 is considered to be overbought. An RSI reading below 30 is considered to be oversold. The most popular time periods for the RSI are 9 and 14 days.

Figure 13-1: RSI Oscillator A 9-day RSI oscillator applied to the Dow Industrials. RSI readings over 70 often coincide with short-term pullbacks. Readings below 30 often identify market bottoms. Click here for a live version of the chart.

Stochastics

This oscillator is also plotted on a scale from 0 to 100. However, the upper and lower lines (marking the overbought and oversold levels) are at the 80 and 20 levels. In other words, readings above 80 are overbought, while readings below 20 are oversold. One added feature of Stochastics is that there are two oscillator lines instead of one. (The slower line is usually a 3-day moving average of the faster line). Trading signals are given when the two lines cross. A buy signal is given when the faster line crosses above the slower line from below 20. A sell signal is given when the faster line crosses beneath the slower line from above 80. The time period used by most chart analysts is fourteen days.

Figure 13-2: Stochastics Oscillator The 14-day stochastics oscillator applied to the S&P 500. The last two bottoms in the S&P were marked by oversold stochastic readings below 20. Readings over 80 coincided with several short-term peaks. Click here for a live version of the chart.

Any Time Dimension

As is the case with most technical indicators, these oscillators can be employed in any time dimension. That means they can be used on weekly, daily and intraday charts. It's a good idea to use the same time span in all time dimensions. When plotting the stochastics lines, for example, use 14 weeks on the weekly chart, 14 days on the daily chart, and 14 hours on an hourly chart, etc.

Another reason for keeping the same numbers is that computers allow you to switch back and forth between weekly, daily and intraday charts with a keystroke. Using the same time spans in all time dimensions makes your work a lot easier.

Ratios and Relative Strength

Technical analysis can be applied to ratio charts. Trendlines and moving averages, for example, can help measure trends on ratios and can alert the user to changes in those trends. A close monitoring of the ratio charts can add a valuable dimension to market analysis.

Sector Ratios

Chapter 11 recommended using a “top-down” market approach to find winning sectors, industry groups, and individual stocks. That is done by applying ratio analysis to determine each market's relative strength. When choosing industry groups, for example, the common technique is to divide an industry index (like the Semiconductor Index) by a market benchmark like the S&P 500. When the ratio line is rising, that means the industry is outperforming the general market. When the ratio is falling, that industry is lagging behind the rest of the market. The idea is to concentrate your attention on groups with rising ratios and avoid those groups with falling ratios. That way you'll be buying only those industry groups that are showing superior relative strength.

Stock Ratios

Once you've identified a winning group, you can apply ratio analysis to the stocks in that group. Simply divide the individual stocks in the group by the group index itself. The stocks with rising ratio lines are the strongest stocks in the group. The idea here is to find the stocks in the group that are showing the greatest relative strength. That way you'll be buying the strongest stocks in the strongest groups.

Market Ratios

Ratio analysis can also be used to compare major market averages. By dividing the Nasdaq Composite Index by the S&P 500, for example, you can determine if technology stocks are leading or lagging the rest of the market. You can use the Russell 2000 versus the S&P to gauge the relative strength (or weakness) of smaller stocks.

Figure 14-1: Ratios and Relative Strength The rising Nasdaq/S&P 500 ratio shows remarkable relative strength in the technology sector during the last quarter of 1999 and the first quarter of 2000. The breaking of the up trendlines, however, signaled new relative weakness in technology. Ratio charts are a good way to spot sector rotations within the stock market. Click here for a live version of the chart.

Options

Options give the holder the right, but not the obligation, to purchase (in the case of a call) or sell (in the case of a put) an underlying market entity at a specific price within a specified period of time. In its simplest application, a trader who is bullish on a market can simply purchase a call; a trader who is bearish can simply purchase a put.

The main advantage in options trading is limited risk. The option trader pays a premium to purchase the option. If the market doesn't move as expected, the option simply expires. The maximum loss the option trader can suffer is the size of the premium.

There are countless option strategies that can be utilized by option traders. However, most option strategies require a market view. In other words, the option trader must first determine whether the market price of the underlying market contract is going to rise, fall, or stay relatively flat. This is because the major factor influencing the value of an option is the performance of its underlying market. In determining an appropriate option strategy, it's important to remember that the principles of market analysis are not applied to the option itself, but to the underlying market.

Therefore, it can be seen that the principles of chart analysis covered in the preceding pages and their application to the financial markets play an important role in options trading.

Option Put/Call Ratio

Trading activity in the options markets is used to generate a popular stock market sentiment indicator–called the put/call ratio. This ratio is actually a ratio of put volume divided by the call volume. It is generally applied to the S&P 100 (OEX) index option traded on the Chicago Board Options Exchange (CBOE) or the CBOE Equity put/call ratio, which uses option volume in individual stocks.

Contrary Indicator

The S&P 100 or the CBOE Equity put/call ratio is a contrary indicator. In other words, a high put/call ratio is considered bullish for the market (because it shows too much bearish sentiment). In the same way, a low put/call ratio (which betrays strong bullish sentiment) is considered bearish for the market. The reasoning behind the put/call ratio being used as a contrary indicator is based on the idea that option traders get too bullish near market tops and too bearish near market bottoms.

CBOE Volatility Index (VIX)

CBOE Volatility (VIX) Index: This contrary indicator is based on the volatility of the S&P 500. Since it is a contrary indicator, a rising VIX implies greater volatility and growing concern about downside correction in the stock market. By contrast, a falling VIX implies less volatility and more confidence in the market. The VIX usually trades in a band between 20 and 40. Dips below 20 are usually associated with an over-extended stock market. Moves above 40 are usually associated with market bottoms.

The Principle of Confirmation

The principle of confirmation holds that the more technical evidence supporting a given analysis, the stronger the conclusion becomes. In the study of an individual market, for example, all of the technical signs should be pointing in the same direction. If some signs are pointing up and the others down, be suspicious. Consult other stocks in the same group. A bullish analysis in a stock would be less than convincing if the other stocks in its group were trending lower. Since stocks in the same group tend to move together, make sure that the other stocks agree with the one being studied.

Look at the various technical indicators to see if they agree. Are the chart patterns being confirmed by the volume? Do the moving averages and oscillators confirm the chart analysis? What do the weekly and monthly charts show? While it is seldom that all of these technical factors will point in the same direction, it pays to have as many of them in your corner as possible.

Summary and Conclusion

We have provided here an introduction to technical analysis as it is applied to the financial markets. We've discussed briefly the major tools utilized by the chartists, including: basic chart analysis, the study of volume, moving averages, oscillators, ratios, weekly, and intraday charts. The successful trader learns how to combine all these elements into one coherent theory of market analysis.

The many software and Internet-based products available on the market today also provide powerful tools that make charting and technical analysis much easier –and far more accessible to general investors–than ever before. For example, many software and Internet-based products include a full suite of technical analysis tools that allow you to create charts easily, have instant access to historical data, and have the ability to create, backtest and optimize self-designed trading systems without any programming knowledge or experience.

Technical analysis provides an excellent vehicle for market forecasting, either with or without fundamental input. Where technical analysis becomes absolutely essential, however, is in the area of market timing. Market timing is purely technical in nature, so successful participation in the markets dictates some application of technical analysis.

It's not necessary to be an expert chartist to benefit from chart analysis. However, chart analysis will go a long way in keeping the trader on the right side of the market and in helping to pinpoint market entry and exit points, which are so vital to trading success. Whether the participant is a day trader or a long-term investor, it's to his or her advantage to learn about chart analysis.

Acknowledgement

From the book “Charting Made Easy” copyright © 2000. Used by arrangement with John Wiley & Sons. Inc.

This is the tenth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Volume Confirmation

In an uptrend, volume should expand as the prices move higher and contract as the prices pull back. As long as this pattern continues, volume is confirming the uptrend. The opposite is true for downtrends. Volume should expand as prices decline and contract during rallies to confirm a downtrend.

Negative divergences can occur if new price highs in an uptrend take place on declining volume. This type of volume activity is an indication of diminishing buying pressure. If the volume also begins to pick up on price pull backs, prices may begin consolidating or reversing into a downtrend.

The same concept is true for positive divergences in downtrends. If volume begins to contract on new price lows but expands during rallies, prices may begin consolidating or reversing into an uptrend.

This is the end of our section on trends and trend lines. In part 11 we'll dive into some of the fundamental price patterns that result from when two trend lines are in effect at the same time.

This is the thirteenth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

The Infamous Head and Shoulders Reversal Pattern

One of the most common reversal patterns is the Head and Shoulders pattern.

This pattern forms in an uptrend and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being lower. The reaction lows of each peak can be connected to form a line of support called a neckline. The top reversal pattern is completed when price breaks below the neckline.

While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights.

It's important to realize that up until the point where prices move back below the level of the left shoulder, things look like a normal, ongoing uptrend. It is only when the left shoulder's price level is violated that the bulls become fearful and the bears start to smell blood. The right shoulder forms as the bulls try to reestablish the uptrend and then fail - usually because many of the more skittish investors will take profits at that point.

As the Head and Shoulders top reversal pattern unfolds, volume plays an important role in confirmation. Buying volume (volume on up days) will slowly translate into selling volume (volume on down days) as the pattern develops. This is seen when volume that previously expanded on rallies begins to expand on declines and contract on rallies.

The Head and Shoulders bottom reversal pattern is just the reverse of the top reversal pattern with volume acting as a confirmation.

As with the Head and Shoulders top reversal pattern, volume action is helpful in confirming the trend reversal. Volume that was previously expanding on declines begins to expand on rallies and contract on declines as the trend reversal develops.

Traders begin noticing lighter selling volume on the declines and heavier buying volume on the rallies. This kind of price and volume action is quickly noticed by the market which results in additional buying volume supporting the trend reversal.

A couple of other comments about this pattern:

• Sometimes several left shoulders will form before a true head appears. Sometimes several right shoulders appear before a true neckline break occurs.

• When a neckline break occurs, the stock will often fall at least as much as the distance from the neckline to the top of the head.

Other Reversal Patterns

Many of the technical analysis books out there will go on to talk about several other kinds of reversal patterns - the rounding bottom, the V-reversal, double tops, triple bottoms, and others. (We have many of them cataloged in our ChartSchool area.) Here's a trade secret - most of those are just variations of the Head and Shoulders reversal pattern that didn't form “perfectly” for some reason. For example, the Triple Top is a Head and Shoulders pattern where the head doesn't go above the left shoulder.

The key point here is this - don't worry about what type of reversal is occurring. Knowing it's a Triple Top instead of a Head & Shoulders won't make you more money. Focus on what the chart is telling you—the fear/greed ratio is changing—and react accordingly.

In part 14, we'll look at the question “How much is too much?"

This is the twelfth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Volume Confirmation of Price Patterns

When identifying potential price patterns on a chart, it is crucial to try and verify that the market psychology behind the price pattern is really happening at that point on the chart. One of the best ways to do that is to use volume to confirm things.

In the case of a rectangle pattern, volume should be decreasing while the rectangle is forming. There may be volume spikes whenever prices get near the top or bottom of the pattern, but in general, as a rectangle pattern continues to develop, volume should decrease. Volume will probably spike up heavily immediately after the breakout as people realize that the support or resistance line has been broken.

Triangle patterns should have a similar volume pattern - decreasing volume while the triangle is forming with a sharp increase in volume once a breakout is achieved.

Again, the diagrams above are idealized - the real-world is much messier. Consider this example:

Notice that EWG didn't have a smooth decrease in volume but instead had several mini-spikes that corresponded to changes in direction of the “coil.” The key, however, is that each mini-spike was smaller than the previous one (with the exception of October 30, but that was early in the coil's formation). Once that downward volume trend was well established, a big spike above that trend line would signal the breakout - just like on December 6.

Consolidation / Continuation Patterns vs. Reversal Patterns

So far, the two price patterns we've looked at - Rectangles and Triangles - are examples of Consolidation Patterns, also known as Continuation Patterns. They are called that because, in general, after the pattern completes, prices will usually continue whatever trend they were in prior to the pattern forming. In order words, if prices are in an uptrend prior to a rectangle pattern forming, prices will usually resume the uptrend once the rectangle pattern finishes. Basically, consolidation patterns are places where the bulls and the bears have another short-term argument about the stock, but it is a half-hearted one. The bigger picture doesn't really change.

Next, we are going to start looking at Reversal Patterns. These are where the fireworks occur. If consolidation patterns are skirmishes, reversal patterns are the big battles. When reversal patterns start to appear, the current trend is in real danger and lots of people start to pay attention.

In part 13 we'll look at the granddaddy of all reversal patterns - the Head and Shoulders reversal.

This is the eleventh part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand”, these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Price Patterns

Price Patterns result when the market is not in agreement on the value of a stock. Essentially, they are the visual remains of a big battle between bulls and bears. In many ways, they are like weather patterns that you see on the nightly news. Often today's weather can be forecast by looking at yesterday's atmospheric data, but occasionally (frequently?) the forecast is wrong. Similarly, chart patterns often but not always indicate future price movements.

At their core, most price patterns are combinations of several trend lines. The simplest pattern is the Rectangle Pattern.

In a rectangle pattern, price moves between two horizontal lines of support and resistance. In order to qualify as a rectangle pattern, both support and resistance lines must be touched at least twice. Rectangle patterns have a narrow or wide price range and last from days to months. The pattern ends once the line of support or resistance is broken.

A price break through resistance may be anticipated if volume expands when prices rise and contracts when prices fall within the rectangle pattern. An imminent price break above resistance may exist if prices don't fall to the support line before rising again.

A price break through support may be anticipated if volume expands when prices fall and contracts when prices rise within the rectangle pattern. An imminent price break below support may exist if prices don't rise to the resistance line before falling again.

As illustrated above, as soon as the pattern breaks down, the top (or bottom) of the rectangle changes into a support (or resistance) line for the stock.

Rectangle patterns clearly show the battle between bulls and bears, with the bulls repeatedly buying when prices hit the support level, and bears repeatedly selling when prices hit the resistance level. At some point, one of those groups will win, and prices will break out of the pattern. The longer prices have been in the pattern, then the larger the breakout move will be and the more significant the new support/resistance line becomes.

Another common price pattern is the Triangle Pattern. The triangle pattern is very similar to the rectangle, except that the upper and/or lower trend lines that define the pattern are sloped instead of horizontal.

Go back to the rectangle diagram above and imagine that bearish sentiment about the stock was growing over time. What would that look like? Well, in that case, more and more sellers would not wait for prices to return to the level of the red resistance line before selling. Instead, they would sell sooner. That would cause the red resistance line to become a downward trend line forming a Descending Triangle Pattern.

Alternately, what if buyers started getting impatient and started buying before the stock got back to its green support line? Then a Rising Triangle Pattern would form.

