Technical Analysis: Introduction
The methods used to analyze and predict the performance of a company's stock fall into two broad categories: fundamental and technical analysis. Those who use technical analysis look for peaks, bottoms, trends, patterns and other factors affecting a stock's price movement and then make buy/sell decisions based on those factors. It is a technique many people attempt, but few are truly successful at it.
The world of technical analysis is huge today. There are literally hundreds of different patterns and indicators that investors claim to have success with. We have tried to keep this tutorial as short as possible. Our goal is to introduce you to the different types of stock charts and the various technical analysis tools available to investors.
Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value; instead they look at stock charts for patterns and indicators that will determine a stock's future performance.
Technical analysis has become increasingly popular over the past several years, as more and more people believe that the historical performance of a stock is a strong indication of future performance. The use of past performance should come as no surprise. People using fundamental analysis have always looked at the past performance of companies by comparing fiscal data from previous quarters and years to determine future growth. The difference lies in the technical analyst's belief that securities move according to very predictable trends and patterns. These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable.
There are many instances of investors successfully trading a security using only their knowledge of the security's chart, without even understanding what the company does.
However, although technical analysis is a terrific tool, most agree it is much more effective when used in combination with fundamental analysis.
Indicator Interpretation An indicator is a mathematical calculation that can be applied to a security's price and/or volume fields. The result is a value that is used to anticipate future changes in prices.
MetaStock for Java includes many of the most popular indicators used among technical analysts. All of the indicators are calculated using only one or two values, either the closing price, the volume, or both.
A moving average fits this definition of an indicator: it is a calculation that can be performed on a security's price to yield a value that can be used to anticipate future changes in prices.
MetaStock for Java also allows you to draw support/resistance lines and trendlines. Support/resistance and trendline analysis lie at the heart of technical analysis, since they are based on basic laws of supply and demand.
BAR CHART The bar chart is one of the most popular types of charts used in technical analysis. As illustrated on the left, the top of the vertical line indicates the highest price at which a security traded during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar and the opening price is shown on the left side of the bar. A single bar like the one to the left represents one day of trading.
The following is the bar chart of AT&T.
CANDLESTICKS Candlestick charts have been around for hundreds of years. They are often referred to as "Japanese candles" because the Japanese would use them to analyze the price of rice contracts.
Similar to a bar chart, candlestick charts also display the open, close, daily high and daily low. The difference is the use of color to show if the stock went up or down over the day.
Investors seem to have a "love/hate" relationship with candlestick charts. People either love them and use them frequently, or they are completely turned off by them. There are several patterns to look for with candlestick charts - here are a few of the popular ones and what they mean:
This is a bullish pattern - the stock opened at (or near) its low and closed near its high.
The opposite of the pattern above, this is a bearish pattern. It indicates that the stock opened at (or near) its high and dropped substantially to close near its low.
Known as "the hammer", this is a bullish pattern only if it occurs after the stock price has dropped for several days. A hammer is identified by a small body along with a large range. The theory is that this pattern can indicate that a reversal in the downtrend is in the works.
Known as a "star", this pattern is used in other patterns such as the "doji star". For the most part, stars typically indicate a reversal and or indecision. There is a possibility that after seeing a star there will be a reversal or change in the current trend.
LONG VS SHORT: Long white candlesticks show strong buying pressures. The longer the candlestick the further the close is above the open. After extended declines, long white candles are a potential turning point or a support level. If buying gets too aggressive after a long advance, it can lead to excessive bullishness.
Long Black candlesticks show strong selling pressure. The longer the candlestick the further close is below the open. After extended advances, long black candlesticks are a
potential resistance level. After a long decline, a long black candlestick can indicate panic or a bearish phase.
Even more potent long candlesticks are the Marubozu brothers, Black and white. Marubozu brothers don’t have upper or lower shadows and the high and low are represented by the open or close. A white Marubozu is formed when the open equals the low and the close equals the high. Black Marubozu is formed when the open equals the high and the close equals the low. This indicates that the sellers controlled the price from the first trade till the last trade.
Candlesticks with long upper shadow and long lower shadow with small real bodies are called spinning tops. One long body indicates a reversal of sorts, spinning tops indicate indecision.
POINT AND FIGURE CHART
The point & figure (P&F) chart is somewhat rare. In fact, most charting services do not even offer it. This chart plots day-to-day increases and declines in price: increases are represented by a rising stack of "X"s, while decreases are represented by a declining stack of "O"s. This type of chart was traditionally used for intraday charting (a stock chart for just one day), mainly because it can be long and tedious to create a P&F chart manually over a longer period of time.
