Technical Analysis

Explanation of some technical analysis concepts, tools, and techniques:

Trend

An up-trending stock is one that is exhibiting a pattern of higher highs and higher lows.  A down-trending stock is one that is exhibiting a pattern of lower highs and lower lows.  A stock that is not doing either of those things is often said to be “trending” sideways, or to have no trend at all.

Moving Average

A moving average represents the average value of the closing price of the stock over the past N days.  For example, a 30 day moving average gives you the average value of the closing prices for the past 30 days.  Every day, the moving average is updated by dropping the oldest day in the 30-day window and adding the current day in.

Various moving averages can be plotted on a price chart.  Typical ones are 20-day, 30-day, 50-day, and 200-day moving averages.  Moving averages often act as support or resistance for a trending stock.  It’s very common to see a stock repeatedly bouncing off its 30-day moving average as it trends up, or to hitting its head on its 30-day moving average on the way down.

Exponential moving averages are very similar, but they are weighted so the most recent days affect the average more than the oldest days.  Many people prefer to use the EMA because it provides a more up-to-date picture of what the stock is doing.

I typically plot the 30-day and 200-day exponential moving averages on my charts to get an idea of where there might be short-term support or resistance on the 30-day EMA and long term on the 200-day EMA.  I usually give more emphasis to supporting or resisting trendlines, but often the EMA can provide another confirmation to those signals.

Ascending Trendline

A stock that is in an up trend often uses an ascending trendline as support.  The trendline connects the low points of a sequence of lower lows, and can often predict the low points of future dips within the up trend.  Just because a stock has an ascending trendline does not mean it will always bounce off of it, but it is often the case that it will do just that.  When trading, it is important to actually observe a bounce rather than assuming that just because the stock has come down to the trendline that it must then bounce back up.  It also useful to get confirmation from other indicators as well.

Descending Trendline

A stock that is in a down trend often uses a descending trendline as resistance.  The trendline connects the high points of a sequence of lower highs, and can often predict the high points of future surges within the down trend.  Just because a stock has a descending trendline does not mean it will always bounce down off of it, but it is often the case that it will do just that.  When trading, it is important to actually observe a bounce rather than assuming that just because the stock has come up to the trendline that it must then bounce down.  It is also useful to get confirmation from other indicators as well.

Channel

A stock that is trending up with an ascending trendline can sometimes also have another ascending trendline connecting the high points of its higher highs.  This trendline acts as resistance.  If the supporting and resisting trendlines are parallel, or close to it, they are referred to as a channel.  It usually takes a fairly significant event to break a stock out of a channel.

Likewise, a stock that is trending down with a descending trendline can also have another descending trendling connecting its lower lows, which will act as support.

MACD

MACD stans for Moving Average Convergence and Divergence.  This is an indicator that provides a measure of the momentum of the stock relative to its own past.  The MACD is calculated by comparing two moving averages with different periods.  A typical setup is to use a 17-day and a 9-day moving average.  The difference between these two moving averages is computed and usually plotted as a histogram.

When the 9-day moving average is higher than the 17-day moving average, or in the histogram when the values are positive, this tells you that in the last 9 days, prices have on average been higher than in the past 17 days.  This means that the price of the stock has upward momentum.  Likewise when the 17-day MA is higher than the 9-day MA, or when the histogram value is negative, this tells you that the short-term values are lower and that there is downward momentum.

Viewing the MACD as a histogram can be useful because it makes it easier to see peaks and valleys in the MACD.  For example, when the MACD histogram gets to be extremely low and then starts to turn back up, you can see that momentum is starting shift towards increasing prices.  Conversely when the MACD is high and starting to turn down, it tells you that momentum is starting to shift towards decreasing prices. 

This should not be used as the only reason to enter a trade because it is quite possible for the MACD to stay extremely high or extremely low for long periods of time before it reverses.  However, the MACD is a useful indicator to use as a confirmation of a bounce off support or resistance.

Stochastic Oscillator

The stochastic oscillator is another indicator that gives you an idea of the performance of the price relative to its own history.  This indicator tells you where the most recent closing price of the stock falls relative to the overall minimum and maximum values it has had in the past several days.  The value is usually represented as a percentile, so it ranges between 0 and 100.

For example, if a stock has been trading within a range of 85 to 95 within the last 14 days and today it closed at 92, the 14-day stochastic oscillator would give you a value of (92 - 85) / (95 - 85) = 70%.

Typically, stochastic oscillator values above 80 are referred to as overbought and below 20 are referred to as oversold.  This doesn’t indicate a trading signal on its own, however.  Usually, you want to see an oversold stochastic oscillator cross back above 20 or an overbought stochastic oscillator to cross back down below 80 to indicate a signal.  I often use a change in direction of the stochastic oscillator as a confirmation of a trendline bounce, along with the MACD indicator.