And what if both the bulls became more bullish while at the same time, the bears became more bearish? Then both the red and green lines would be slanted and we'd have a Symmetric Triangle Pattern.

By the way, triangle patterns are also referred to as “coils.” Can you see why? As the upper and lower parts of the triangle get closer together, the battle between the bulls and the bears gets more intense and the suspense builds. Obviously, at some point, prices are going to move outside of the triangle's boundaries - but will they move higher or lower? Psychological energy coils up like a spring inside of the triangle and the closer the lines get, the bigger the inevitable breakout will be.

As you probably guessed, the diagrams above are not realistic. Typically, triangle patterns have a breakout well before the apex of the triangle is reached. It is the direction of the breakout that is the key question when watching a triangle form. Will the bulls win? Will the bears win?

A couple of clues can be found in the price action that precedes the triangle. If the stock was in an uptrend prior to the triangle, there is a good chance it will break out of the triangle pattern on the upside and continue the uptrend. In addition, rising triangles tend to break out to the upside while descending triangles often break lower. Symmetric triangles are usually not completely even, i.e., the support side may be stronger than the resistance side making the triangle point up or, if the support side is weaker, point down. In that case, the triangle often breaks in the direction it is pointing.

In part 12 we'll look at how to confirm these patterns with volume and examine some real-world examples.

This is the fifteenth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Gaps

Price charts often have blank spaces known as gaps. They represent times when no shares were traded within a particular price range. Gaps result from extraordinary buying or selling interest developing when the market is closed. When the market opens, the price is raised or lowered enough to satisfy all of the buying or selling orders.

For an up gap to form, the low price after market close on the day of the up gap must be higher than the high price of the previous day. Up gaps are generally considered bullish.

A down gap is just the opposite of an up gap; the high price of the down gap day after market close must be lower than the low price of the previous day. Down gaps are usually considered bearish.

Up and down gaps can form on daily, weekly or monthly charts and are considered significant when accompanied with higher than average volume.

A price chart with gaps almost every day is typical for very lightly traded securities and should be avoided. Prices often gap up or down at market open and then close the gap before market close. Such temporary intraday gaps should not be considered as having anything more significance than normal market volatility.

Many investors mistakenly believe that gaps influence future prices to the point of eventually filling the gap. Instances where gaps close within a few days of forming can be significant. However, gaps have little to no influence on price action weeks or months after forming.

Breakaway gaps signal a change in market psychology about the future prospect of a security, especially when accompanied by above average volume. A bullish breakaway gap forms when a security gaps up after an extended decline, extended base or a consolidation period. A bearish breakaway gap forms when a security gaps down after an extended advance, an extended top or a consolidation period.

Common gaps occur within a trading range or shortly after a sharp move as a reaction. These gaps do not reflect a change in market psychology, but rather represent price volatility or temporary imbalance of supply and demand. For instance, if a security has declined 20% in a week and gaps up, it would be considered a common gap and not likely to signify a change in trend. Or, if a trading range develops between $20 and $30, and a gap forms in the middle, it is probably a common gap.

Continuation gaps form near the middle of a short or intermediate trend in the same direction. These gaps signal a continuation of the preceding trend. Continuation gaps are also known as measuring or runaway gaps. These gaps can be triggered by news events that bring more market attention to a security.

Exhaustion gaps occur in the direction of extended trends. For an exhaustion gap to be considered valid, prices should reverse soon after the gap and close the gap. In the later stages of a trend, the extent of the trend becomes widely reported; eventually causing a surge in trading that cannot be sustained. These events often mark the end of the trend.

In part 16 we'll take a look at Candlestick Chart Patterns

This is the fourteenth part of a series of articles about technical analysis from a new course we're developing. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Fibonacci Lines

How high is “too high?” How low is “too low?” Think back to any time that you've owned a stock and think about when you started to get worried about its performance. At what point did “your gut” start to tell you that you needed to sell? Chances are your gut started talking to you after the stock had moved up (or down) by 38.2%.

Wow, that's a really specific number - “38.2”! It seems kind of arbitrary, also. There's no way that could be correct, right? I mean, without knowing anything about the stock you were trading, or the amount of money involved, or the overall market conditions, or anything else - how can we stand here and tell you that you got nervous right at 38.2%?

The reason is because 38.2 appears to be programmed into the human psyche (as well as many other parts of nature). It's one of a set of numbers called “Fibonacci Percentages.” They are derived from the “Fibonacci Sequence” which is a list of numbers where each number equals the sum of the previous two, i.e.,

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 etc.

The branching in trees, the arrangement of leaves on a stem, the flowering of artichokes, an uncurling fern and the arrangement of a pine cone - all these things exhibit Fibonacci characteristics. In addition, if you take any large Fibonacci number and divide it by the previous number, you'll get something very close to 1.6180339887 (the larger the number, the closer you'll get). Now, 1.6180 has been known for centuries as “The Golden Ratio,” mostly, because we humans tend to prefer things - art, sculpture, architecture, etc. - that have proportions that equal the golden ratio.

Which of these picture looks the most natural to you? The middle one has golden ratio proportions.

Getting back to stock charting, R.N. Elliott made the first well-known connection between price movements and the golden ratio. He noted that many reversals occurred around 61.8% or its complement 38.2% (i.e., 100 - 61.8). Combined with 50% and 100%, they make up the standard set of Fibonacci Percentages.

Regardless of how the numbers were arrived at, chart analysts have observed that prices often will reverse after moving up (or down) by one of those percentages. Basically, those percentages are where something tells many people that it is time to take action - and thus prices reverse. Strange but true. Check it out:

The Fibonacci Lines on this chart were created based on the move from Feb. 9th to May 30th - so just focus on the shaded blue area of the chart. Like a weatherman, the lines “forecast” that support for IBM would occur around 88.79 essentially because lots of people would probably feel that IBM had “fallen enough” and would start buying it again. That is precisely what happened at the end of June (red circle).

Unfortunately, many people have gone on to claim that Fibonacci lines (and their variants) have almost “magical powers” to predict price movements. Like most technical analysis tools, we think Fibonacci Lines are useful forecasting tools - but not magical.

You can add Fibonacci Lines to your charts using our ChartNotes annotation tool. To get started, simply click on the “Annotation” link below any SharpCharts.

In part 15, we'll cover Price Gaps.

Introduction

In his 2006 book Irrational Exuberance, Robert Shiller argues that high stock market valuations in 2000 and 2005 were unjustified. The text opens with Shiller examining the historic valuations (based on PE ratios) in the two periods, which were well above those seen at prior peaks in 1901, 1929 and 1966. This book, however, is not about valuation. Instead, the author identifies a series of factors that brought about these speculative excesses, focusing on 12 factors that facilitated big market moves from 1995 to 2000 and from 2002 to 2005. Shiller then goes on to explain the mechanisms that amplified these factors. The book also covers cultural and psychological influences that further contribute to irrational decision-making when it comes to making investments. Shiller, after explaining the human instinct to rationalize this irrational behavior, then offers some solutions to prevent future speculative bubbles.

Taking its title from Alan Greenspan's famous description of the stock market in 1996, Irrational Exuberance was first published in 2000 and coincided with the Nasdaq peak that same year. Needless to say, the timing was most prophetic. The second edition was published in 2005 with the S&P 500 up some 50% from its 2002 low. This advance continued another 30% before the financial crisis triggered a massive decline in 2008.

Ties with Technical Analysis

Many of the theories put forth in this book fall into the realm of behavioral finance or behavioral economics. Behavioral finance is considered a branch of technical analysis. (In fact, Irrational Exuberance was required reading for the Chartered Market Technician (CMT) exam in 2011.) Behavioral finance is an attempt to understand the behavior of investors and institutions when investing in stocks, bonds, real estate, tulips or other securities. What prompts individuals to buy or sell a security? How do investors handle risk or loss? Why do speculative bubbles appear and then burst? Is there such thing as the dumb money and the smart money? Shiller sheds light on the investing process by highlighting the key factors that led to Irrational Exuberance in the late 1990s.

Structural Factors

Shiller identifies 12 structural factors that contributed to the unprecedented rise in stock prices from 1995 to 2000. Even after the big decline into the 2002 lows, valuations were again at relatively high levels a few years later.

1. The capitalist explosion and the ownership society encouraged stock investing. Societies built on communism and socialism opened up to capitalistic ways; Russia and China come to mind over the last 20 years. George W. Bush promoted the ownership society by advocating property and stocks for all. Corporate downsizing and the decline of labor unions prompted people to take their destiny into their own hands and spawned the entrepreneurial spirit. Corporations tied salaries to performance with stock options.

2. Cultural and political changes favor business success. There has been a significant rise in materialistic values over the years. Shiller reports that more people viewed money as important to success in the mid-90s than in the mid-70s. Society viewed successful businessmen more favorably than scientists or artists. The 1995 Republican Congress proposed cutting the capital gains tax and it was cut in 1997. Further cuts were proposed soon thereafter. These tax cuts, as well as the anticipation of future capital gains tax cuts, provided incentives to buy stocks.

3. New information technology appeared to herald a new era. The first cell phones appeared in the early 1980s, which is when the great bull market started. The Internet came of age in the mid-1990s and grew rapidly the next five years. Investors viewed this Internet revolution as a game changer that justified the stock market boom.

4. Monetary policy and the Greenspan put took perceived risk out of the equation. The Fed did nothing to stop the surging stock market from 1995 to 1999. Interest rates did not increase until August 1999. In addition to letting the bubble grow, the Fed indicated that it would be there to pick up the pieces should anything go wrong, just like in 1987 and 1998. Having the Fed on standby in the event of a market crash was like owning a put option.

5. The perceived effects of the baby boomer generation. There was indeed a baby boom after World War II and this boom resulted in a large number of people aged 35-55 in 2000. However, Shiller argues with data that there is no correlation between a baby boom and a surging stock market. Instead, Shiller argues that, as with the Internet, the public perceptions of the baby boom influence help inflate the stock market.

6. The 1990's surge in business media undoubtedly contributed to interest in the stock market. Not much explanation is needed here. Newspapers created big glossy business sections to attract readers. Good stories replaced hard news. Increased media exposure led to more advertising, which fed the public appetite for stocks. The media continued to pour it on, with the investment show Mad Money debuting in 2005.

7. Analysts' estimates were routinely over-optimistic in the late 1990s. Shiller notes that Zachs reported sell recommendations on 9.1% of stocks in 1989 and just 1% of stocks in late 1999. Analysts were hesitant to issue sell recommendations because many firms also had investment banking ties with the company. Analysts also did not want to offend the company because they might then be cut off from earnings guidance or key information.

8. Defined-Contribution Pension Plans grew and replaced many Defined-Benefit Plans. Among other things, the decline in unions and big manufacturing industries (autos) contributed to this trend. More people also wanted control over their retirement funds. Those with Defined-Benefit Plans must make their own investment choices and this increases the exposure to stocks.

9. The number of mutual funds surged. From 1982 to 1998, the number of mutual funds grew tenfold (340 to 3513). At one point, there were more mutual funds than stocks listed on the NYSE. Mutual funds became a regular part of 401K's. Money moving into these mutual funds from 401K's and individual investors found its way into the stock market to feed the bubble. Shiller also notes that widespread advertising compounded this growth and increased public awareness to new levels.

10. Benign inflation created the illusion of wealth and prosperity. After runaway inflation in the 1970s, the inflation outlook steadily improved from 1982. Shiller's research found that the public associates inflation with economic prosperity and social welfare. Such perceptions promote positive expectations for the economy and the stock market.

11. The explosion of trading volume kept the bid in the bubble. Increased interest in the stock market and a dramatic decline in commissions facilitated a surge in trading volume on the exchanges. The growth in online trading also facilitated increased interest and made it easy to trade more frequently.

12. There was an increase in gambling over the years. Government sanctioned gambling (lotteries) and commercial gambling grew in popularity over the years. Poker players became stars. Lottery jackpots were heavily promoted. Slick adverts portrayed gambling as sophisticated and increased one's propensity to take risks. Online gambling facilitated growth as well.

Amplification Mechanisms

As if the structural factors listed above were not enough, Shiller argues that amplification mechanisms intensified the effects. First, there was a change in investor attitudes toward stocks. By the late 1990s stocks were considered a long-term investment that could not go wrong. Jeremy Siegel first published Stocks for the Long Run in 1994. Subsequent editions have appeared in 1998, 2002 and 2007. Stocks indeed performed well from 1995 until 2000, when the S&P 500 peaked around 1550. The S&P 500 then went on a 10-year stretch of underperformance. In fact, the S&P 500 was trading below its 2000 level in early 2011. This means 11 years of negative returns for buy-and-hold investors that bought in 2000.

Second, as inferred above, Shiller asserts that public attention to the stock market hit new levels in the 1990s. This heightened awareness made more money available for stocks. The media fed this infatuation with increased coverage. Dinner party conversations invariably turned to the stock market. Stock tips and advice were also readily shared among acquaintances.

Third, the consistent rise in stock prices provided a feedback loop that kept public attention on stocks. As the media reported the rise in the stock market, new money found its way into the stock market and pushed prices even higher. Higher prices led to more news and more news led to more investment money. A feedback loop evolved where price increases were feeding more price increases. Shiller calls these mechanisms naturally occurring Ponzi schemes because they feed on the perception of prior success.

Cultural Factors

The news media and new-era thinking are among the cultural factors cited by Shiller. Yes, the media seems to keep popping up in the book. Maybe that is why technical analysts only look at price charts!

The speculative bubble was clearly aided and abetted by the news media. Newspapers, television, radio and Internet media compete for public attention. Sensational stories with sound bites are more likely to attract attention than drab analysis with numbers and facts. Despite an inattention to detail, the news media was always there with specific reasons for a stock market move. The media always found the perfect excuse or news event to justify the move - after the fact. It is kind of like a solution in search of a problem.

Shiller notes that news of price changes is influential on investor behavior. In his survey after the crash on October 19th, 1987, Shiller listed all the recent news events that seemed relevant and asked respondents to rate the stories. News of the October 14th price decline was also included in this list. At the time, this was the single largest one-day point decline in the Dow Industrials. Surprisingly, the stories relating to the past price declines were deemed the most significant news events. In Shiller's words:

Thus it appears that the stock market crash had substantially to do with a psychological feedback loop among the general investing public from price declines to selling and thus to further price declines, along the lines of a negative bubble. The crash apparently had nothing particularly to do with any news story other than that of the crash itself, but rather with theories about other investors' reasons for selling and about their psychology.

New era economic thinking was also cited by Shiller as a cultural factor that contributed to the stock market bubble. New era thinking is not new. Stock market advances in the late 1800s, 1920s and 1960s were also facilitated by new era thinking. At the 1901 peak, new era thinking centered around railroads, big industrial trusts and the age of optimism. The roaring 20s were marked by the electrical age for big cities and the widening use of autos. The 1960s were punctuated by a baby boom, the proliferation of television and low inflation. And finally, the 1990s saw the Internet boom, low inflation, the new economy and the alleged end of the business cycle.