The idea behind P&F charts is that they help you to filter out less significant price movements and to focus on the most important trends. Below is an example of a P&F chart for AT&T (T):
MACD Overview The MACD ("Moving Average Convergence/Divergence") is a trend following momentum indicator that shows the relationship between two moving averages of prices. The MACD was developed by Gerald Appel, publisher of Systems and Forecasts.
The MACD is the difference between a 26-day and 12-day exponential moving average. A 9-day exponential moving average, called the "signal" (or "trigger") line is plotted on top of the MACD to show buy/sell opportunities. (Appel specifies exponential moving averages as percentages as explained on page 170. Thus, he refers to these three moving averages as 7.5%, 15%, and 20% respectively.) Interpretation The MACD proves most effective in wide-swinging trading markets. There are three popular ways to use the MACD: crossovers, overbought/oversold, and divergences.
Crossovers. The basic MACD trading rule is to sell when the MACD falls below its signal line. Similarly, a buy signal occurs when the MACD rises above its signal line. It is also popular to buy/sell when the MACD goes above/below zero.
Overbought/Oversold Conditions. The MACD is also useful as an overbought/oversold indicator. When the shorter moving average pulls away dramatically from the longer moving average (i.e., the MACD rises), it is likely that the security price is overextending and will soon return to more realistic levels. MACD overbought and oversold conditions exist vary from security to security.
Divergences. A indication that an end to the current trend may be near occurs when the MACD diverges from the security. A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs. Both of these divergences are most significant when they occur at relatively overbought/oversold levels.
One of the easiest indicators to understand, the moving average, shows the average value of a security's price over a period of time. To find the 50-day moving average, you would add up the closing prices (but not always - we'll explain later) from the past 50 days and divide them by 50. Because prices are constantly changing, the moving average will move as well. It should also be noted that moving averages are most often used when compared or used in conjunction with other indicators such as moving average convergence divergence (MACD) and exponential moving average (EMA).
The most commonly used moving averages are of 20, 30, 50, 100 and 200 days. Each moving average provides a different interpretation on what the stock will do - there is not one right time frame. The longer the time span, the less sensitive the moving average will be to daily price changes. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations (or "noise") that can confuse interpretation
Notice that back in September the stock price dropped well below its 50-day average (the green line). There has been a steady downward trend since then and no really strong divergence until the end of December when it rose above its 50-day average and continued to rise for several weeks.
Moving Average
Overview A Moving Average is an indicator that shows the average value of a security's price over a period of time. When calculating a moving average, a mathematical analysis of the security's average value over a predetermined time period is made. As the security's price changes, its average price moves up or down.
There are several popular ways to calcuate a moving average. MetaStock for Java calculates a "simple" moving average--meaning that equal weight is given to each price over the calculation period. Interpretation The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security's price with the security's price itself. A buy signal is generated when the security's price rises above its moving average and a sell signal is generated when the security's price falls below its moving average.
This type of moving average trading system is not intended to get you in at the exact bottom nor out at the exact top. Rather, it is designed to keep you in line with the security's price trend by buying shortly after the security's price bottoms and selling shortly after it tops.
The critical element in a moving average is the number of time periods used in calculating the average. When using hindsight, you can always find a moving average that would have been profitable. The key is to find a moving average that will be consistently profitable. The most popular moving average is the 39-week (or 200-day) moving average. This moving average has an excellent track record in timing the major (long-term) market cycles.
Moving Average Crossover Overview A Moving Average is an indicator that shows the average value of a security's price over a period of time. When calculating a moving average, a mathematical analysis of the security's average value over a predetermined time period is made. As the security's price changes, its average price moves up or down. See the Moving Average page for more information on moving averages.
The Moving Average Crossover indicator prompts you for two parameters. A shorter moving average and a longer moving average. Interpretation The most popular method of interpreting a single moving average is to compare the relationship between a moving average of the security's price with the security's price itself. However, you can also compare the relationship between a shorter-term moving average and a longer-term moving average. For example, by entering 9 in the first box, and 39 in the second box, MetaStock for Java will plot both moving averages on the price chart. Look for possible buying opportunities when the shorter moving average crosses above the longer moving average. Conversely, look for possible selling opportunities when the shorter moving average crosses below the longer moving average.
