The Basics of Technical Analysis

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Yesterday we went over the concept of technical analysis, and why it's relevant to any investor's strategy.  (If you missed yesterday's issue, click here) 

Technical analysis isn't just a tool for advanced day-traders and high-flying hedge fund gunslingers.  Strong fundamental analysis is always crucial, but technical indicators can sometimes give you an added edge for specific entry and exit points.   

As I said yesterday: "fundamental analysis helps you decide what to buy; technical analysis helps you decide when."   

Technical analysis is especially useful for deciding how to build a position in a small-cap company.  That's because smaller companies tend to be more volatile than their large-cap peers, and the only real way to combat volatility is to understand technical analysis.   

Today, we will discuss the most basic technical analysis charting concept – and how you can use it to decide when to buy.   

Some Technical Basics 

*****Everyone should be aware of some of the most basic price patterns that chartists and technicians look for.  

The most basic premise in technical analysis is that specific patterns have meaning and tell you what the price is going to do next.  

If the price moves toward new upper or lower levels and breaks through, that often implies that a new trading range is being established, or that a new short-term trend is occurring and that prices are going to continue to move in the newly established direction. Equally important, if a price range test is made but fails, that often indicates that the price direction is now going to move in the opposite direction. 

Trading Ranges and Channels 

The first important technical indicator is called the trading range. This is the space between the highest and lowest price that a stock typically reaches within a period of time. As a company grows, the trading range, also known as the channel, will change as well, hopefully to the upside. The trading range defines volatility and also serves as the benchmark for most other indicators. For example, when a stock trades within a very narrow trading range, volatility is said to be low; meaning the market risk is lower. But risk has a flipside, called opportunity. So an exceptionally narrowly trading stock has both lower risk and lower opportunity. 

The trading range defines a stock's volatility and market risk. The broader the range and the greater price movement within the range, the higher the volatility. When the barriers of the trading range are continually challenged and breached, the market risk (and profit or loss potential) is greatly increased as well. 

The top of the trading range is called resistance, because it is known as the price limit within the current trading range. It is the highest price that buyers have recently paid. If resistance is ever passed, technicians see that as an indication that the price may rise further. The bottom level is called support. This is the lowest price that a stock has recently. If a stock's price falls below current support, it may signal a declining trend to a lower trading range. 

In the illustration below you can see an example of a trading range. Original resistance (1) is joined by two lower resistance levels (3, 5) and then lower again (6). When the price moved up from 4 the resistance level 3, would not allow prices to rise further. Initial support starts at point 2 and the price tried twice to move lower than this point. Both times the support level at point 2 held and prices moved higher. The more times a price touches resistance or support points, the stronger the level of support or resistance tends to be. If prices move beyond points 2 or 3 it is likely that the asset will develop an entirely new trading range shortly afterwards. 

  *****In the stock chart below, the line clearly demonstrates a downward price channel until Jan 20. The stock finally finds support at $50. For three weeks the stock struggles to move higher. Each time $55 acts as resistance and $50 shows support. Finally, on Feb 20 the support level breaks. 

 An important distinction has to be made between stationary and moving ranges. A stationary range remains level over time, and the moving range demonstrates an evolving price direction as seen in the above falling channel. Another way that trading ranges evolve is in the breadth itself. If a trading range of the recent past covered about six points but more recently has doubled to 12 points from high to low, that's a big increase in price volatility.  

If a stock's price range is trending upward but the breadth of the range remains the same, then the stock is not becoming more or less volatile. The same is true if price is trending to the downside; as long as the trading range's breadth is unchanged, that is a no sign of change in volatility or market risk. As you track stocks in growing small-cap companies, a growing price level with unchanged trading breadth is a very strong sign, indicating that future growth will continue to follow this trend. 

For example, Range Resources (NYSE: RRC), a Fort Worth, Texas, independent oil and gas drilling company, was selling around $35 per share early in 2009, about half its all-time high of just over $76. However, between late 2002 and mid-2008 it showed a steady upward movement, marked by ups and downs on different days, which over time maintained a relatively narrow breadth. 

The illustration below shows an example of a rising prices without a change in breadth. Note how the breadth of this evolving range holds the same range even as prices grow. Resistance and support both rise, but the breadth does not show any increase or decrease in volatility. 

 A Downside Indicator 

The chart below is somewhat different. The breadth remains the same as the price trend increases; the breakdown occurs once price moves below support.

This is an important signal, especially after a long-established upward trend. A breakdown means that the share price has collapsed, falling below the support level. This can indicate lower prices in the future. 

 An Upside Breakout 

The same observation works on the way down. The illustration below shows a declining price trend without any change in breadth.  

The breakout to the upside would be confirmed by the analysis of other technical indicators, notably changes in daily volume. With the trading range serving as the basis for most technical analysis, and resistance and support serving as the lines in the sand for significant price movement, there are six important technical patterns you need to know: 

All technical indicators are generalizations, and none by themselves can be used reliably to make specific trading decisions. But used in groupings, technical indicators are effective tools for timing of entry and exit. In addition, technical indicators can be used to confirm emerging fundamental trends in a company's ever-changing competitive stance. The best approach to studying a company is utilizing a wise combination of fundamental and technical indicators, and tracking both types over a period of time. 

*****The Bottom Line 

• Technical analysis can compliment fundamental research, helping determine the timing of trades to maximize profits.

• Institutional investors can use technical analysis for program trading based on the technical movements of stocks.

• Stocks trade within ranges, and when those ranges are violated, share prices are likely to move either higher or lower, depending on the direction of the movement.

• Technical analysis can be effectively used to determine the short-term direction of a stock.

• Long-term, stocks move based on the fundamentals, not based on the technicals.