Psychological Factors

Shiller asserts that there is a human tendency towards “overconfidence in one's beliefs,” and that people often rely on intuition when making investment decisions. The decision process is not based on carefully considered facts backed by numbers and evidence. Instead, investors make investment decisions based on the opinion of others, stemming from the need to conform. Investors make decisions based on “good stories” or stories that seem logical. Because people get their information from the same sources, there is little or no evidence of independent behavior. Instead, individuals getting the same information react the same way to produce a herd mentality.

Conclusion and Critiques

Shiller identified several credible factors that influenced investment decisions during the bubble years. Many of these factors exist today and his analysis provides food for thought when considering behavioral finance. Not all factors or influences are listed here. Shiller offers more factors and detailed evidence in the book. After examining efficient markets, random walks, bubbles and investor attitudes, Shiller also offers several remedies to contain “speculative volatility in a free society”.

Behavioral finance can help us understand what is happening, but understanding may not help with making money in the stock market. While the first edition coincided with the stock market peak in 2000, the stock market rose another 30% after the second edition was published in February 2005. There is an argument to be made for historical valuations, but markets can remain irrational a lot longer than traders can remain solvent. In other words, one would have left a lot of money on the table by selling in early 2005 or one would have gone broke shorting stocks in early 2005. To his credit, Shiller does provide evidence of past mispricing in the stock market. It can and does happen.

Furthermore, who is to say how much a stock is actually worth? The value of any asset is only what someone is willing to pay for it. Valuations are set every day as stocks change hands on Wall Street. Just as prices trend, valuations also trend from overvaluation to undervaluation. Sometimes these trends get extreme on both sides. Stocks were severely overvalued in early 2000 and severely undervalued in March 2009. It would appear that some sort of timing mechanism is needed to avoid the big declines and participate in the big advances. Hmm … sounds like technical analysis!

Central to the fields of both psychology and behavioral finance, cognitive biases describe the innate tendencies of the human mind to think, judge, and behave in irrational ways that often violate sensible logic, sound reason or good judgment. The average human – and the average investor – is largely unaware of these inherent psychological inefficiencies, despite the frequency with which they arise in our daily lives and the regularity with which we fall victim to them. While the complete list of cognitive biases is extensive, this article focuses on eleven of the most common tendencies, chosen for both their prevalence in human nature and their relevance to investing in the financial markets. The purpose of this article is to educate you on these psychological predispositions so that you can better recognize and overcome them in your own decision making.

Anchoring

Also referred to as focalism, anchoring is the tendency to be over-influenced by the earliest information presented to us when making decisions, thereby allowing oneself to be driven to a decision or conclusion that is biased towards that initial piece of information. This earliest piece of information is known as the “anchor,” the standard off of which all other alternatives are judged. Thus, subsequent decisions are made not on their own, but rather by adjusting away from the anchor.

For example, in price negotiations over a used car, the first price offered by the salesman sets the anchor point, from which all subsequent offers are based. By offering an initial price of, say, $30,000, a used-car salesman anchors the customer to that price, implementing a bias towards the $30,000 level in the subconscious of the other party. Even if the $30,000 offer is significantly above the true value of the car, all offers below that level appear more reasonable and the customer is likely to end up paying a higher price than he or she originally intended.

While the used car example may seem somewhat harmless, psychologists have captured the effects of the anchoring bias in other more significant settings. For example, researchers have shown that court decisions of judges can be swayed significantly by anchoring effects. In one setting, judges were presented with details of a court case and asked to award damages to the appropriate party. Some of the judges were provided with a low anchor (a low damage estimate) while others were provided no anchor. On average, damages awarded by judges who were given the low anchor were 29% less than those awarded by the non-anchored judges. In a similar study, judges were provided details of a case and asked to determine the duration of an appropriate prison sentence. The anchor given to the judges was set by rolling two dice on the table directly front of them. Even when the anchor was set completely randomly in this fashion and its source was witnessed by the judges, the study showed that their sentencing decisions were still subject to the anchoring effect and biased when a high dice number was rolled.

In a financial market setting, anchoring is at play anytime the estimates or expectations of another party are allowed to influence your own judgments. For example, if a price target for a stock that you are considering is set by a particularly vocal Wall Street analyst at $200.00, your own estimates for that security’s potential price movement can be easily swayed towards that figure, potentially blurring your clarity of thought, inflating your expectations and dragging you into a poor decision.

Loss Aversion and the Endowment Effect

First demonstrated by prominent psychologists Amos Tversky and Daniel Kahneman, the concept of loss aversion refers to the human tendency to strongly prefer decisions that allow us to avoid losses over those that allow us to acquire gains. Loss aversion implies, for example, that the pain one will suffer from a loss of $500 is significantly greater than the satisfaction they will receive from a gain of $500. Many studies on loss aversion commonly suggest that the human perception of loss is twice as powerful as that of gain. This forms the basis of what is known as Prospect Theory, a behavioral economics concept that describes the way in which people choose between probabilistic alternatives that involve risk. At its core, Prospect Theory shows that a loss is perceived as more significant than an equivalent gain. When graphed, the Prospect Theory value function developed by Tversky and Kahneman forms the following curve, the asymmetrical shape of which demonstrates the unequal valuing of identical gains and losses:

Loss aversion is discussed at great length not only in psychological studies of how humans make decisions, but also in the field of economics. In economics, loss aversion is a core concept at work when considering how individuals act in scenarios that involve risk. Because individuals prefer avoiding losses to achieving gains, loss aversion drives us to be risk-averse when evaluating outcomes that involve similar gains and losses.

Loss aversion was first proposed by Kahneman and his colleagues in 1990 as an explanation for a strongly related concept known as the endowment effect. The endowment effect describes the human tendency to place greater value on a good that we own than that which we place on an identical good that we do not own. Together, loss aversion and the endowment effect lead to a violation of the basic economic principle known as the Coase Theorem, which says that “the allocation of resources will be independent of the assignment of property rights when costless trades are possible”. Research has shown that even when a trade involves no cost, ownership still creates disparities in perceived value between parties due to the endowment effect.

For example, researchers have demonstrated the endowment effect by distributing a coffee mug to each participant in a study and then offering them the opportunity to sell or trade the mug for an alternative good (in this case, pens) of equal value. On average, the compensation that the participants required to part with the mug (their willingness to accept) was nearly twice as high as the amount they were willing to pay for the mug (their willingness to pay). In just a few short minutes, those participants who received a mug had ascribed ownership to the object, raising their perception of its value. Another famous study on the endowment effect found that participants' hypothetical selling price for NCAA Final Four basketball tickets was an average of 14 times greater than participants' hypothetical purchase price. Even when entirely imaginary, ownership (endowment) of the tickets fosters greater perceived value of them.

Relating the concepts of loss aversion and the endowment effect back to the financial markets, it is easy to see how these tendencies can influence an investor. Loss aversion has a distinct impact on our risk tolerance both before and after executing a trade. Combined with other cognitive biases, our tendency to steer away from loss can lead to denial as losses build in a poor position, for example, causing us to ignore weakening positions in an attempt to diminish their emotional impact. Similarly, if the endowment effect leads us to ascribe greater value to a security simply because we feel a sense of ownership over it, then that emotional attachment can lead to clouded judgment when the time comes to sell.

The Framing Effect

The framing effect describes our tendency to react to, judge, or interpret the exact same information in distinctly different ways depending on how it is presented to us, or “framed” (most commonly, whether the information is framed as a loss or as a gain). Building off of the previously discussed concepts of loss aversion and Prospect Theory, people tend to avoid risk when information is presented in a positive frame but seek risk when information is presented in a negative frame.

The most commonly cited example of this is a 1981 Tversky and Kahneman study that asked participants to choose between two treatments, A and B, for 600 people affected by a deadly disease. Treatment A was predicted to result in a guaranteed total of 400 deaths, while treatment B had a 33% chance that no one would die but a 66% chance that everyone would die. The same two alternatives were then presented to the study's participants either under a positive frame (how many peoples' lives would be saved) or under a negative frame (how many people would die).

When the alternatives were framed positively, 72% of participants chose Treatment A (“saves 200 lives”). When the exact same alternatives were framed negatively, however, only 22% of participants chose Treatment A (now presented as “400 people will die”). Saving 200 of the 600 lives is the exact same outcome as letting 400 of the 600 die, but the manner in which this identical treatment option was framed resulted in a massive decrease in the number of participants who chose it. Under the positive frame, the majority of participants avoided risk by choosing the treatment that resulted in a sure saving of 200 lives. Under the negative frame, however, the majority of participants sought the riskier alternative treatment that offered a 33% chance of saving all 600 lives.

Another famous example that demonstrates the impact of framing is a study that found 93% of PhD students registered for classes early when a penalty fee for late registration was emphasized, but only 67% did so when the same number was presented as a discount for early registration.

It is no secret that investors in the financial markets are under a constant barrage of information from all different sides - bullish, bearish, and everything in between. The exact same information can be framed by multiple sources in many different ways, biasing your interpretation of it. As you filter the stream of news and financial data that comes your way, consider the manner in which those numbers, statistics or reports are framed and think about the impact that their presentation has on the opinions they lead you to form.

Confirmation Bias

Confirmation bias is the tendency to overweight, favor, seek out, exaggerate or more readily recall information or alternatives in a way that confirms our preconceived beliefs, hypotheses or desires, while simultaneously undervaluing, ignoring or otherwise giving disproportionately less consideration to information or alternatives that do not confirm our preconceived beliefs, hypotheses or desires. This inherent flaw in our cognitive reasoning leads to misconstrued interpretations of information, errors in judgment, and poor decision making. The effects of confirmation bias have been shown to be much stronger for emotionally-charged issues or beliefs that are deeply entrenched. In addition to overvaluing information that confirms our preexisting beliefs, confirmation bias also includes our tendency to interpret ambiguous evidence as supporting existing positions, even if no true relationship exists. In short, this concept says that individuals are biased towards information that confirms their existing beliefs and biased against information that disproves their existing beliefs, leading to overconfidence in our opinions and our decisions even in the face of strong contrary evidence.

As an investor in the financial markets, it can be difficult to maintain a separation between informed estimates or expectations and emotional judgments based on hopes or desires. By causing us to overweight information that confirms such hopes or desires, confirmation bias can affect our abilities to make sound assessments and form well-reasoned opinions about, for example, a stock's upside potential. Awareness of our natural biases towards confirming information and, perhaps more importantly, our biases against disproving information is the first step in combating the unwanted effects of confirmation bias.

Hindsight Bias and the Availability Heuristic

Hindsight bias describes our inclination, after an event has occurred, to see the event as having been predictable, even if there had been little to no objective basis for predicting it. This is the psychological tendency that causes us, after witnessing or experiencing the outcome of even an entirely unforeseeable event, to exclaim “I knew it all along!”

The discovery of hindsight bias emerged during the early 1970s as the field of psychology witnessed an expansion of investigations into heuristics and biases, largely led by Amos Tversky and Daniel Kahneman. Along with the uncovering of tendencies such as the hindsight bias came the discovery of the availability heuristic, a common mental shortcut that causes individuals to rely on immediate information or examples that come to mind first when evaluating a specific topic, concept, method or decision. According to the cognitive reasoning behind the availability heuristic, if something can be recalled, it must be important, or at least more so than alternatives that are not as readily recalled. As a result, individuals tend to more heavily weight recent or immediately-recalled information, creating a bias towards the latest news, events, experiences or memories.

The Sunk Cost Fallacy

The sunk cost fallacy rests on the economic concept of a sunk cost: a cost that has already been incurred and cannot be recovered. While theoretical economics says that only future (prospective) costs are relevant to an investment decision and that rational economic actors therefore should not let sunk costs influence their decisions, the findings of psychological and behavioral finance research show that sunk costs do in fact affect real-world human decision making. Because of our tendencies towards Loss Aversion and other cognitive biases, we fall victim to the sunk cost fallacy, which describes our irrational belief that sunk costs should be considered a legitimate factor in our forward decision making when, in fact, their consideration often leads us towards inefficient outcomes.

For example, let's say a gentleman named Fred is concerned about his weight and decides to go on a diet. As part of his cleanse, he empties his fridge of all tasty temptations. When he comes across an unopened tub of ice cream, however, he falls victim to the Sunk Cost Fallacy. Even though the $15.00 Fred spent on the ice cream is a sunk cost that has already been incurred and cannot be recovered, Fred convinces himself that he cannot let the ice cream go to waste because he previously spent his hard-earned dollars to buy it. Eating a full tub of ice cream is in no way in line with his current weight-loss objectives, as the calories he will take in by consuming it are many times the daily total target of his new diet. Still, despite the adverse consequences for his health goals, Fred is swayed into eating the ice cream because of the Sunk Cost Fallacy.

In an investment setting, the consequences of the sunk cost fallacy can be much more severe than some unwanted calories. As the share price of a security falls, investors often begin to employ the logic that “I've already lost $XXX, it's too late to sell now.” As prices keep falling further and losses grow, the investor's commitment to the sunk cost continues to escalate. “Now I’ve lost $XXXXX, there's no way I can sell now. It has to come back eventually. I'll just hold on to it.” Improper or irrational considerations of sunk costs can lead to poor decisions that continue to spiral out of control, simply because of an incorrect perception of an expense that is irrecoverable.

The Gambler's Fallacy

The gambler's fallacy, also known as the Monte Carlo Fallacy, is the mistaken tendency to believe that, if something happens more frequently than “normal” during a period of time, it must happen less frequently in the future, or that, if something happens less frequently than “normal” during a period of time, it must happen more frequently in the future. This tendency presumably arises out of an ingrained human desire for nature to be constantly balanced or averaged. In situations where the event being observed or measured is truly random (such as the flip of a coin), this belief, although appealing to the human mind, is false.

The gambler's fallacy is, rather obviously, most strongly associated with gambling, where such errors in judgment and decision making are common. It can, however, arise in many practical situations, including investing. Winning and losing trades are in many ways similar to the flip of a coin and thus subject to the same psychological biases. If an investor has a series of losing trades, for example, he or she can begin to erroneously believe that, since the statistics feel unbalanced, his or her probability of making a profitable trade increases. In reality, the probability of his or her next trade being profitable is unaffected by previous losses.

The Hot-Hand Fallacy

The hot-hand fallacy is the mistaken belief that an individual who has experienced success with a random event has a greater chance of continuing that success in subsequent attempts. This cognitive bias is most frequently applied to gambling (where individuals in games such as blackjack believe that the luck they have randomly stumbled upon is actually a “hot hand” and will continue indefinitely) and sports such as basketball (where “hot” shooters see a spike in confidence after making multiple shots in a row, fueling a belief that the trend will continue throughout the rest of the game). While previous success at a skill-based athletic task, such as making a shot in basketball, can change the psychological behavior and future success rate of a player, researchers continue to find little evidence for a true “hot hand” in practice. Similar to what was discussed with the gambler's fallacy, individuals often have trouble processing or believing statistically-acceptable deviations from the average, causing them to assume that forces other than normal statistics must be at play. As an investor, a series of winning trades can induce risky overconfidence one’s “hot hand” of the moment, leading to errors in judgment and poor decision making.

