Technical Analysis: Tools & Tactics

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Just as with fundamental analysis, there are tools that technical analysts use to determine when to buy or sell a stock. For some people, technical analysis can seem confusing. With practice, however, it should make more sense.

Volume: An Underestimated but Powerful Indicator

Volume shows how many shares changed hands during a given period. It is the fuel that drives stock prices higher or lower. By studying the volume of shares being traded, you can obtain clues as to whether a stock is moving because of true buying or selling interest or other factors that could influence the direction of the stock.

In today's market, billions of shares of stock are traded every day on all three stock exchanges. If less than a billion shares are traded during the day, it is considered a light volume day. It isn't hard to guess why this is true. In 1929, only 8% of the people in the United States were invested in the stock market. Now it is estimated that over 60% of the people are invested in the market, either through mutual funds or directly in stocks.

Sometimes you will hear people on Wall Street talk about a liquid market. This is another way of saying that there is a lot of volume in the market or in an individual stock. The pros on Wall Street want to see a lot of liquidity and do everything in their power to bring people into the market, especially buyers. The more liquid a stock is, the easier it is to get into and out of it. That is why you want a lot of liquidity in the market. 

Moving Averages: A Simple but Powerful Tool

One of the simplest but most valuable technical indicators for both investors and traders is the MOVING AVERAGE (MA). A moving average is the average price of a stock for a specified period-for example, a specified number of hours, days, or weeks. When plotted on a chart, it is displayed as a line that moves forward with each trading day. When moving averages are put on a chart, they give technicians a lot of clues about where a stock is headed.

Many technical analysts use moving averages as support and resistance. If the stock price rises above the moving average, this is seen as a bullish sign. Conversely, if the stock price drops below the moving average, this is seen as bearish and is a signal to sell. In particular, many institutional investors use the 200-day MA as support and resistance. For example, if the stock price is trading below the 200-day MA, this is a signal to sell. If the stock price is trading above the 200-day MA, this is a signal to buy.

Short-term traders tend to use the 40- or 50-day MA to determine support and resistance levels. It's sometimes uncanny how a stock can nudge up to the 40- or 50-day MA and then immediately reverse direction. Keep in mind that you should not base your trading decisions solely on moving averages (or any other technical indicator), but the MA does give you an idea of the strength and direction of the stock trend.

On-Balance Volume (OBV): A Measure of Volume

ON-BALANCE VOLUME (OBV) is one of the most underutilized but important indicators. OBV measures volume, which, as you remember, is the force that makes stocks go up or down. When you put OBV on a chart, a volume line appears at the bottom of the chart on top of the volume bars. OBV basically measures how much money is flowing into or out of a security.

If the OBV line is dropping, it tells you that people are selling. If the OBV line is rising, it tells you that people are buying. After all, no matter what is happening in the market, if people are pulling money out of a stock, its price will go down. Conversely, if people are buying a stock, its price will go up. Because technical analysis is not an exact science, many traders use OBV to confirm what is happening with a stock. For example, let's say that a stock is up by 3 points but the OBV is dropping. This tells you that although the stock is temporarily going up, it's not going to last. For whatever reason, people, most likely institutional investors, are selling. The dropping OBV is a signal that you should immediately sell the stock.

One of the biggest problems with technical analysis is that you sometimes get false signals. OBV helps you determine whether the buying and selling pressure is real or whether a reversal is imminent. For example, let's say that the price of a stock is falling but OBV is rising. An alert trader will buy, not sell, because it's possible that the stock price will reverse as more buyers accumulate shares.

Relative Strength Indicator: Measure of Whether Stocks are Overbought or Oversold

The relative strength indicator (RSI) measures the relative strength or weakness of a stock when it is compared to itself over a specified period. It is an OSCILLATOR with an upper and lower band that ranges from 0 to 100 on a vertical scale.

To understand the RSI, you need to know what is meant by RELATIVE STRENGTH and RELATIVE WEAKNESS, two of the most important concepts in technical analysis. Relative strength means that a stock is strong compared to another stock or to an index. Generally, you avoid buying stocks with relative weakness.

When used in conjunction with other technical indicators such as moving averages and OBV, the RSI is a powerful tool that can help to identify whether a stock is OVERBOUGHT or OVERSOLD. This allows you to determine which stocks are going to run out of energy and succumb to the bears (overbought). On the other hand, the RSI will also help you to identify stocks that have fallen and are about to reverse and move higher (oversold).

For example, if the stock price is dropping, but the RSI rises above 70 and then crosses back down, this is a sign that the stock might reverse direction (this price reversal is called DIVERGENCE). Conversely, if the stock price is rising, but the RSI drops below 30 and crosses back up, the stock might reverse. The idea is that the stock price will eventually move in the direction of the RSI.

Bollinger Bands: Another Measure of Whether Stocks are Overbought or Oversold

Like the RSI, Bollinger bands are an OSCILLATOR that helps traders identify whether a stock is overbought or oversold. Bollinger bands have two lines, an upper and a lower band with a gap between them that expands or contracts as the stock price moves. You should keep your eye on the third line in the middle. This is called the price indicator, and where it goes signals whether a stock is about to reverse direction.

Technicians look for a number of signals when using Bollinger bands. First, if the two outer bands move so close together that they are almost touching (narrow), this is a signal that there could be a sudden move in the stock price, either up or down. Second, if the price indicator is pushed well outside the upper or lower band, this means that there is strong buying or selling activity. Many times, a stock will ride the upper or lower band for minutes or hours and then cross through. Often, if the price indicator begins in one band, it will cross to the other band. This tells you that in the next few minutes, or perhaps hours, the stock price will reverse direction.

The good news is that in the hand of an expert, technical indicators like Bollinger bands are extremely useful. The bad news is that the indicators change so quickly that they are useful primarily to short-term traders. As always, you should experiment and practice before risking real money on technical indicators or oscillators.

One of the problems with technical analysis is that it is extremely difficult to read the signals correctly. If all it took to be successful in the market were sophisticated oscillators and indicators, then most people would use only technical analysis. Although most investors should have a basic understanding of how to read charts and how to use technical indicators like moving averages, this probably won't help for long-term investments. After all, technical analysis is most useful for short-term decisions.

Although charting stocks can be fun and profitable, you must also be careful to keep it simple. Many traders find that the more indicators they use on a chart, the more confused they get. It is what one trader friend of mine calls "analysis paralysis." You spend so much time studying charts that you don't make trades. Keep it simple-the less complicated the information on your chart, the better.

Source/Disclaimer: Excerpted from Understanding Stocks by Michael Sincere. © 2004 by The McGraw-Hill Companies.

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