Technically Speaking… Technical Analysis (“TA”) is forecasting financial price movements based on the careful examination of past price movements. TA can help investors anticipate what is likely to happen to stock prices over time.
TA can be used to forecast stocks, indices, commodities or futures where the instrument’s price is influenced by supply and demand dynamics.
TA involves understanding important price dynamics, which include a combination of factors such as:
high, low, open, close, volume, and open interest.
These price dynamics are then plotted against the variable of time that can be used to situate the data on intraday, daily, weekly, or monthly intervals.
Long-term View – Many Months to Years
Short-term View – Intraday to Several Months
Technical Analysis
Technical Analysis depends upon the laws of supply and demand to move a security’s price. TA does not work well when additional forces beyond supply and demand influence the price of a security.
Further, TA makes several important assumptions about the securities being analyzed:
High Liquidity. Outside forces acting on thinly traded stocks make them unsuitable for TA.
No artificial Price Changes. This includes splits, dividends, and distributions. For TA to work, stock data must be adjusted and applied historically prior to anticipating price change.
No extreme news. TA cannot predict extreme events, such as “Acts of God.”
TA relies upon many ideas put forth by Charles Dow, known as “Dow Theory.” Several of Dow’s theories stand out:
Price discounts everything. This means that analysts believe that a stock’s current price fully reflects all information. This theorem is also known as strong or semi-strong market efficiency.
Price movements are not entirely random. Most analysts believe that prices trend. There are, however, periods when price movement may be viewed as solely random fluctuation. Analysts must be able to distinguish between these two periods – this point is critical. Chartists believe that it is possible to invest, or trade based upon an unfolding trend. And these trends may be short- or long-term in nature.
Look at the graph below. The broad trend is up, but the rise preceded by a long trading period in a relatively narrow price range.
“What” is more important than “Why”. Technical analysts are concerned with two main things:
What is the current price of the security?
What is the history of the security’s price movement?
Remember that price is the result of the tension between supply and demand – this represents a direct approach. Concentrate on the what and never mind the why.
Top-Down Approach
Begin with a broad-based market analysis. From here, narrow down to specific sectors and ultimately individual stocks. Broad market analysis uses major indices such as the S&P 500, DJIA, or NASDAQ. Sector analysis identifies the strongest groups and peer sets within the broader market. And, lastly, individual stock analysis can be used to identify the best performers within select sectors or industries.
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Chart Analysis
TA allows a series of generally accepted well-established principles to be applied to a variety of levels of analysis. Principles of support, resistance, trend, and trading range are utilized in studying nearly any chart. The beauty of TA is that it can be as complex or as simple as you want it.
Overall Trend – First identify the overall trend. Analysts are able to do this through the use of trend lines and simple moving averages. Here is a one-year price chart for Alpha and Omega Semiconductor Ltd. It is easy to see that since the third week of September 2021, the stock is exhibiting a “positive” or “up” trend. You can see that higher troughs form on each pullback and higher highs form on each subsequent advance.
Support – This refers to the fact that previous lows below the current market price form support or base levels. Think of them as foundations or floors from which prices have the potential to advance or decline. To that end, any movement below this layer would be considered bearish and hurt the overall price trend. The price chart of Commercial Metals below shows two levels of support between $27.85 and $29.60.
Resistance – These are areas of congestion where previous highs now mark current ceilings that cause the stock price to trade sideways or fall when coming into contact. Two levels of resistance are defined in the chart of Louisiana Pacific Corporation below.
Momentum – Refers to the speed or velocity of price change of a stock. Momentum shows the rate of change over a period of time to help investors determine the strength of a trend. The goal of momentum investing isn’t to buy a stock at an attractive valuation. Rather, the goal is to buy stocks that have already gone up considerably to take advantage of the “momentum” in their business and, therefore, in their stock price.
I prefer to define momentum investing as buying great companies that have already performed well for investors and holding them for a long period of time, as opposed to buying stocks to make a quick profit based on daily or weekly price fluctuations.
2022 Momentum Stocks
Some 2022 stocks to consider, considering their 2021 performance as “momentum stocks,” include the following:
1) Moderna (“MRNA”)
2) Lucid Group (“LCID”)
3) Upstart (“UPST”)
4. Tanger Factory Outlet Centers (“SKT”)
5. Alphabet (“GOOGL”)
6. Marathon Oil (“MRO”)
Buying / Selling Pressure – For securities and indices with volume figures, volume is used to measure buying or selling pressure. For stocks, volume is measured in the numbers of shares traded and for futures and options, volume is based on how many contracts have changed hands. Three volume indicators are On-balance Volume (OBV), Chaikin Money Flow, and Klinger Oscillator. Each indicator uses a different formula, and traders should find the indicator that works best for their particular market approach.
Relative Strength – This price relative line is formed by dividing the security by a benchmark. For example, take the stock price and divided by the S&P 500. The plot of this line will explain if the stock is outperforming (rising) or underperforming (falling) the major index.
Analysts will then synthesize the analysis above to identify the strength and maturity of the trend. They will carefully consider the reward-to-risk ratio of taking a position and determine potential entry levels for a new long position.
In the next article, we will discuss the three most common and profitable chart patterns.
References
Corporate Finance Institute