The Money Illusion

In economics and behavioral finance, the money illusion describes the tendency to think of currency in nominal terms rather than in real terms. In other words, humans commonly consider money in terms of its numerical or face value (nominal value) instead of considering it in terms of its real purchasing power (real value). Because modern currencies have no intrinsic value, the real purchasing power of money is the only true (and rational) metric by which it should be judged. Still, humans often struggle to do so because, derived from all the complex underlying value systems in both domestic and international economies, the real value of money is constantly changing. In the financial markets, many average investors commonly ignore the real value of their currency when valuing their investments or interpreting their appreciation, leading to incorrect perceptions of value and past performance.

About the Author

Further Study

This is the sixteenth article in our technical analysis series. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Candlestick Patterns

A series of candlesticks often develop into recognizable patterns that can give a trader insight about the current market psychology and the likelihood of near-term price moves. Many of these 1, 2 or 3 candlestick patterns are used as warning signs for upcoming trend reversals.

Dozens of candlestick patterns have been identified dating back to the 1700s with Japanese rice futures traders. Japanese traders were able to quickly identify and communicate short-term supply and demand forces in the market with these recurring patterns of price action.

Doji Candlestick

One candlestick that has significance by itself and in combination with other candlesticks is the doji candlestick shown above. Price moves above and below the opening price during the day and then closes at the same, or nearly so, price as it opened. This is an indication that buying and selling market forces were balanced even though investors had a roller-coaster ride in price swings during the day.

The SharpChart of ERIE above illustrates a doji candlestick. The intraday 10-minute SharpChart of this particular doji candlestick below shows the 2.2% price swing from high to low that investors endured during the day. Doji candlesticks are a sign of market indecision which often precedes a trend reversal.

With doji candlesticks, a long lower shadow is considered bullish since buying interest moved the price up from a deep intraday decline before market close. Long upper shadows are bearish for a similar reason; initial buying interest gives way to sellers by market close.

Doji Candlestick Formations

The candlestick patterns above are often present in trend changes. The doji in these patterns illustrate how market indecision often acts as a pivot in trend changes.

Other Important Candlestick Patterns

While there are literally hundreds of candlestick patterns out there, the following candlestick patterns have been found by Thomas N. Bulkowski to be six of the most reliable candlestick patterns based on testing on 4.7 million candle lines.

In part 17, we'll cover Comparison Charting.

This is the seventeenth article in our technical analysis series. If you are new to charting, these articles will give you the “big picture” behind the charts on our site. If you are an “old hand,” these articles will help ensure you haven't “strayed too far” from the basics. Enjoy!

Comparison Charting

Comparison charting allows the analyst to study individual price performance and performance relative to other stocks. John Murphy, who provides expert market commentary on StockCharts.com, uses comparison charting extensively in his market analysis.

Individual Price Performance

The SharpChart above shows how the Performance plotting style can be used to monitor the year-to-date performance of the Dow Jones Industrial Average. Once this chart is generated, the page can be bookmarked as a favorite in your browser for quick access in the future.

Multiple symbols can be plotted and compared in this manner by using the Price indicator and other ticker symbols as parameters with a Behind Price position setting. The SharpChart above shows the performance of AA compared with BA and IBM.

Relative Performance Comparison

The SharpChart above illustrates how the performance between Boeing (BA) and the Dow Jones Industrial Average (DJIA) index can be compared in the Indicator Panel above the Price Plot Area. The relative performance indicator is displayed by selecting Price as an indicator on the workbench and inserting BA:$INDU as a parameter.

A positive slope of the indicator line shows that the first symbol in the ratio is outperforming the second symbol. A negative slope indicates the opposite; the first ticker symbol is underperforming the second ticker symbol. And a flat line indicates that both symbols have similar performance.

This information can be used in several ways. In the case of comparing a stock to a market index, the analyst can quickly determine whether or not a stock is outperforming the market. In the case of comparing two stocks, the analyst can easily determine how the stocks are performing relative to each other.

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Before investing or trading, it is important to develop a strategy or game plan that is consistent with your goals and style. The ultimate goal is to make money (win), but there are many different methods to go about it.

As with many aspects of trading, many sports offer a good analogy. A football team with goals geared towards ball control and low-scoring games might adopt a conservative style that focuses on the run. Teams that want to score often and score quickly are more likely to pursue an aggressive style geared towards passing. Teams are usually aware of their goal and style before they develop a game plan. Investors and traders can also benefit by keeping in mind their goals and style when developing a strategy.

Goals

First and foremost are goals. The first set of questions regarding goals should center on risk and return. One cannot consider return without weighing risk. It is akin to counting your chickens before they hatch. Risk and return are highly correlated. The higher the potential return, the higher the potential risk. At one end of the spectrum are US Treasury bonds, which offer the lowest risk (so-called risk-free rate) and a guaranteed return. For stocks, the highest potential returns (and risk) center around growth industries with stock prices that exhibit high volatility and high price multiples (PE, Price/Sales, Price/Hope). The lowest potential returns (and risk) come from stocks in mature industries with stock prices that exhibit relatively low volatility and low price multiples.

Style

After your goals have been established, it is time to develop or choose a style that is consistent with achieving those goals. The expected return and desired risk will affect your trading or investing style. If your goal is income and safety, buying or selling at extreme levels (overbought/oversold) is an unlikely style. If your goals center on quick profits, high returns, and high risk, then bottom-picking strategies and gap trading may be your style.

Styles range from aggressive day traders looking to scalp quarter- to half-point gains to investors looking to capitalize on long-term macroeconomic trends. In between, there are a whole host of possible combinations including swing traders, position traders, aggressive growth investors, value investors and contrarians. Swing traders might look for 1-5 day trades, position traders for 1-8 week trades, and value investors for 1-2 year trades.

Your style will depend not only on your goals, but also on your level of commitment. Day traders are likely to pursue an aggressive style with high activity levels. The goals would be focused on quick trades, small profits, and very tight stop-loss levels. Intraday charts would be used to provide timely entry and exit points. A high level of commitment, focus and energy would be required.

On the other hand, position traders are likely to use daily end-of-day charts and pursue 1-8 week price movements. The goal would be focused on short to intermediate price movements and the level of commitment, while still substantial, would be less than a day trader. Make sure your level of commitment jibes with your trading style. The more trading involved, the higher the level of commitment.

Strategy

Once the goals have been set and the preferred style adopted, it is time to develop a strategy. This strategy would be based on your return/risk preferences, trading/investing style, and commitment level. Because there are many potential trading and investing strategies, I will focus on one hypothetical strategy as an example.

GOAL First, the goal would be a 20-30% annual return. This is relatively high and would involve a correspondingly high level of risk. Because of the associated risk, I would only allot a small percentage (5-10%) of my portfolio to this strategy. The remaining portion would go towards a more conservative approach.

STYLE Although I like to follow the market throughout the day, I cannot commit to day trading and the use of intraday charts. I would pursue a position trading style and look for 1-8 week price movements based on end-of-day charts. Indicators will be limited to three, with price action (candlesticks) and chart patterns carrying the most influence.

Part of this style would involve a strict money management scheme that would limit losses by imposing a stop-loss immediately after a trade is initiated. An exit strategy must be in place before the trade is initiated. Should the trade become a winner, the exit strategy would be revised to lock in gains. The maximum allowed per trade would be 5% of my total trading capital. If my total portfolio were 300,000, then I might allocate 21,000 (7%) to the trading portfolio. Of these 21,000, the maximum allowed per trade would be 1050 (21,000 * 5%).

STRATEGY The trading strategy is to go long stocks that are near support levels and short stocks near resistance levels. To maintain prudence, I would only seek long positions in stocks with weekly (long-term) bull trends and short positions in stocks with weekly (long-term) bear trends. In addition, I would look for stocks starting to show positive (or negative) divergences in key momentum indicators and signs of accumulation (or distribution). My indicator arsenal would consist of two momentum indicators (PPO and Slow Stochastic Oscillator) and one volume indicator (Accumulation/Distribution Line). Even though the PPO and the Slow Stochastic Oscillator are momentum oscillators, one is geared towards the direction of momentum (PPO) and the other towards identifying overbought and oversold levels (Slow Stochastic Oscillator). As triggers, I would use key candlestick patterns, price reversals, and gaps to enter a trade.

This is just one hypothetical strategy that combines goals with style and commitment. Some people have different portfolios that represent different goals, styles, and strategies. While this can become confusing and time-consuming, separate portfolios ensure that investment activities pursue a different strategy than trading activities. For instance, you may pursue an aggressive (high-risk) strategy for trading with a small portion of your portfolio and a relatively conservative (capital preservation) strategy for investing with the bulk of your portfolio. If a small percentage (~5-10%) is earmarked for trading and the bulk (~90-95%) for investing, the equity swings should be lower and the emotional strains less. However, if too much of a portfolio (~50-60%) is at risk through aggressive trading, the equity swings and the emotional strain could be large.

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Moving Average Crossovers

A popular use for moving averages is to develop simple trading systems based on moving average crossovers. A trading system using two moving averages would give a buy signal when the shorter (faster) moving average crosses above the longer (slower) moving average. A sell signal would be given when the shorter moving average crosses below the longer moving average.

The speed of the systems and the number of signals generated will depend on the length of the moving averages. Shorter moving average systems will be faster, generate more signals, and be nimble for early entry. However, they will generate more false signals than systems with longer moving averages.

Some Examples

In Apple, Inc.'s (AAPL) daily chart below, a 30/100 exponential moving average (EMA) crossover generated buy and sell signals.

A buy signal is generated when the 30-day EMA moves above the 100-day EMA. A sell signal is in force when the 30-day EMA falls below the 100-day EMA. A 30/100 differential plot is shown below the price chart using the Percentage Price Oscillator (PPO) set to (30,100,1). The 30-day EMA is greater than the 100-day EMA when the differential is positive. When negative, the 30-day EMA is less than the 100-day EMA.

As with all trend-following systems, the signals work well when the stock develops a strong trend but are ineffective when the stock is in a trading range. The one generated in Nov 2023 was a good entry point for a long position. However, the exit signal based on the moving average crossover generated on March 2024 would have given back some profits.

In the example below, a 20/60 EMA crossover system generated several buy and sell signals.

The plot below the price is the 20/60 EMA differential, shown as a percent and displayed using the PPO set at (20,60,1). The dashed blue lines above and below zero (the centerline) represent the buy and sell trigger points. Using zero as the crossover point for the buy and sell signals generated too many false signals. To reduce the number of signals, you can set the buy signal just above the zero line, say at +2%, and the sell signal just below the zero line, at -2%. A buy signal is in force when the 20-day EMA is more than 2% above the 60-day EMA. A sell signal is in force when the 20-day EMA is more than 2% below the 60-day EMA.

You can find many good signals, but you may also find some whipsaws. Although much would depend on the exact entry and exit points, you could have made profitable trades using this system, but some may not be large profits that are probably not enough to justify the risk.

If a stock fails to hold a trend, you'd have to place tight stop-losses to lock in profits. A trailing stop or use of the parabolic SAR might have helped lock in profits.

The Bottom Line

Moving average crossover systems can be effective but should be used with other aspects of technical analysis (patterns, candlesticks, momentum, volume, and so on). While it's easy to find a system that worked well in the past, there is no guarantee it will work in the future.

What Is Multicollinearity?

Multicollinearity is a statistical term referring to the unknowing use of the same type of information more than once. It is a common problem in technical analysis. Analysts need to be careful not to utilize technical indicators that reveal the same type of information.

Here is how John Bollinger puts it: “A cardinal rule for the successful use of technical analysis requires avoiding multicollinearity amid indicators. Multicollinearity is simply the multiple counting of the same information. The use of four different indicators all derived from the same series of closing prices to confirm each other is a perfect example.”

Multicollinearity is a serious issue in technical analysis when your money is at stake. It is a problem because collinear variables contribute redundant information and can cause other variables to appear to be less important than they are. One of the real problems is that, oftentimes, multicollinearity is difficult to spot.

Indicators From Different Categories

Technical indicators should be arranged in categories to avoid using too many from the same category. Below is a table that categorizes the indicators available at StockCharts.com.

The best way to quickly determine if an indicator is collinear with another one is to chart it. Make sure you have enough data on the chart to get a good indication. If they rise and fall in the same areas, the odds are that they're collinear and you should just use one of them.

The first chart below shows some examples of indicators that are collinear. Notice that all three indicators are basically saying the same thing. If your analysis was that this was supportive information, you would be falling into the multicollinearity trap. Pick one of the indicators for your analysis and do not use the others.

Below are some examples of indicators that are not collinear. When interpreted correctly, each will give different information. The indicators can be used to confirm a trading signal.

The Takeaway

If you are randomly selecting indicators to support your analysis, you will more than likely fall into the multicollinearity trap of using multiple indicators that are all saying the same thing. They are not giving you any additional information; in fact, they are restricting your overall view of the market. Don't search for supporting information among collinear indicators; though they can be appealing, they are ultimately misleading.

Each one of Gatis Roze's "Traders Journal" articles covers some aspect of one of his "10 Essential Stages of Stock Market Mastery." Together, those 10 stages make up Gatis' "Tensile Trading" methodology. Below is a curated list of Gatis' articles, organized according to their corresponding stage.

The bottom line: pick a chair close to the exit before you buy an equity and then sit down. As they say in the movie MARGIN CALL, "it's not panic selling if you are first out the door.”

No one can predict the stock market with 100% consistency, but a logical chart-based investment methodology will significantly shift the probabilities for your investment success towards that direction.

If the trend turns against you, the first loss is always the cheapest. Don’t wait for a gift wrapped invitation to the selling party! Monitoring is all about you, the investor.

Behavioral finance proves that it is possible to model particular behavioral and psychological attributes in order to actually incorporate these into one’s own style and enhance one’s own investment record. Don’t be intimidated by the fancy label the academics gave this study of the investor self which basically integrates cognitive psychology with investing. Its foundation is rooted on the premise that we make financial decisions based on a combination of facts and what we believe about those facts.

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Ten Timeless Tenets of Trading: A 2,500 Year Perspective For those of you who pooh-pooh the lessons of history, listen up! I myself am guilty of being overly focused on today’s web – obsessed with the latest hot stocks, investment technologies and trading methodologies.

Ten Timeless Tenets of Trading: A 2,500 Year Perspective Part II Art, history and life can parallel investing. This blog is my continuation from last week’s Part I where I encouraged readers to be open to a sort of borderless-type of thinking.