Relative Strength Index (RSI) Overview The Relative Strength Index ("RSI") is a popular oscillator. It was first introduced by Welles Wilder in an article in Commodities (now known as Futures) Magazine in June, 1978. The name "Relative Strength Index" is slightly misleading as the Relative Strength Index does not compare the relative strength of two securities, but rather the internal strength of a single security. A more appropriate name might be "Internal Strength Index." Interpretation When Wilder introduced the Relative Strength Index, he recommended using a 14-day Relative Strength Index. Since then, the 9-day and 25-day Relative Strength Indexs have also gained popularity. The fewer days used to calculate the Relative Strength Index, the more volatile the indicator.
The Relative Strength Index is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the Relative Strength Index is to look for a divergence in which the security is making a new high, but the Relative Strength Index is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a "failure swing." The failure swing is considered a confirmation of the impending reversal.
In Mr. Wilder's book, he discusses five uses of the Relative Strength Index:
Tops and Bottoms. The Relative Strength Index usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart. Chart Formations. The Relative Strength Index often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.
Failure Swings (also known as support or resistance penetrations or breakouts). This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough). Support and Resistance. The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance. Divergences. As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the Relative Strength Index.
The RSI is a reasonably simple model that anyone can use. It is calculated using the following formula
RSI = 100 - [100/(1 + RS)]
where: RS = (Avg. of n-day up closes)/(Avg. of n-day down closes) n= days (most analysts use 9 - 15 day RSI)
The RSI ranges from 0 to 100. At around the 70 level, a stock is considered overbought and you should consider selling. But this number is not written in stone: in a bull market some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30, a stock is considered oversold and you should consider buying. Again, make the adjustment to 20 in a bear market.
The smaller the number of days used, the more volatile the RSI is and the more often it will hit extremes. A longer term RSI is more rolling, fluctuating a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks in some industries will go as high as 75-80 before dropping back, while others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (one year or more) to determine at what level the historical RSI has traded and how the stock reacted when it reached those levels
Above, we have an RSI chart for AT&T. The RSI is the green line, and its scale is the numbers on the right hand side that go from 0 to 100. Notice the RSI was approaching the 60-70 level in December and January, and then the stock (blue line) sold off. Also, notice that when the RSI dropped to 25 around October the stock climbed up nearly 30% in just a couple of weeks.
Using the moving averages, trendlines, divergence, support and resistance lines along with the RSI chart can be very useful. Rising bottoms on the RSI chart can produce the
same positive trend results as they would on the stock chart. Should the general trend of the stock price tangent from the RSI, it might spark a warning that the stock is either over- or underbought.
The RSI is a great indicator that can help you make some serious money. Be aware that big surges and drops in stocks will dramatically affect the RSI, resulting in false buy or sell signals. Most investors agree that the RSI is most effective in "backing up" or increasing confidence before making an investment decision
Stochastic Oscillator Overview The Stochastic Oscillator compares where a security's price closed relative to its price range over a given time period.
Interpretation The Stochastic Oscillator is displayed as two lines. The main line is called "%K." The second line, called "%D," is a moving average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.
There are several ways to interpret a Stochastic Oscillator. Three popular methods include:
Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level.
Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line.
Look for divergences. For example, where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.
SUPPORT AND RESISTANCE
Support - A price level below the current market price, at which buying interest should be able to overcome selling pressure and thus keep the price from going any lower.
Resistance - A price level above the current market price, at which selling pressure should be strong enough to overcome buying pressure and thus keep the price from going any higher.
One of two things can happen when a stock price approaches a support/resistance level. On the one hand, it can act as a reversal point: in other words, when a stock price drops to a support level, it will go back up. On the other hand, S/R levels may reverse roles once they are penetrated. For example, when the market price falls below a support level, that former support level will then become a resistance level when the market later trades back up to that level. The foundation of most technical analysis tools is rooted in the concept of supply and demand. There is nothing mysterious about support and resistance--it is classic supply and demand. Remembering "Econ 101" class, supply/demand lines show what the supply and demand will be at a given price.
Resistance is equivalent to a "supply" line. When prices increase, the quantity of sellers also increases as more investors are willing to sell at these higher prices. When too much selling occurs, however, prices retreat. When this happens repeatedly near a specific price level, resistance forms at that price level.
