Now that we have understood the basics of technical analysis, let us move on to the actual implementation. We will discuss how technical indicators can be seen on stock charts and what how to implement these. Then, we will move on to understanding some important theories of technical analysis. All the fundamentals of technical analysis are based on these theories. Let’s first start by learning how to do technical analysis of stocks.
To put it in an easy way, you are looking for patterns in a stock chart that will explain how its price will move next. For this, you will use some qualitative and quantitative techniques. These are called technical indicators. The qualitative indicators used for technical analysis aim at finding support and resistance levels. Quantitative concepts, on the other hand, aim to study price patterns to identify whether a stock is in an upward trend or a downward trend. Accordingly, you can select whether to buy the stock or not. They include moving averages and momentum indicators.
We have discussed quantitative techniques in the previous section. In this section, we will understand how to do technical analysis of stocks based on qualitative indicators. Here are some of the important qualitative indicators:
Every house has a ceiling and floor, which supports you from the bottom. Alternatively, you cannot go above the ceiling (assume there is no terrace). So, the ceiling restricts your movements. Similarly, Technical analysis theory believes that there is a glass ceiling (top) and a glass floor (bottom) in every stock chart. Stock prices move only between these two levels unless there are major breakouts.
When the ceiling is reached, a stock will not appreciate any further. If you are in possession of the stock, you should sell it immediately. This glass ceiling is called resistance. Similarly, there is also a minimum price level, below which the stock will not fall. This level is called resistance. Every time the stock falls to this low, it will bounce back. As a result, you want to buy at this price.
Successful investors are able to pick these technical indicators accurately. They buy a stock when it is close to its support and sell it when it is approaching its resistance. These supports and resistances are not constant over the long term and keep changing. Supports and resistances keep moving higher or lower.
Supports and resistances are created because investors act in packs. When they think a stock is good, they all scramble to buy it and when a stock is bad and should be sold, they sell it. This tendency is called herd mentality. Buying in bunches prevents prices from falling beyond a level. Similarly, selling in packs prevents the price from rising beyond the resistance. You should try to spot supports and resistances by looking at stock charts and finding points where prices have stagnated or reversed after rising/ falling for some time. You should look out for what happens when these price points are reachedin the future.
So, what happens when supports and resistances are breached? Since investor activity is so high at these levels, a breach means that investors are not interested in buying and selling them anymore. This leads to prices moving violently. Once a support is breached, stock prices tend to enter a freefall zone. They form new supports. Similarly, when resistances are broken, prices tend to shoot up and form new resistances. According to the change in polarity principal, every time a support is breached it becomes a resistance. Likewise, every time a resistance is breached, it becomes a support for the future. You must watch out for prices when they are around a support or resistance zone and act upon any breach instantly.
You must also watch out for some other important chart patterns that reveal where the stock price will head next. These patterns are classified into reversal and continuation patterns. Reversal patterns indicate that a trend that was guiding the stock price till now has ended. Now, the stock will move in the reverse direction. So, if the stock was appreciating it will fall, and vice versa. Important reversal patterns include head and shoulders, inverse head and shoulders and, double tops and double bottoms.
Continuation patterns are a confirmation that the present trend will continue. You must keep holding on to your stocks if they are rising or, sell them at once if they are falling. Important continuation patterns include triangle pattern, rectangle pattern and flags and pennants. We will discuss these patterns in the section on chart patterns.
Technical analysis, like all other disciplines of note, has its own body of knowledge. Two theories are considered to be the foundation of technical analysis—the Dow Theory and the Elliot Wave Theory. Most of the fundamentals of technical analysis that you will read about in subsequent sections emanate from these. Understanding these theories is important before we progress in our quest to learn technical analysis of stocks.
The Dow Theory is considered to be the foundation of technical analysis. It was derived from several articles written by Charles H. Dow in the Wall Street Journal between 1900 and 1902. However, Dow was not able to complete his work in his lifetime. William Peter Hamilton, Robert Rhea and E. George Schaefer took over and gave his work the form of a theory. The Theory classifies market trends into primary, secondary and minor. The primary trend lasts for one to three years and contains, within it, several secondary trends. Secondary trends have a life of only a few months. Minor trends last for under a week. Many minor trends join to form a secondary trend.
Each consists of three phases. In accumulation phase, only the technically aware, professional investors buy a stock. This is usually against the general public opinion and therefore doesn’t affect the price much. In the second phase, other investors also become aware of the stock’s worth and start buying it. This drives its price up, and is called the public participation phase. Finally, prices become so unrealistically high that informed investors start exiting the stock. They feel that the top has been reached and a fall is coming up. This phase is called the distribution phase. All market trends consist of these phases. These phases are largely caused by new information, which gets reflected in prices instantly because all investors become aware of it and apply it to investing.
According to Dow’s Theory, for a trend to be real, market movements should supplement each other. This is because most stocks are related to each other in some way. If one moves up, the other should too. If this doesn’t happen, it is a sign that a trend is not stable. You should then consider a reversal in the trend to be imminent. The last part of the Dow Theory is that market trends should be believed to continue unless there is a clear sign of a reversal. Speculation distorts prices for some time. Unless there is a clear sign of reversal, stock prices will not change from the existing market trend for long.
The Elliott Wave Theory was proposed by R.N. Elliott in 1938. This Theory is largely based on Charles Dow’s work. In the Theory, Elliott proposes that stock markets move in cycles that repeat themselves and called them cycles’ waves. To predict price movements, we must understand the pattern of these waves and locate our current position on them.
According to Elliott, waves are of different magnitude. Each wave contains a series of sub-waves. The largest wave is called the Grand Super cycle. It takes centuries to get completed. There are many super cycles in it, which contain other smaller wave patterns. The smallest cycle is the ‘subminuette’. It only takes minutes to complete.
These cycles, put together, account for the up-moves and down-moves in the market. According to the Theory, market trends—both bull (upward) and bear (downward) market—are a combination of five Waves. He named these waves differently for bull markets and bear markets. The combination of these five Waves is referred to as an ‘impulse Wave’. When the markets have moved substantially in one direction and the pattern is complete, the direction of the movement reverses. An upward moving stock will fall and vice versa. This is called a ‘corrective wave’ or a correction. A corrective move is a combination of three waves.
In case of a bull run, i.e. an upward market trend, Elliott describes the impulse wave as a combination of five moves—up, down, up, down, up, in that sequence. This is the pattern in which stock prices move up. However, down moves are small. They end with the price falling less than in the previous fall. This can be seen in the figure below. The first section of the figure illustrates a bull market impulse wave. Once the sequence of five is complete, the corrective move kicks in. It is a combination of three Waves—down, up, down. This can be seen in the second section of the figure. When the correction is complete, a different wave will guide future prices.
Spotting market patterns is the key to success in Elliott wave-based trading. This is a very tricky art to master. It requires extensive study and practice. Decoding Elliott Waves involves use of complex mathematical concepts.He relied upon a method based on the Fibonacci sequence and the ‘golden ratio’.
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