I must admit, I am not smart enough to have devised these ridiculously simple trading rules. A great trader gave them to me some 15 years ago. However, I will tell you, they work. If you follow these rules, breaking them as infrequently as possible, you will make money year in and year out, some years better than others, some years worse - but you will make money. The rules are simple. Adherence to the rules is difficult.

"Old Rules ... but Very Good Rules"

If I've learned anything in my decades of trading, I've learned that the simple methods work best. Those who need to rely upon complex Stochastics, linear weighted moving averages, smoothing techniques, Fibonacci numbers etc., usually find that they have so many things rolling around in their heads that they cannot make a rational decision. One technique says buy; another says sell. Another says sit tight while another says add to the trade. It sounds like a cliche, but simple methods work best.

1. The first and most important rule is - in bull markets, one is supposed to be long. This may sound obvious, but how many of us have sold the first rally in every bull market, saying that the market has moved too far, too fast? I have before, and I suspect I'll do it again at some point in the future. Thus, we've not enjoyed the profits that should have accrued to us for our initial bullish outlook, but have actually lost money while being short. In a bull market, one can only be long or on the sidelines. Remember, not having a position is a position.

2. Buy that which is showing strength - sell that which is showing weakness. The public continues to buy when prices have fallen. The professional buys because prices have rallied. This difference may not sound logical, but buying strength works. The rule of survival is not to “buy low, sell high”, but to “buy higher and sell higher”. Furthermore, when comparing various stocks within a group, buy only the strongest and sell the weakest.

3. When putting on a trade, enter it as if it has the potential to be the biggest trade of the year. Don't enter a trade until it has been well thought out, a campaign has been devised for adding to the trade, and contingency plans set for exiting the trade.

4. On minor corrections against the major trend, add to trades. In bull markets, add to the trade on minor corrections back into support levels. In bear markets, add on corrections into resistance. Use the 33-50% corrections level of the previous movement or the proper moving average as a first point in which to add.

5. Be patient. If a trade is missed, wait for a correction to occur before putting the trade on.

6. Be patient. Once a trade is put on, allow it time to develop and give it time to create the profits you expected.

7. Be patient. The old adage that “you never go broke taking a profit” is maybe the most worthless piece of advice ever given. Taking small profits is the surest way to ultimate loss I can think of, for small profits are never allowed to develop into enormous profits. The real money in trading is made from the one, two or three large trades that develop each year. You must develop the ability to patiently stay with winning trades to allow them to develop into that sort of trade.

8. Be patient. Once a trade is put on, give it time to work; give it time to insulate itself from random noise; give it time for others to see the merit of what you saw earlier than they.

9. Be impatient. As always, small losses and quick losses are the best losses. It is not the loss of money that is important. Rather, it is the mental capital that is used up when you sit with a losing trade that is important.

10. Never, ever under any condition, add to a losing trade, or “average” into a position. If you are buying, then each new buy price must be higher than the previous buy price. If you are selling, then each new selling price must be lower. This rule is to be adhered to without question.

11. Do more of what is working for you, and less of what's not. Each day, look at the various positions you are holding, and try to add to the trade that has the most profit while subtracting from that trade that is either unprofitable or is showing the smallest profit. This is the basis of the old adage, “let your profits run.”

12. Don't trade until the technicals and the fundamentals both agree. This rule makes pure technicians cringe. I don't care! I will not trade until I am sure that the simple technical rules I follow, and my fundamental analysis, are running in tandem. Then I can act with authority, and with certainty, and patiently sit tight.

13. When sharp losses in equity are experienced, take time off. Close all trades and stop trading for several days. The mind can play games with itself following sharp, quick losses. The urge “to get the money back” is extreme, and should not be given in to.

14. When trading well, trade somewhat larger. We all experience those incredible periods of time when all of our trades are profitable. When that happens, trade aggressively and trade larger. We must make our proverbial “hay” when the sun does shine.

15. When adding to a trade, add only 1/4 to 1/2 as much as currently held. That is, if you are holding 400 shares of a stock, at the next point at which to add, add no more than 100 or 200 shares. That moves the average price of your holdings less than half of the distance moved, thus allowing you to sit through 50% corrections without touching your average price.

16. Think like a guerrilla warrior. We wish to fight on the side of the market that is winning, not wasting our time and capital on futile efforts to gain fame by buying the lows or selling the highs of some market movement. Our duty is to earn profits by fighting alongside the winning forces. If neither side is winning, then we don't need to fight at all.

17. Markets form their tops in violence; markets form their lows in quiet conditions.

18. The final 10% of the time of a bull run will usually encompass 50% or more of the price movement. Thus, the first 50% of the price movement will take 90% of the time and will require the most backing and filling and will be far more difficult to trade than the last 50%.

There is no “genius” in these rules. They are common sense and nothing else, but as Voltaire said, “Common sense is uncommon.” Trading is a common-sense business. When we trade contrary to common sense, we will lose. Perhaps not always, but enormously and eventually. Trade simply. Avoid complex methodologies concerning obscure technical systems and trade according to the major trends only.

What Is Correlation?

In statistics, correlation measures the degree to which two (or more) variables move together. Positive correlation values indicate movement together in the same direction. Negative correlation values indicate movement in opposite directions. Correlation values range from -1.0 to +1.0, with a value of 0 indicating no relationship between the variables.

In finance and financial markets, correlation measures the relationship between two securities (stocks, bonds, ETFs, mutual funds, indexes, etc.) and the degree to which they move together. Securities with high positive correlation values move together in the same direction. Securities with high negative correlation values move in exactly opposite directions. Securities with very low correlation values (at or around 0) are unrelated with respect to the directions in which they move.

Why Use Correlation?

Correlation values can be used to construct a well-diversified portfolio, reducing risk while also improving returns. By building a portfolio that consists of a diverse set of securities across multiple asset classes, each with low correlation values, you can limit risk by reducing exposure to singular market shocks.

How To Use Correlation

To use correlation to your advantage, balance the securities in your portfolio according to their correlation values, while ensuring that the correlation values against a common benchmark (such as the S&P 500) are not all clustered in a specific range. For example, if you have 10 stocks and funds in your portfolio, all with correlation values against the S&P 500 ranging from +0.87 to +0.98, the assets in your portfolio can be shown to move in very similar directions, increasing your risk exposure to singular market shocks. If, however, the set of stocks and funds in your portfolio is more diverse and the correlation values range from, for example, -0.79 to +0.95, your portfolio can be considered more broadly diversified and thus less exposed to singular market shocks.

This section describes the different types of financial charts found at StockCharts.com. It covers the construction of various chart types and how they can be used to make informed investing decisions.

The Fundamentals

What Are Charts? Learn about charts—what they are, how to pick timeframes, how charts are formed, and the different types of price scaling.

Support and Resistance Understand support and resistance, where they are established, and the methods used to establish them.

Trend Lines What are trend lines, how are they used, and why are they important? You'll find answers to these questions, plus information about scale settings, validation, and angles.

Gaps and Gap Analysis Explore gaps (areas on price charts where no trades occur) and what they imply regarding the fundamentals or mass psychology surrounding a stock.

Introduction to Chart Patterns An overview of chart patterns and how you can recognize them.

Chart Patterns How many chart patterns are there? Here, you'll find a detailed explanation of the common chart patterns.

Chart Types

Arms CandleVolume A price chart that merges traditional candlesticks with EquiVolume boxes.

CandleVolume A price chart that merges traditional candlesticks with volume.

Elder Impulse System A charting system developed by Alexander Elder that colors price bars based on simple technical signals.

EquiVolume Price boxes that are sized based on their trading volume.

Heikin-Ashi A candlestick method that uses price data from two periods instead of one.

Kagi Charts A Japanese charting method based on volatility and reversal amounts.

Renko Charts A Japanese charting method where boxes rise and fall in 45-degree patterns.

Three Line Break Charts A Japanese charting method that ignores time and only represents change in terms of price movements.

MarketCarpets A charting tool used to visually scan large groups of securities.

Relative Rotation Graphs (RRG Charts) A visualization tool for relative strength and momentum analysis.

Seasonality Charts A unique StockCharts tool for identifying monthly seasonal patterns.

Yield Curve A visualization tool using bond yields to analyze market conditions and the economic cycle.

Candlestick Charts

Introduction to Candlesticks We present an overview of candlesticks, including history, formation and key patterns.

Candlesticks and Traditional Chart Analysis We discuss how to use candlesticks with moving averages, volume and chart patterns.

Candlesticks and Support We examine how candlestick chart patterns can mark support levels.

Candlesticks and Resistance We examine how candlestick chart patterns can mark resistance levels.

Candlestick Bullish Reversal Patterns We describe common bullish reversal candlestick patterns in detail.

Candlestick Bearish Reversal Patterns We describe common bearish reversal candlestick patterns in detail.

Candlestick Pattern Dictionary We present a comprehensive list of common candlestick patterns.

Point & Figure Charts

Point and Figure Charts We discuss how to use and interpret Point and Figure Charts.

Chart Annotations Tools

Andrews' Pitchfork We illustrate how to draw, adjust and interpret this trend channel tool.

Cycles We present the steps to finding cycles and using the Cycle Lines Tool.

Fibonacci Retracements We define Fibonacci retracements and show how to use them to identify reversal zones.

Fibonacci Arcs We show how Fibonacci Arcs can be used to find reversals.

Fibonacci Fans We explain what Fibonacci Fans are and how they can be used.

Fibonacci Time Zones We describe what Fibonacci Time Zones are and how they can be used.

Quadrant Lines We define Quadrant Lines and show how they can be used to find future support and resistance zones.

Raff Regression Channel We examine this channel tool based on two equidistant trend lines on either side of a linear regression.

Speed Resistance Lines We present how these retracement-based trend lines are used on charts.

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Donchian General Guidelines

First published in 1934, many of the 20 trading guidelines from Richard Donchian are as relevant today as they were during the golden age of technical analysis. Considered by many as the father of trend following, Donchian developed one of the first trend-following systems based on two different moving averages, which were cutting edge in the early thirties. Based on his experiences, Donchian developed 20 trading guidelines split into two groups: general and technical. The guidelines shown below have been paraphrased for a more straightforward explanation. The original guides are also shown in the bottom half of this page.

11 General Guidelines

1. Be careful buying when the crowd is excessively bullish or selling when the crowd is excessively bearish.

Even when the crowd is correct, excessive sentiment in one direction or another can delay a move.

2. When prices trade in a narrow range with little volatility, look for a volume increase to confirm the direction of the next move.

Subsequent strength on higher volume is bullish, while subsequent weakness on higher volume is bearish.

3. Let your profits run and cut your losses short.

This guideline overrides any other guideline.

4. Trade in smaller amounts during times of uncertainty.

Trading losses and whipsaws can be reduced by focusing on solid setups and robust signals.

5. Do not chase a position after a three-day move.

Wait for a one-day reversal to improve the risk-reward ratio.

6. Use a stop-loss to limit losses and protect accrued profits.

Stop-losses should be based on the trading pattern at work. A triangle pattern will have a different stop-loss structure than a rising wedge or head-and-shoulders pattern.

7. Due to the law of percentages, long positions should be larger than short positions during a broad uptrend.

This assumes that the upswings will be larger than the downswings as a series of rising peaks and troughs evolves. A short position on a decline from 50 to 40 would produce a 20% profit, but a long position on an advance from 40 to 50 would make a 25% profit. The percentage gain on advances will be greater.

8. Use limit orders when initiating a position.

Use market orders when closing a position.

9. Buy securities that are in uptrends and show relative strength.

Sell securities that are in downtrends and show relative weakness. These two guidelines are subject to all other guidelines.

10. A broad market advance is more likely to continue when transportation stocks lead (Dow Transports).

A broad market advance is suspect when transportation stocks lag.

11. A security's capitalization, its activity level in the marketplace and its trading characteristics are just as important as its fundamentals.

The interpretation of this guideline is rather difficult because it is unclear what Donchian means with “capitalization”.

Nine Technical Guidelines

1. When it follows an initial advance, a consolidation (a sideways trading range) will often lead to another advance of equal proportions.

After this second advance, you can expect a counter move and decline back towards the consolidation. Similarly, a consolidation after an initial decline often leads to another decline of equal proportions. After this second decline, chartists can expect a counter move and advance back towards the consolidation.

2. A long sideways consolidation after an advance marks future resistance.

Expect resistance or a bearish reversal when prices decline and then return to this level. A long sideways consolidation after a decline marks future support. Expect support or a bullish reversal when prices advance and then return to this level.

3. Look for buying opportunities when prices decline to a trend line on average or low volume.

Conversely, look for selling opportunities when prices advance to a trend line on average or low volume. Be careful if prices stall around the trend line (hug) or if the trend line has been touched too often.

4. Prepare for a bearish trend line break when prices decline to a rising trend line, fail to bounce, and subsequently crawl along the trend line. Prepare for a bullish trend line break when prices advance to a falling trend line, hold most of their gains, and crawl along the trend line.

Repeated bumping of a trend line also increases the chances of a break.

5. Major trend lines define the longer trend. Minor trend lines define the shorter trend.

When prices are above a major trend line (rising), use minor trend lines (falling) to define short pullbacks and generate buy signals with upside breaks. When prices are below a major trend line (falling), use minor trend lines (rising) to define short bounces and generate sell signals with downside breaks.

6. Triangles are usually broken on the flat side.

This means an ascending triangle is usually broken with an upside breakout, while a descending triangle is usually broken to the downside. Chartists must look for other clues to determine if a triangle signals accumulation or distribution.

7. Look for a volume climax to signal the end of a long move.

An extended advance sometimes ends with a volume surge that marks a blow-off. Conversely, an extended decline sometimes ends with a volume surge that marks a selling climax.

8. Not all gaps are filled.

Breakaway gaps signal the start of a new trend and are not filled. Continuation gaps mark a continuation of the existing trend and are not filled. Exhaustion gaps mark a trend reversal and are filled. Chartists should not count on a gap being filled unless they can determine the type of gap, which is easier said than done.

9. During an advance, initiate or add to long positions after a one-day decline, no matter how small the decline is, especially when the decline is on lower volume. During a decline, initiate or add to short positions after a one-day advance, no matter how big the bounce, especially if the bounce is on lower volume.

The Takeaway

At least three themes emerge from these rules. First, the direction of the underlying trend determines position preference. Chartists should focus on long positions during an uptrend and short positions during a downtrend. Second, volume plays an important part in the analysis process. Price moves in the direction of the bigger trend should be on higher volume, while counter-trend moves should be on lower volume. However, note that volume climaxes can mark the end of an extended move. Third, trading ranges and consolidations are important chart patterns. Long consolidations can mark reversals and future support or resistance levels. Short consolidations often mark a rest in the ongoing trend.