Support is equivalent to a "demand" line. When prices decrease, the quantity of buyers increases as more investors are willing to buy at lower prices. When too much buying occurs, however, prices rise. When this happens repeatedly near a specific price level, support forms at that price level.
Following the penetration of a support/resistance level, it is common for traders to question the new price levels. For example, after a breakout above a resistance level, buyers and sellers may both question the validity of the new price and may decide to sell. This creates a phenomena referred to as "traders' remorse" where prices return to a support/resistance level following a price breakout. The price action following this remorseful period is crucial. One of two things can happen. Either the consensus of expectations will be that the new price is not warranted and prices will move back to their previous level; or investors will accept the new price and prices will continue to move in the direction of the penetration.
This chart shows an excellent example of support and resistance levels for General Electric (GE). Notice that once the stock price penetrated below the support level in December, it became the resistance level. You also need to understand that S/R levels vary in strength, leading to certain price levels being designated as major or minor S/R levels. For example, a five-year high on a bar chart would be a much more significant and useful resistance level than a one-month resistance level.
MONEY FLOW INDEX The Money Flow Index (MFI) measures the strength of money flowing into and out of a stock. The difference between the RSI and the MFI is this: while the RSI looks only at prices, the MFI also takes volume into account.
The MFI is a bit more difficult to calculate than the RSI: First we need the average price for the day: Day High + Day Low + Close Average Price = 3
Now we need the Money Flow: Money Flow = Average Price x Day's Volume
Now, to calculate the money flow ratio you need to separate the money flows for a period into positive and negative. If the price was up in a particular day, this is considered to be "positive money flow". If the price closed down, it is considered to be "negative money flow". Positive Money Flow Money Flow Ratio = Negative Money Flow
It is the Money Flow Ratio that is used to calculate the Money Flow Index.
The money flow ranges from 0 to 100. Just as with the RSI, a stock is considered overbought in the 70- 80 range and oversold in the 20-30 range.
The smaller the number of days you use, the more volatile the money flow is. The chart below is for Home Depot (HD) and uses a 14-day average.
The MFI is identified by the green line. Notice that each time the money flow dropped below 30, the stock began to rally. Furthermore, each time the money flow rose above 70, the stock started to sell off.
Like any indicator, the MFI is not correct 100% of the time. Back in early October when the stock price dropped from around $55 down to $37, the MFI didn't detect a thing. Just remember that money flow is useful to detect momentum, but it cannot predict unsystematic risk.
Bollinger Bands
Overview Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels above and below a moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods.
Bollinger Bands were created by John Bollinger.
Interpretation Bollinger Bands are usually displayed on top of security prices, but they can be displayed on an indicator. These comments refer to bands displayed on prices.
As with moving average envelopes, the basic interpretation of Bollinger Bands is that prices tend to stay within the upper- and lower-band. The distinctive characteristic of Bollinger Bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (i.e., high volatility), the bands widen to become more forgiving. During periods of stagnant pricing (i.e., low volatility), the bands narrow to contain prices.
Mr. Bollinger notes the following characteristics of Bollinger Bands.
Sharp price changes tend to occur after the bands tighten, as volatility lessens. When prices move outside the bands, a continuation of the current trend is implied.
Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
The Bollinger band indicator uses three lines: the upper, the lower and the simple moving average (SMA) that is between the two. The upper/lower bands are plotted two standard deviations away from a SMA. Standard deviation is a measure of volatility; therefore, Bollinger bands adjust themselves to market conditions. When the markets become more volatile, the bands widen, and they contract during less volatile periods.
The closer the prices move to the upper band, the more overbought the stock is. The closer the prices move to the lower band, the more oversold the stock is. Below is an example using General Electric (GE). Bollinger bands are blue for the lower band, green for the average and red for the upper band:
The blue circle is where the stock price started to create a "base" on the lower band - it appeared that the stock was oversold. Buying at this point would have been a wise choice, as the stock proceeded to jump 20% or more in the next few weeks
The two red circles are areas where the stock price was touching or breaking through the upper red band. This is usually an indication that the stock is overbought. In both instances, the stock dropped substantially in subsequent weeks.
Bollinger bands are a good tool to use, but as we've been saying all along, you should never invest based solely on what just one indicator says. Notice that there were instances when the stock touched the upper or lower band and did not react. Rather than basing their investment decisions on Bollinger bands, many investors use this indicator to confirm a decision they are about to make.
Momentum
Overview The Momentum indicator measures the amount that a security's price has changed over a given time span.