Further Study

Thomas Carr's Trend Trading for a Living shows traders how to trade in the direction of the underlying trend. This hands-on book will also show readers how to configure a bullish and bearish watchlist to set your entry and exit prices.

Michael Covel's Trend Following introduces the fundamental concepts and techniques for various trend-following systems, including a system made famous by the Turtles. Additionally, Covel's book shows why market prices contain all available information. Readers will learn how to interpret price movements and profit from trend following.

Original Guides

A version of Donchian's original guidelines can be found on the Trading Tribe website (www.seykota.com). Ed Seykota is an original “market wizard” from Jack Schwager's book of the same name. He is a trend-following disciple who credits Richard Donchian as a major influence in developing his trading philosophy.

General Guides:

1. Beware of acting immediately on a widespread public opinion. Even if correct, it will usually delay the move.

2. From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.

3. Limit losses and ride profits, irrespective of all other rules.

4. Light commitments are advisable when the market position is not certain. Clearly defined moves are signaled frequently enough to make life interesting, and concentration on these moves will prevent unprofitable whip-sawing.

5. Seldom take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal.

6. Judicious use of stop orders is a valuable aid to profitable trading. Stops may be used to protect profits, limit losses, and take positions from certain formations, such as triangular foci. Stop orders are apt to be more valuable and less treacherous if used in proper relation to the chart formation.

7. In a market where upswings are likely to equal or exceed downswings, heavier positions should be taken for the upswings for percentage reasons - a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100%.

8. In taking a position, price orders are allowable. In closing a position, use market orders.

9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules.

10. Moves in which rails lead or participate strongly are usually more worth following than moves in which rails lag.

11. A study of the capitalization of a company, the degree of activity of an issue, and whether an issue is a lethargic truck horse or a spirited racehorse is fully as important as a study of statistical reports.

Technical Guides:

12. A move followed by a sideways range often precedes another move of almost equal extent in the same direction as the original move. Generally, when the second move from the sideways range has run its course, a counter-move approaching the sideways range may be expected.

13. Reversal or resistance to a move is likely to be encountered upon reaching levels at which, in the past, the commodity has fluctuated for a considerable length of time within a narrow range or on approaching highs or lows.

14. Watch for good buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too frequently.

15. Watch for “crawling along” or repeated bumping of minor or major trend lines and prepare to see such trend lines broken.

16. Breaking of minor trend lines counter to the major trend gives most other important position taking signals. Positions can be taken or reversed on stops at such places.

17. Triangles of ether slope may mean accumulation or distribution depending on other considerations, although triangles are usually broken on the flat side.

18. Watch for volume climaxes, especially after a long move.

19. Don't count on gaps being closed unless you can distinguish between breakaway gaps, normal gaps, and exhaustion gaps.

20. During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, especially if volume declines.

Bob Farrel's Market Rules

Bob Farrell is a Wall Street veteran who draws on 50 years of experience crafting his investing rules. After finishing a master's program at Columbia Business School, he launched his career as a technical analyst with Merrill Lynch in 1957. Even though Mr. Farrell studied fundamental analysis under Gramm and Dodd, he turned to technical analysis after realizing there was more to stock prices than balance sheets and income statements. He became a pioneer in sentiment studies and market psychology. His 10 rules on investing stem from personal decades of experience with dull markets, bull markets, bear markets, crashes, and bubbles. In short, Bob Farrell has seen it all and lived to tell about it.

10 Rules

1. Markets tend to return to the mean over time.

Translation: Trends that get overextended in one direction or another return to their long-term average. Even during a strong uptrend or downtrend, prices often move back (revert) to a long-term moving average.

The chart below shows a 15-year chart of the S&P 500 with a 52-week exponential moving average (EMA). The blue arrows show several reversions to this moving average in uptrends and downtrends. The indicator window shows the Percentage Price Oscillator (1,52,1) reverting to the zero line.

2. Excess moves in one direction will lead to an excess move in the opposite direction.

Translation: Markets that overshoot on the upside will also overshoot on the downside, like a pendulum. The further it swings to one side, the further it rebounds to the other side. The chart below shows the Nasdaq bubble in 1999 and the Percent Price Oscillator (52,1,1) moving above 40%. This means the Nasdaq was over 40% above its 52-week moving average and overextended. This excess led to a similar one when the Nasdaq plunged in 2000–2001, and the Percent Price Oscillator moved below -40%.

3. There are no new eras—excesses are never permanent.

Translation: There will be a hot group of stocks every few years, but speculation fads do not last forever. In fact, over the last 100 years, we have seen speculative bubbles involving various stock groups. Autos, radio, and electricity powered the roaring 20s. The nifty-fifty powered the bull market in the early 70s. Biotechs bubble up every 10 years or so and there was the dot-com bubble in the late 90s. “This time it is different” is perhaps the most dangerous phrase in investing. As Jesse Livermore puts it:

A lesson I learned early is that there is nothing new in Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

Translation: Even though a hot group will ultimately revert back to the mean, a strong trend can extend for a long time. Once this trend ends, however, the correction tends to be sharp. The chart below shows the Shanghai Composite ($SSEC) advancing from July 2005 until October 2007. This index was overbought in July 2006, early 2007 and mid-2007, but these levels did not mark a top as the trend extended with a parabolic move.

5. The public buys the most at the top and the least at the bottom.

Translation: The average individual investor is most bullish at market tops and most bearish at market bottoms. The survey from the American Association of Individual Investors is often cited as a barometer for investor sentiment. In theory, excessively bullish sentiment warns of a market top, while excessively bearish sentiment warns of a market bottom.

6. Fear and greed are stronger than long-term resolve.

Translation: Don't let emotions affect your decisions or your long-term plan. Plan your trade and trade your plan. Prepare for different scenarios so you will not be surprised by sharp adverse price movement. Sharp declines and losses can increase the fear factor and lead to panic decisions in the heat of battle.

Similarly, sharp advances and outsized gains can lead to overconfidence and deviations from the long-term plan. To paraphrase Rudyard Kipling, you will be a much better trader or investor if you can keep your head about you when all about are losing theirs. When the emotions are running high, take a breather, step back, and analyze the situation from a greater distance.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

Translation: Breadth is important. A rally on narrow breadth indicates limited participation and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small- and mid-caps (troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.

8. Bear markets have three stages—sharp down, reflexive rebound, and a drawn-out fundamental downtrend.

Translation: Bear markets often start with a sharp and swift decline. Following this decline is an oversold bounce that retraces a portion of that decline. The decline then continues, but at a slower and more grinding pace as the fundamentals deteriorate. Dow Theory suggests that bear markets consist of three down legs with reflexive rebounds in between.

9. When all the experts and forecasts agree – something else is going to happen.

Translation: This rule fits with Farrell's contrarian streak. When all analysts have a buy rating on a stock, there is only one way to go (downgrade). Excessive bullish sentiment from newsletter writers and analysts should be viewed as a warning sign. Investors should consider buying when stocks are unloved, and the news is all bad. Conversely, investors should consider selling when stocks are the talk of the town, and the news is all good. Such a contrarian investment strategy usually rewards patient investors.

10. Bull markets are more fun than bear markets.

Translation: Wall Street and Main Street are more in tune with bull markets than bear markets.

Closing Thoughts

Like all rules on Wall Street, Bob Farrell's 10 rules are not intended to be considered hard and fast or set in stone. There are exceptions to every rule. Nevertheless, these rules will benefit you as a trader or as an investor by helping you to look beyond the latest news headlines or your gut emotions. Being aware of sentiment can prevent traders from selling near the bottom and buying near the top, which often goes against our natural instincts. Human nature causes individual investors and traders to often feel most confident at the top of a market. At the same time, they often feel most pessimistic or cautious at market bottoms. Awareness of these emotions and their potential consequences is the first step towards conquering their adverse effects.

To read our investment psychology article about 11 of the most common cognitive biases affecting investors and traders in financial markets, click here.

Further Study

Stock Charts: The Nuts and Bolts

In a nutshell, a price chart is a sequence of prices plotted over a specific timeframe. If you're into statistical terms, charts are called time series plots.

In the chart below, the y-axis (vertical axis) represents the price scale, and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis, with the most recent plot being the furthest right. The price plot extends from August 24, 2018, to August 24, 2021.

Technicians, technical analysts, and chartists use charts to analyze various securities and forecast future price movements. "Security” refers to any tradable financial instrument or quantifiable index such as stocks, bonds, commodities, futures, or market indices. Any security with price data can be used to create a chart for analysis.

While technical analysts use charts almost exclusively, charts are not limited to technical analysis. Because charts provide an easy-to-read graphical representation of a security's price movement over time, they can also greatly benefit fundamental analysts. A graphical historical record makes it easy to observe a security's performance over time, whether it's trading near its highs, lows, or in-between. You can also see the effect of key events on price.

How to Pick a Timeframe

The timeframe for creating a chart depends on the compression of the data—intraday, daily, weekly, monthly, quarterly, or annual. The less compressed the data, the more detail is displayed.

Below, you see an example of a daily and weekly chart.

Daily data consists of intraday data compressed to show each day as a single data point or period. Weekly data includes daily data that has been compressed to show each week as a single data point. A 100 data points (or periods) on the daily chart is equal to the last five months of the weekly chart (data marked in the red rectangle).

The more the data is compressed, the longer the timeframe possible for displaying the data. If the chart can display 100 data points, a weekly chart will hold 100 weeks (almost two years). A daily chart that displays 100 days would represent about five months. There are about 20 trading days in a month and about 252 trading days in a year. There's no right data compression and timeframe to use. It depends on the data available and your trading or investing style.

• Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the timeframe and the less compressed the data is, the more detail that is available. While long on detail, short-term charts can be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges, and price gaps can affect volatility, which can distort the overall picture.

• Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts (typically one to four years) cover a longer timeframe with compressed data, price movements do not appear as extreme and there is often less noise.

• Some investors might use a combination of long- and short-term charts. Long-term charts are good for analyzing the big picture to get a broad perspective of historical price action. After analyzing the general picture, you can use a short-term chart such as a daily chart to zoom in on a narrower range of time (e.g., the last few months).

How Are Charts Formed?

There are different chart types. We will focus on the four most popular charting methods—line, bar, candlestick, and point & figure charts.

Line Chart

Some investors and traders consider the closing level to be more important than the open, high, or low. By focusing only on the close, you can ignore the intraday swings. Line charts are also used when open, high, and low data points aren't available. Sometimes only closing data are available for certain indices, thinly-traded stocks, and intraday prices.

Bar Chart

Bar charts are popular among investors and traders. The high, low, and close form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar (see chart below). On a daily chart, each bar represents the high, low, and close for a particular day. Weekly charts would have a bar for each week based on Friday's close and the high and low.

Bar charts can also display the open, high, low, and close (see chart below). The difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar. Whether or not a bar chart includes the open depends on the data available.

Bar charts can be effective for displaying a large amount of data. Line charts are less cluttered but don't offer as much detail (no high-low range). Each bar chart is relatively skinny, allowing users to fit more bars while keeping the chart comparatively neat.

If you are not interested in the opening price, bar charts are ideal for analyzing the close relative to the high and low. Bar charts that include the open tend to become cluttered. If you are interested in the opening price, candlestick charts probably offer a better alternative. But remember that when using candlestick charts, 200 data points can take up a lot of room, resulting in a cluttered chart.

Candlestick Chart

Originating in Japan over 300 years ago, candlestick charts have become quite popular recently. The open, high, low, and close are required for a candlestick chart. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range, and Friday's close.

Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and the close. Hollow candlesticks form when the close is higher than the open, and filled candlesticks form when the close is lower. The rectangular area between the open and close is called the body (hollow body or filled body). The lines above and below are called shadows and represent the high and low.

Some candlestick charts use color to show the relationship between the close and the previous close. If the close is higher than the previous, you can choose to display the bar as green; if it is lower, you can choose to display the bar as red (see chart below).

See this ChartSchool article for more information about candlestick charts.

Point & Figure Chart

All the charting methods mentioned above plot one data point for each period. Regardless of price movement, each day or week is represented by one point, bar, or candlestick along the time scale. Even if the price is unchanged from one day to the next or one week to the next, a dot, bar, or candlestick is plotted to mark the price action. Contrary to this methodology, point & figure charts are based solely on price movement and don't take time into consideration. There is an x-axis, but it doesn't extend evenly across the chart.

The beauty of point & figure charts is their simplicity. Little or no price movement is deemed irrelevant and, therefore, not duplicated on the chart. Only price movements that exceed specified levels are recorded. This focus on price movement makes identifying support and resistance levels, bullish breakouts, and bearish breakdowns easier.

Price Scaling

There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points (or dollars) as the same vertical distance regardless of the price level. Each unit of measure is identical throughout the entire scale. If a stock advances from 10 to 80 over six months, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80. Even though this move is the same in absolute terms, it is not the same in percentage terms.

A logarithmic or log scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three advances would appear as the same vertical distance on a log scale. Most charting programs refer to the log scale as a semi-log scale because the time axis is still displayed arithmetically.

The charts below illustrate the difference between arithmetic and logarithmic scaling.

On the log scale version, the distance between 20 and 40 is the same as the distance between 40 and 80. However, on the arithmetic scale, the distance between 40 and 80 is significantly greater than the distance between 20 and 40.

Key points on the benefits of arithmetic scale charts include:

• Arithmetic scales are useful when the price range is confined within a relatively tight range.

• Arithmetic scales are useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar.

Key points on the benefits of log scale charts include:

• Log scales are useful when the price has moved significantly, be it over a short or extended timeframe

• Trend lines tend to match lows better on log scale charts.

• Log scale charts are useful when gauging the percentage movements over a long period. Large movements are put into better perspective.

Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book. With this in mind, it also makes sense to analyze price movements in percentage terms.

The Bottom Line

Even though many different charting techniques are available, one method is not necessarily better than the other. The data may be the same, but each method will provide its unique interpretation with benefits and drawbacks. A breakout on the point & figure chart may not occur in unison with a breakout in a candlestick chart. Signals that are available on candlestick charts may not appear on bar charts. How the security's price is displayed, be it a bar chart or candlestick chart, with an arithmetic scale or semi-log scale, is not the most important aspect. After all, the data is the same, and price action is price action. It is the analysis of the price action that separates successful technicians from not-so-successful technicians. The choice of which charting method to use will depend on personal preferences and trading or investing styles. Once you have chosen a particular charting methodology, it is probably best to stick with it and learn how to read the signals. Switching back and forth may confuse and undermine the focus of your analysis. The chart rarely causes faulty analysis. Before blaming your charting method for missing a signal, look at your analysis.

The keys to successful chart analysis are dedication, focus, and consistency:

• Dedication. Learn the basics of chart analysis, apply your knowledge regularly, and continue your development.

• Focus. Limit the number of charts, indicators, and methods you use. Learn how to use them and how to use them well.

• Consistency. Maintain your charts on a regular basis and study them often (daily if possible).