Interpretation The interpretation of the Momentum indicator is identical to the interpretation of the Price ROC. Both indicators display the rate-of-change of a security's price. However, the Price ROC indicator displays the rate-of-change as a percentage whereas the Momentum indicator displays the rate-of-change as a ratio. There are two ways to use the Momentum indicator:
You can use the Momentum indicator as a trend-following oscillator similar to the MACD (this is the method I prefer). Buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down. You may want to plot a shortterm (e.g., 9-period) moving average of the indicator to determine when it is bottoming or peaking.
If the Momentum indicator reaches extremely high or low values (relative to its historical values), you should assume a continuation of the current trend. For example, if the Momentum indicator reaches extremely high values and then turns down, you should assume prices will probably go still higher. In either case, only trade after prices confirm the signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).
You can also use the Momentum indicator as a leading indicator. This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out). This is often the case, but it is also a broad generalization.
As a market peaks, the Momentum indicator will climb sharply and then fall off-diverging from the continued upward or sideways movement of the price. Similarly, at a market bottom, Momentum will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices.
Price Patterns
Overview A basic principle of technical analysis is that security prices move in trends. We also know that trends do not last forever. They eventually change direction and when they do, they rarely do so on a dime. Instead, prices typically decelerate, pause, and then reverse. These phases occur as investors form new expectations and by doing so, shift the security's supply/demand lines.
The changing of expectations often causes price patterns to emerge. Although no two markets are identical, their price patterns are often very similar. Predictable price behavior often follows these price patterns.
Chart patterns can last from a few days to many months or even years. Generally speaking, the longer a pattern takes to form, the more dramatic the ensuing price move.
Interpretation The following sections explain several of the more common price patterns. For more information on chart patterns, we suggest the book, Technical Analysis of Stock Trends by Robert Edwards and John Magee.
Head and Shoulders Rounding Tops and Bottoms Triangles Double Tops and Bottoms
Head and Shoulders - This is a chart formation resembling an "M" in which a stock's price: - rises to a peak and then declines, then - rises above the former peak and again declines, and then - rises again but not to the second peak and again declines.
The first and third peaks are shoulders, and the second peak forms the head. This pattern is considered a very bearish indicator.
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During a healthy up-trend, volume should increase during each rally. A sign that the trend is weakening occurs when the volume accompanying rallies is less than the volume accompanying the preceding rally. In a typical Head-and-Shoulders pattern, volume decreases on the head and is especially light on the right shoulder.
Following the penetration of the neckline, it is very common for prices to return to the neckline in a last effort to continue the up-trend. If prices are then unable to rise above the neckline, they usually decline rapidly on increased volume.
An inverse (or upside-down) Head-and-Shoulders pattern often coincides with market bottoms. As with a normal Head-and-Shoulders pattern, volume usually decreases as the pattern is formed and then increases as prices rise above the neckline.
Cup and Handle - This is a pattern on a bar chart that can be as short as seven weeks and as long as 65 weeks. The cup is in the shape of a "U". The handle has a slight downward drift. The right-hand side of the pattern has low trading volume. As the stock comes up to test the old highs, the stock will incur selling pressure by the people who bought at or near the old high. This selling pressure will make the stock price trade sideways with a tendency towards a downtrend for anywhere from four days to four weeks, then it will take off.
This pattern looks like a pot with a handle. It is one of the easier patterns to detect, and investors have made a lot of money using it.
Rounding Tops and Bottoms Rounding tops occur as expectations gradually shift from bullish to bearish. The gradual, yet steady shift forms a rounded top. Rounding bottoms occur as expectations gradually shift from bearish to bullish.
Volume during both rounding tops and rounding bottoms often mirrors the bowl-like shape of prices during a rounding bottom. Volume, which was high during the previous trend, decreases as expectations shift and traders become indecisive. Volume then increases as the new trend is established.
Triangles A triangle occurs as the range between peaks and troughs narrows. Triangles typically occur as prices encounter a support or resistance level which constricts the prices.
A "symmetrical triangle" occurs when prices are making both lower-highs and higher-lows.
An "ascending triangle" occurs when there are higher-lows (as with a symmetrical triangle), but the highs are occurring at the same price level due to resistance. The odds favor an upside breakout from an ascending triangle.
A "descending triangle" occurs when there are lower-highs (as with a symmetrical triangle), but the lows are occurring at the same price level due to support. The odds favor a downside breakout from a descending triangle.
Just as pressure increases when water is forced through a narrow opening, the "pressure" of prices increases as the triangle pattern forms. Prices will usually breakout rapidly from a triangle. Breakouts are confirmed when they are accompanied by an increase in volume. The most reliable breakouts occur somewhere between half and three-quarters of the distance between the beginning and end (apex) of the triangle. There are seldom many
clues as to the direction prices will break out of a symmetrical triangle. If prices move all the way through the triangle to the apex, a breakout is unlikely.
Double Tops and Bottoms
A double top occurs when prices rise to a resistance level on significant volume, retreat, and subsequently return to the resistance level on decreased volume. Prices then decline marking the beginning of a new down-trend.
A double bottom has the same characteristics as a double top except it is upside-down.
This pattern resembles a "W" and occurs when a stock price drops to a similar price level twice within a few weeks or months. You should buy when the price passes the highest point in the handle. In a perfect double bottom, the second decline should normally go slightly lower than the first decline to create a shakeout of jittery investors. The middle point of the "W" should not go into new high ground. This is a very bullish indicator.
The belief is that, after two drops in the stock price, the jittery investors will be out and the long-term investors will still be holding on.
Trendlines
In the preceding section, we saw how support and resistance levels can be penetrated by a change in investor expectations (which results in shifts of the supply/demand lines). This type of a change is often abrupt and "news based."
In this section, we'll review "trends." A trend represents a consistent change in prices (i.e., a change in investor expectations). Trends differ from support/resistance levels in that trends represent change, whereas support/resistance levels represent barriers to change.
As shown in the following chart, a rising trend is defined by successively higher lowprices. A rising trend can be thought of as a rising support level--the bulls are in control and are pushing prices higher.
As shown in the next chart, a falling trend is defined by successively lower high-prices. A falling trend can be thought of as a falling resistance level--the bears are in control and are pushing prices lower.
Volume Overview Volume is simply the number of shares (or contracts) traded during a specified time frame (e.g., hour, day, week, month, etc). If volume is reported for the security, MetaStock for Java automatically plots it along the bottom of the chart as a histogram. The analysis of volume is a basic yet very important element of technical analysis. Volume provides clues as to the intensity of a given price move.
Interpretation Low volume levels are characteristic of the indecisive expectations that typically occur during consolidation periods (i.e., periods where prices move sideways in a trading range). Low volume also often occurs during the indecisive period during market bottoms.
High volume levels are characteristic of market tops when there is a strong consensus that prices will move higher. High volume levels are also very common at the beginning of new trends (i.e., when prices break out of a trading range). Just before market bottoms, volume will often increase due to panic-driven selling.
Volume can help determine the health of an existing trend. A healthy up-trend should have higher volume on the upward legs of the trend, and lower volume on the downward (corrective) legs. A healthy downtrend usually has higher volume on the downward legs of the trend and lower volume on the upward (corrective) legs.
Volume Oscillator Overview The Volume Oscillator displays the difference between two moving averages of a security's volume. The difference between the moving averages can be expressed in either points or percentages.
Interpretation You can use the difference between two moving averages of volume to determine if the overall volume trend is increasing or decreasing. When the Volume Oscillator rises above zero, it signifies that the shorter-term volume moving average has risen above the longer-term volume moving average, and thus, that the short-term volume trend is higher (i.e., more volume) than the longer-term volume trend.
There are many ways to interpret changes in volume trends. One common belief is that rising prices coupled with increased volume, and falling prices coupled with decreased volume, is bullish. Conversely, if volume increases when prices fall, and volume decreases when prices rise, the market is showing signs of underlying weakness.
The theory behind this is straight forward. Rising prices coupled with increased volume signifies increased upside participation (more buyers) that should lead to a continued move. Conversely, falling prices coupled with increased volume (more sellers) signifies decreased upside participation.
Accumulation/Distribution
Overview The Accumulation/Distribution is a momentum indicator that associates changes in price and volume. The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.
Interpretation The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator. Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.
When the Accumulation/Distribution moves up, it shows that the security is being accumulated as most of the volume is associated with upward price movement. When the indicator moves down, it shows that the security is being distributed as most of the volume is associated with downward price movement.
Divergences between the Accumulation/Distribution and the security's price imply a change is imminent. When a divergence does occur, prices usually change to confirm the Accumulation/Distribution. For example, if the indicator is moving up and the security's price is going down, prices will probably reverse.