What Are Trend Lines, How Are They Used, and Why Are They Important?

Trend lines are straight lines that connect two or more price points on a chart to identify and confirm trends.

In technical analysis, trend lines are a fundamental tool that traders and analysts use to identify and anticipate the general pattern of price movement in a market. Essentially, they represent a visual depiction of support and resistance levels in any time frame.

The importance of trend lines in technical analysis lies in their ability to provide a clear visual representation of market trends and potential reversal points, which can help traders make informed trading decisions. They provide a simple yet effective means to identify and anticipate market behavior.

Many of the principles applicable to support and resistance levels can be applied to trend lines as well. It's important that you understand all of the concepts presented in our Support and Resistance article before continuing on.

What Is an Uptrend Line?

An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Note that at least three points must be connected before the line is considered a valid trend line.

Uptrend lines act as support and indicate that net demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net demand has weakened, and a change in trend could be imminent.

What Is a Downtrend Line?

A downtrend line has a negative slope formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Note that at least three points must be connected before the line is considered a valid trend line.

Downtrend lines act as resistance and indicate that net supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that the net-supply is decreasing and that a trend change could be imminent.

For a detailed explanation of trend changes, which are different from trend line breaks, please see our article on the Dow Theory.

Scale Settings for Trend Lines

High and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 to $20 is a 100% gain and would appear to be much larger than a move from $100 to $110, which is only a 10% gain.

In the weekly chart of AMZN (see below), there were two false breaks above the downtrend line as the stock declined between 2000 and 2001. These false breakouts could have led to premature buying as the stock declined after each one. The stock lost 60% of its value three times over two years. The semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.

In the case of EMC, there was a large price change over a long period. While there were no false breaks below the uptrend line on the arithmetic scale, the ascent rate appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trend line fits all the way up. On the arithmetic scale, three trend lines were required to keep pace with the advance.

How Do You Validate a Trend Line?

It takes two or more points to draw a trend line. The more points used to draw the trend line, the more validity is attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line. Even though trend lines are an important aspect of technical analysis, drawing trend lines on every price chart is not always possible. Sometimes, the lows or highs don't match up, and it is best not to force the issue.

A general trendline rule: It takes two points to draw a trend line, and the third one confirms the validity.

The chart of Microsoft (MSFT) below shows an uptrend line that has been touched four times. After the third touch in Nov-99, the trend line was considered a valid support line.

When the stock price bounced off the trend line level a fourth time, the soundness of the support level was enhanced even more. As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net supply was increasing and that a change in trend could be imminent.

What Are the Spacing Rules for Trend Lines?

The lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart or close together. The most suitable distance apart will depend on the timeframe, the degree of price movement, and personal preferences.

If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line comprises relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.

In the WalMart (WMT) example below, the second high point appears too close to the first high point for a valid trend line; however, it would be feasible to draw a trend line beginning at point 2 and extending down to the February reaction high.

What Are Trend Angles?

As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established will often prove difficult.

In the chart below, there were four trend line touches over five months. The spacing between the points is reasonable, but the steepness of the trend line could be more sustainable, and the price is more likely than not to drop below the trend line. However, trying to time this drop or make a play after the trend line is broken is a difficult task.

The amount of data displayed and the chart size can affect the angle of a trend line. When assessing the validity and sustainability of a trend line, keep in mind that short and wide charts are less likely to have steep trend lines than long and narrow charts.

What Are Internal Trend Lines?

Sometimes, you may see the possibility of drawing a trend line, but the exact points do not match up cleanly. The highs or lows might be out of whack, the angle too steep, or the points too close together. If one or two points were ignored, you could form a fitted trend line. But with market volatility, prices can overreact and produce spikes that distort the highs and lows. One method for dealing with over-reactions is to draw internal trend lines, which ignore these price spikes to a reasonable degree.

The long-term trend line for the S&P 500 ($SPX) extends up from the end of 1994 and passes through low points in July 1996, September 1998, and October 1998. These lows were formed with selling culminations and represented extreme price movements that protruded beneath the trend line. By drawing the trend line through the lows, the line appears at a reasonable angle, and the other lows match up well.

Sometimes, a price cluster with a high or low spike stands out. In a price cluster, prices are grouped within a tight range over time. You can ignore the price spikes by using the price cluster to draw the trend line.

The Coca-Cola (KO) chart below shows an internal trend line formed by ignoring price spikes and using price clusters instead.

KO formed a peak in October and November 1998, with the November peak just higher than the October peak (red arrow). If the November peak had been used to draw a trend line, the slope would have been more negative, and there would have appeared to be a breakout in December 1998 (gray line). However, this would have only been a two-point trend line because the May–June highs are too close together (black arrows). Once the December 1999 peak formed (green arrow), it would have been possible to draw an internal trend line based on the price clusters around the Oct/Nov 1998 and the Dec 1999 peaks (blue line). This trend line is based on three solid touches and accurately forecasts resistance in Jan 2000 (blue arrow).

The Bottom Line

Trend lines can offer great insight but, if used improperly, can also produce false signals. To validate trend line breaks, other tools, such as horizontal support and resistance levels or peak-and-trough analysis, should be employed.

Trend lines are popular analytical tools but are only one tool for establishing, analyzing, and confirming a trend. In the chart below, price touched the uptrend line four times and seemed to be a valid support level. Even though the trend line was broken in January 2000, the previous reaction low held and didn't confirm the trend line break. In addition, the stock recorded a new higher high before the trend line break.

Trend line breaks should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend.

Trend Line FAQs

Additional Resources

Greg Morris: "On Trendlines"

What Are Price Gaps?

Price charts often have blank spaces known as gaps, representing times when no shares were traded within a particular price range. Usually this occurs between the market close and the next trading day's open. There are two primary kinds of gaps—up gaps and down gaps.

For an up gap to form, the low price after the market closes must be higher than the high price of the previous day. Up gaps are generally considered bullish.

A down gap is the opposite of an up gap; the high price after the market closes must be lower than the low price of the previous day. Down gaps are usually considered bearish.

Gaps result from extraordinary buying or selling interests often developing while the market is closed. For example, if an unexpectedly strong earnings report comes out after the market has closed, a lot of buying interest will be generated overnight. This results in an imbalance between supply and demand. So, when the market opens the next morning, the stock price rises in response to the increased demand from buyers. If the stock price remains above the previous day's high throughout the day, then an up gap is formed.

Gaps can offer evidence that something important has happened to the fundamentals or psychology of the crowd that accompanies the price movement.

Timeframe of Gaps

Up and down gaps can form on daily, weekly, or monthly charts and are considered significant when accompanied by above average volume.

Gaps appear more frequently on daily charts—every day presents an opportunity to create an opening gap. Gaps on weekly or monthly charts are rare. If you're looking at a weekly chart, the gap would have to occur between Friday's close and Monday's open. If you're looking at a monthly chart, the gap would have to be between the last day of the month's close and the first day of the next month's open for monthly charts.

A price chart with gaps that occur almost daily is typical for thinly-traded securities and should probably be avoided. Prices often gap up or down at market open, but the gap does not last until the market closes. Such temporary intraday gaps should not be considered as having any more significance than normal market volatility.

Types of Gaps

Gaps can be subdivided into four basic categories:

• Common Gaps

• Breakaway Gaps

• Runaway Gaps, and

• Exhaustion Gaps

What Are Common Gaps?

This type of gap is sometimes referred to as a trading gap or an area gap. Common gaps are usually uneventful. They can be caused by a stock going ex-dividend when the trading volume is low. These gaps are common (get it?) and usually get filled fairly quickly.

“Getting filled” means that the price action at a later time (a few days to a few weeks) usually retraces, at the least, to the last day before the gap. This is also known as closing the gap. Below is a chart of three common gaps that have been filled. Notice how, following each gap, the price retraced to where the gap started. In other words, the gap has been filled.

A common gap usually appears in a trading range or congestion area, reinforcing the apparent lack of interest in the stock. This is often further exacerbated by low trading volume. Being aware of these types of gaps is good, but it's doubtful that they will produce trading opportunities.

What Are Breakaway Gaps?

Breakaway gaps are exciting. These occur when the price action is breaking out of a trading range or congestion area. To understand gaps, you have to understand the nature of congestion areas in the market.

A congestion area is a price range in which the market has traded for some time, usually a few weeks or so. The area near the top of the congestion area is usually a resistance area when approached from below. Likewise, the area near the bottom of the congestion area is a support area when approached from above. To break out of these areas requires market enthusiasm and either many more buyers than sellers for upside breakouts or many more sellers than buyers for downside breakouts.

Volume will (should) pick up significantly from the increased enthusiasm and also because many are holding positions on the wrong side of the breakout and will need to cover or sell them. It's better if the increase in volume happens after the gap occurs. This means that the new change in market direction has a chance of continuing. The point of the breakout now becomes the new support (if it's an upside breakout) or resistance (if it's a downside breakout). Avoid falling into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time for the gap to be filled. Instead, go with the thought that a new trend in the direction of the stock has taken place and trade accordingly.

Notice in the chart below how prices spent a few weeks consolidating. Prices broke above resistance at low volume and pulled back. The following breakaway gap took place with high volume, indicating a significant bullish shift in sentiment and triggering the start of a new uptrend.

Price gaps associated with classic chart patterns tend to be stronger than those that aren't. For example, an ascending triangle with a breakaway gap to the upside can be a much better trade than a breakaway gap without a good chart pattern.

What Are Runaway Gaps?

Runaway gaps are best described as gaps caused by increased interest in the stock. Runaway gaps to the upside typically represent traders who didn't get in during the initial move of the up trend and, while waiting for a retracement in price, decided it would not happen. Increased buying interest happens suddenly, and the price gaps above the previous day's close. This type of runaway gap represents a near-panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. In the chart below, note the significant increase in volume during and after the runaway gap.

Runaway gaps can also happen in downtrends. This usually represents increased stock liquidation by traders and buyers standing on the sidelines. Those holding the stock will eventually panic and sell. But sell to whom? The price has to continue to drop and gap down to find buyers. Not a good situation.

The term measuring gap is also used for runaway gaps. It isn't easy to find examples for this interpretation, but it's a way to help decide how much longer a trend will last. The theory is that the measuring gap will occur in the middle of, or halfway through, the move.

Sometimes, the futures market will have runaway gaps caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of the trend. These are not common occurrences in the futures market, despite all the wrong information being touted by those who don't understand it (and are only repeating something they read from an uninformed reporter).

What Are Exhaustion Gaps?

Exhaustion gaps happen near the end of a good up or downtrend. The gaps are often the first signal of the end of that move. They're identified by high volume and a large price difference between the previous day's close and the new opening price. They can easily be mistaken for runaway gaps if you overlook the exceptionally high volume.

It is almost a state of panic if the gap appears during a long down move where pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock. The prices gap up with huge volume; then, there is great profit taking, and the demand for the stock dries up. Prices drop, and a significant change in trend occurs (see chart below for an example of an exhaustion gap).

After the stock price jumped, it lost momentum, as bulls might have suspected that price was overvalued. This sentiment continued for two weeks, after which prices resumed trending upward.

Final Thoughts

Price gaps can be crucial indicators of shifts in trading activity. Gaps provide valuable insights into market sentiment and potential trading opportunities. Recognizing and understanding the different types of gaps can be an invaluable asset for traders at all levels. Each type signifies different market conditions, with implications for strategy and risk management.

The adage that all gaps eventually get filled might not always hold true, especially in the case of Breakaway and Runaway gaps. Waiting for breakout or runaway gaps to be filled can devastate your portfolio. Similarly, waiting for prices to fill a gap before getting on board a trend might make you miss a big move. So, instead of waiting for gaps to be filled, you may be better off focusing on the message gaps convey about market dynamics. Gaps are a significant technical development in price action and chart analysis. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives.

Price Gaps FAQs

The Double Bottom Reversal is a bullish reversal pattern typically found on bar charts, line charts, and candlestick charts. As its name implies, the pattern comprises two consecutive troughs that are roughly equal, with a moderate peak in between.

Although there can be variations, the classic Double Bottom Reversal usually marks an intermediate or long-term change in trend. Many potential double bottom reversals can form during a downtrend, but until key resistance is broken, a reversal cannot be confirmed. To help clarify, let's look at the key points in the formation and then walk through an example.

• Prior Trend. With any reversal pattern, there must be an existing trend to reverse. In the case of the Double Bottom Reversal, a significant downtrend of several months should be in place.

• First Trough. The first trough should mark the lowest point of the current trend. The first trough is fairly normal, and the downtrend remains firmly in place.

• Peak. Generally, after the first trough, an advance follows, ranging from 10 to 20%. Volume on the advance from the first trough is usually inconsequential, but an increase could signal early accumulation. The peak's high is sometimes rounded or drawn out a bit from the hesitation to go back down. This hesitation indicates that demand is increasing but still not strong enough for a breakout.

• Second Trough. The decline of the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a Double Bottom Reversal exists and still needs to be confirmed. The time between troughs can vary from a few weeks to many months, with the norm being one to three months. While exact troughs are preferable, there is room to maneuver; typically, a trough within 3% of its predecessor is considered valid.

• Advance From Trough. Volume is more important for the Double Bottom Reversal than the double top. There should be clear evidence that volume and buying pressure are accelerating during the advance off of the second trough. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment.

• Resistance Break. Even after trading up to resistance, the double top and trend reversal are still incomplete. Breaking resistance from the highest point between the troughs completes the Double Bottom Reversal. Like advances, these should occur with increased volume and/or an accelerated ascent.

• Resistance Turned Support. Broken resistance becomes potential support, and sometimes, the first correction tests this newfound support level. Such a test can offer a second chance to close a short position or initiate a long one.

• Price Target. To estimate a target, the distance from the resistance breakout to trough lows can be added to the price at which the breakout took place. This would imply that the bigger the formation, the larger the potential advance.

It's important to remember that the Double Bottom Reversal is an intermediate- to long-term reversal pattern that doesn't form in a few days. Although formation in a few weeks is possible, having at least four weeks between lows is preferable.

Bottoms usually take longer to form than tops; patience can often be a virtue. Give the pattern time to develop and look for the proper clues. The advance off of the first trough should be 10-20%. The second trough should form a low within 3% of the previous low, and volume on the ensuing advance should increase. Volume indicators such as Chaikin Money Flow (CMF), OBV, and Accumulation/Distribution can be used to look for signs of buying pressure. Just as with the double top, waiting for the resistance breakout is paramount. The formation is not complete until the previous reaction high is taken out.

After trending lower for almost a year, Pfizer, Inc. (PFE) stock formed a Double Bottom Reversal and broke resistance with an expansion in volume (see chart below).

• From a high near $50 in April 1999, PFE declined to 30 in December 1999, a new 52-week low.

• The stock advanced over 20% off its low and formed a reaction high of around $37.50. Volume expanded, and the January 13 advance (green arrow) occurred at the highest volume since November 5.

• After a short pullback, another attempt to break above resistance failed. Even so, volume on advancing days was generally higher than on declining days. The stock's ability to remain in the mid-thirties for an extended period of time indicated some strengthening in demand.

• The decline from $37.50 back to $30 was sharp, but downside volume didn't expand materially. There were two days when volume on a decline exceeded the 60-day Exponential Moving Average (EMA) of volume, and CMF dipped near -10% twice. However, money flows indicated accumulation throughout the decline by remaining mostly above zero with periodic movements above +10%.

• The second trough formed with a low equal to the previous low ($30). The two lows were a little over two months apart.

• The advance off the second low witnessed an accelerated move with a volume expansion. After the second low at $30, five of the next six advancing days saw volume well above the 60-day EMA. The CMF, which didn't weaken, moved above +20% within six days of the low.

• Resistance at $37.50 was broken with a gap up on the open and another volume expansion. After running from $30 to $40 in a few weeks, the stock pulled back to the resistance break at $37.50, which now turned into support. There was a brief chance to put on a long position on the pullback. The stock quickly advanced past $45.

What Is a Broadening Top?

A broadening top is a chart pattern characterized by successive higher peaks and lower valleys. If you were to draw a trendline across the top and bottom of the price action, the pattern would resemble a megaphone or a reverse triangle.

What Does the Broadening Top Indicate?

Perhaps the most reliable indication that any broadening formation tells us—whether it’s a Broadening Top or a Broadening Bottom—is that there’s a volatile disagreement between bullish and bearish investors.

Bullish investors are bidding prices higher, while bearish investors sell (or sell short) the stock, causing it to fall. As a result, you see a series of consecutive higher highs (HHs) and lower lows (LLs).

Are Broadening Tops Bearish or Bullish?

While many long-term investors consider broadening tops to be bearish, as volatility and uncertainty tend to be bearish, the historical performance of this pattern makes it much less discernible:

• Its historical performance as a bearish or bullish pattern is poor, as it tends to pull back into the pattern range over 60% of the time (meaning, if you trade the breakout, it will likely pull back in the opposite direction of your trade).

• For a “topping” formation, its historical statistics tell us that it often tends to rise more than it falls, making it more of a continuation pattern than a reversal pattern.

• Still, the pattern is tradable, but given its volatile characteristics, you might expect it to exhibit wide fluctuations (post-breakout) even if it eventually reaches your profit target.

How Do You Identify Broadening Tops? There are a couple of key characteristics to pay attention to when identifying a Broadening Top:

• Number of Touches. There should be at least five touches in total. Three of these can be peaks or valleys that touch the associated trend line. Two or more touches should be of the other trendline. Bear in mind that a “touch” is different from an “approach” that comes close to the trend line but doesn’t touch. Ideally, the second touch should make contact with the trend line.

• Filled Spaces. Prices should cross the pattern from one side to the other, filling the area with price movement. In short, there shouldn’t be wide “white spaces” in the pattern showing a lack of price activity.

• Breakout Direction. A breakout can occur in any direction and happens when the price pierces a trendline or moves above/below the height of the formation.

How Do You Trade a Broadening Top?

One of the most common approaches to trading a Broadening Top would be to buy an upward breakout or sell a downward breakout.

1. Compute the height of the pattern. Calculate the difference between the highest peak and the lowest valley. This gives you the “height” of the pattern.

2. If the breakout is to the upside. Add the pattern's height to the top of the formation to get your potential price target. You can take profits when price reaches 100% of the pattern’s height or close to it.

3. If the breakout is to the downside. Subtract the height of the pattern from the bottom of the pattern to get your potential price target. You can take profits when price reaches 100% of the pattern’s height.

4. Place a stop loss at the opposite end of the pattern. In short, place it at the opposite swing high or swing low, depending on whether you’re going long or short.

5. Beware pullbacks. Once you open your position (long or short), prices tend to pull back into the pattern range over 60% of the time, meaning it will likely go beyond your entry point and in the opposite direction.

Also, remember important support and resistance areas, which can be significant historical levels or projected levels such as those that Fibonacci Retracements can determine.

You will also want to pay attention to various volume indicators that can give you insight into buying and selling pressure (such as the Chaikin Money Flow) or the strength and momentum of a breakout (such as the Rate of Change).

The Bottom Line

A Broadening Top is a unique chart pattern resembling a reverse triangle or megaphone that signals significant volatility and disagreement between bullish and bearish investors. Though often seen as bearish due to its volatility and uncertainty, its historical performance makes it ambiguous.

Given the pattern's tendency for pullbacks, it's best to approach this pattern with prudence and a solid understanding of your risk tolerance. Additionally, while several technical indicators can aid in trading Broadening Tops, understanding the broader economic or political landscapes influencing the pattern can offer invaluable insights. In short, while the Broadening Top presents a trading opportunity, it's a pattern that demands both technical acumen and a finger on the pulse of the larger market narrative.

• Prior Trend. For this to be a reversal pattern, it is important to establish the existence of a prior uptrend. Without a prior uptrend to reverse, there cannot be a Head and Shoulders reversal pattern (or any reversal pattern, for that matter).

• Left Shoulder. While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After this peak, a decline ensues to complete the shoulder formation (1). The low of the decline usually remains above the trend line, keeping the uptrend intact.

• Head. From the left shoulder's low, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline generally breaks below the uptrend line, which jeopardizes the uptrend.

• Right Shoulder. The advance from the low (2) forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.

• Neckline. The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the right shoulder's beginning. Depending on the relationship between the two low points, the neckline can slope up, down, or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness—a downward slope is more bearish than an upward slope. In some cases, multiple low points can be used to form the neckline.

• Neckline Break. The head and shoulders pattern isn't complete, and the uptrend is not reversed until the neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.

• Support Turned Resistance. Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break and offer a second chance to sell.

• Price Target. After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should also be considered. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.

Archer Daniels Midland Company (ADM) formed a Head and Shoulders Top reversal with a slightly upward-sloping neckline.

Key points include:

• The low at $17.50 marked the end of the left shoulder and the beginning of the head (1).

• During the advance to $20.50, volume was still high but not as high as during the left shoulder advance. However, volume tapered off significantly during the next advance to $20.

• Volume continued to decline until the breaking of the neckline. (Note red line on volume bars.)

• The decline from $20.50 to $17.50 formed the second low point (2).

• During the decline of the right shoulder and neckline break, volume expanded (red oval), and Chaikin Money Flow (CMF) turned negative.

• After the initial decline, there was a return to the neckline break (black arrow). Even during this decline, CMF remained negative. The subsequent decline took the stock below $11.

• The measurement from the neckline to the top of the head was 3. With the neckline break at $17.50, this would imply a move to around $14.50. The July 1998 low was $13.50. After a decline from $20.50, at least, a short reaction rally could have been expected.

The head and shoulders pattern is one of the most common reversal formations. It is important to remember that it occurs after an uptrend and usually marks a major trend reversal when complete. While the left and right shoulders should be symmetrical, it's not an absolute requirement. They can be different widths as well as different heights. The most critical factor is identifying neckline support and volume confirmation on the break.

The support break indicates a renewed willingness for investors to sell at lower prices. Lower prices combined with a volume increase indicate an increase in supply. The combination can be lethal, and sometimes, there is no second chance return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds, other aspects of the technical picture will likely take precedence.

What is a Falling Wedge Pattern?

Is the Falling Wedge a Reversal or Continuation Pattern?

While this article will focus on the falling wedge as a reversal pattern, it can also fit into the continuation category. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing uptrend. As a reversal pattern, the falling wedge slopes down and with the prevailing trend. Regardless of the type (reversal or continuation), falling wedges are regarded as bullish patterns.

What Are the Characteristics of a Falling Wedge?

The following characteristics must be met for a pattern to be considered a falling wedge.

• Prior Trend. To qualify as a reversal pattern, there must be a prior trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low. The pattern usually forms over a three to six-month period, and the preceding downtrend should be at least three months old.

• Upper Resistance Line. It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be lower than the previous highs.

• Contraction. The upper resistance line and lower support line converge to form a cone as the pattern matures. The reaction lows penetrate the previous lows, but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with a less negative slope than the upper resistance line.

• Resistance Break. Bullish confirmation of the pattern is established once the resistance line is broken in a convincing fashion. It's sometimes prudent to wait for a break above the previous reaction high for further confirmation. Once resistance is broken, there can sometimes be a correction to test the newfound support level.

The chart below provides a textbook example of a falling wedge at the end of a long downtrend.

• Prior Trend. The downtrend for FCX began in the third quarter of 1997. There was a brief advance in Mar-98, but the downtrend resumed, and the stock was trading at new lows by Feb-99.

• Upper Resistance Line. The upper resistance line formed with four successively lower peaks.

• Lower Support Line. The lower support line formed with four successive lower lows.

• Contraction. The upper resistance line and lower support line converged as the pattern matured. Even though each low is lower than the previous low, these lows are only slightly lower. The shallowness of the new lows indicates that demand is stepping almost immediately after a new low is recorded. The supply overhang remains, but the slope of the upper resistance line is more negative than the lower support line.

• Volume. After the large volume decline on 24-Feb (red arrow), upside volume began to increase. Above-average volume continued on advancing days and when the stock broke trend line resistance. Money flows confirmed the strength by surpassing their Nov-98 high and moving to their highest level since Apr-98.

• After the trend line breakout, there was a brief pullback to support from the trend line extension. The stock consolidated for a few weeks and then advanced further on increased volume again.

The Bottom Line

The Falling Wedge is a bullish pattern that suggests potential upward price movement. This pattern, while sloping downward, signals a likely trend reversal or continuation, marking a potential inflection point in trading strategies. Falling wedges can develop over several months, culminating in a bullish breakout when prices convincingly exceed the upper resistance line, ideally with a strong increase in trading volume.

The Falling Wedge can be a valuable tool in your trading arsenal, offering valuable insights into potential bullish reversals or continuations. Because of its nuances and complexity, however, it's important for you to have a good understanding of this pattern in order to effectively leverage it in a live trading environment.

Falling Wedge FAQs

The price action that forms the Head and Shoulders Bottom is similar to the Head and Shoulders Top, but reversed. Volume action is the main difference between the two. Generally speaking, volume plays a larger role in bottom formations than top ones. While an increase in volume on the neckline breakout for a Head and Shoulders Top is welcomed, it is absolutely required for a bottom. We will look at each component of the pattern, keeping volume in mind. Then we'll put the parts together with some examples.

• Prior Trend. For this to be a reversal pattern, it is important to establish the existence of a prior downtrend. Without a prior downtrend to reverse, there cannot be a Head and Shoulders Bottom formation.

• Left Shoulder. While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the left shoulder formation (1). The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact.

• Head. From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.

• Right Shoulder. The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head and is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete.

• • Volume levels during the first half of the pattern are less important than in the second half. Volume on the decline of the left shoulder is usually pretty heavy, and selling pressure is intense. The intensity of selling can continue during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances.

  • The advance from the low of the head should show an increase in volume and/or better indicator readings, e.g., Chaikin Money Flow (CMF) > 0 or a rise in OBV. After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied by light volume. It's normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback, indicators like CMF and OBV should remain strong. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid, there needs to be a volume expansion on the price advance and during the breakout.

• Neckline Break. The Head and Shoulders Bottom pattern is incomplete (and the downtrend is not reversed) until the neckline resistance is broken. For a Head and Shoulders Bottom, this must occur convincingly, with an expansion of volume.

• Resistance Turned Support. Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break and offer a second chance to buy.

Alaska Air Group, Inc. (ALK) formed a Head and Shoulders Bottom with a downward-sloping neckline.

Key points include:

• The stock began a downtrend in early July and declined from $60 to $26.

• The low of the left shoulder formed with a large spike in volume on a sharp down day (red arrows).

• The decline from $42.50 to $26 (head) was quite dramatic, but volume did not get out of hand. CMF was mostly positive when the lows around $26 were forming.

• After the reaction high around $39, the second point of the neckline could be drawn (2).

• The decline from $39 to $33 occurred on light volume until the final two days when volume reached its highest point in a month. Even though there are two long black (down) volume bars, these are surrounded by above-average gray (up) volume bars. Also, notice how the trend line resistance near $35 became support around $33.

• The advance off the right shoulder's low occurred with above-average volume. CMF was at its highest levels and surpassed +20% shortly after neckline resistance was broken.

• After breaking neckline resistance, the stock returned to this newfound support with a successful test of around $35 (green arrow).

AT&T (T) formed a head and shoulders bottom with a flat neckline. The shoulders are slightly shallow, but the neckline and head are well-pronounced.

Key points include:

• The stock established a six-month downtrend, with the trend line extending down from March 1998.

• After a head fake above the trend line in late June, the stock fell from $66 to $50 with a sharp increase in volume to form the left shoulder.

• The rally to $61 met resistance from the trend line, and the high reaction became the neckline's first point.

• The advance from the low of the head broke above the trend line, extending down from March 1998, and met resistance around $61. This reaction high formed the second point of the neckline.

• The right shoulder was relatively short and shallow. The low was recorded at $57 and CMF remained above +10% the whole time. Support was found from the trend line that offered resistance a few weeks earlier.

• The stock advanced sharply off the lows that formed the right shoulder, and volume increased three straight days (blue arrow). This is a bit early, but volume remained just above average for the neckline breakout a few days later. Also, CMF remained above +10% the entire time.

• After neckline resistance break, the stock tested this renewed support twice while consolidating recent gains. The power arrived a few weeks later with a strong move off the support and a massive increase in volume. The stock subsequently advanced from the low $60s to the low $80s.

Head and Shoulder Bottoms are among the most common and reliable reversal formations. It is important to remember that they occur after a downtrend and usually mark a major trend reversal when complete. While the left and right shoulders should be symmetrical, it is not an absolute requirement. Shoulders can be of different widths and heights.

Remember that technical analysis is more of an art than a science. Finding the perfect pattern may take a long time.

When analyzing the Head and Shoulders Bottom pattern, focus on correctly identifying neckline resistance and volume patterns, the two most important aspects of a successful read and, by extension, a successful trade. The neckline resistance breakout, combined with an increase in volume, indicates increased demand at higher prices. It means buyers are exerting greater force, which is affecting the price.

As the examples show, traders don't always have to chase a stock after the neckline breakout. Often, but not always, price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds, other aspects of the technical picture will likely take precedence. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture.

Chart Types

Arms CandleVolume A price chart that merges traditional candlesticks with EquiVolume boxe

CandleVolume A price chart that merges traditional candlesticks with volume.

Elder Impulse System A charting system developed by Alexander Elder that colors price bars based on simple technical signals.

EquiVolume Price boxes that are sized based on their trading volume.

Heikin-Ashi A candlestick method that uses price data from two periods instead of one.