Technical Analysis I

Support and Resistance

Hi there,

As i said in my last article, the next major concept is that of ‘support’ and ‘resistance’. These are two terms that are used very frequently by stock analysts.

To put in very simple terms -Support is the price level below which a stock is not expected to fall. Resistance, on the other hand, is the price level which a stock is not expected to surpass.

You also need to go thru the next topic on ‘volume’ to fully understand the concept of support and resistance.

SUPPORT AND RESISTANCE

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic is that, when the price declines, there will be more demand for the particular share. By the time the price reaches a particular level (called support level), it is believed that demand will overcome supply and prevent the price from falling below support

Resistance is just the opposite of ‘support’. A Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic behind the theory is that , as the price advances , sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches a particular level (called the resistance level) it is believed that supply will overcome demand and prevent the price from rising above resistance.

In the book “Trading for a Living,” Dr. Alex Elder gives a simple, but effective image of support and resistance – “A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance is like a floor and a ceiling, with prices sandwiched between them.” When a stock’s price has fallen to a level where demand at that price increases and buyers begin to buy, this creates a “floor” or support level. When a stock’s price rises to a level where demand decreases and owners begin to sell to lock in their profits, this creates the “ceiling” or resistance level.

Shown below is a typical share price movement on a chart. The two lines drawn horizontally are called trendlines. The red arrows illustrate ‘resistance’ or ‘ceiling’. As you can observe, the price fails to pass above that particular level. Similarly the blue arrows illustrate ‘support’ level or ‘floor’ beyond which the price fails to fall.

HOW TO RECOGNIZE SUPPORT AND RESISTANCE.

You can identify support and resistance levels by studying a chart. (See the chart above) Look for a series of low points where a stock falls to this level, but then falls no further. This is a support level. When you find that a stock rises to a certain high, but no higher, you have found a resistance level.

The more times that a stock bounces off support and falls back from resistance, the stronger these support and resistance levels become. It creates a self-fulfilling prophecy. The more often it happens, the more likely it is to happen again. The more those historical patterns repeat themselves, the more traders “know,” and the more confident they become in forecasting the future behavior of the stock.

ROUND NUMBERS

One type of universal support and resistance that tends to be seen across a large number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be important in support and resistance levels because they often represent the major psychological turning points at which many traders will make buy or sell decisions.

Buyers will often purchase large amounts of stock once the price starts to fall toward a major round number such as Rs 50, which makes it more difficult for shares to fall below the level. On the other hand, sellers start to sell off a stock as it moves toward a round number peak, making it difficult to move past this upper level as well. It is the increased buying and selling pressure at these levels that makes them important points of support and resistance and, in many cases, major psychological points as well.

THE IMPORTANCE OF SUPPORT AND RESISTANCE

Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the share price moves toward this point because it is unlikely that it will move past this level.

THE PSYCHOLOGY BEHIND SUPPORT AND RESISTANCE

To understand the psychology behind support and resistance, we need to first categorize market participants. Market participants can typically be classified into:

1) The longs -traders who have a ‘BUY’ position and stand to profit if prices increase.

2) The shorts -traders who have a ‘SELL’ and stand to profit if prices decrease.

3) Traders who got out of their previous positions prematurely.

4) Traders who are undecided on which side of the market to be on and are looking for entry points either on the short side or the long side.

Assuming now, that prices start advancing from a support area, the longs who bought around this area would have regretted not buying more. So, every time prices come back to the support area, they would likely decide to buy more.

Traders on the short side however, would have likely realized that they are on the wrong side of the market and they would be hoping for prices to come back to the support area where they entered their short positions so that they can get out and at least break even.

The traders who had previously got out of their long positions at the support area would likely be annoyed at themselves for getting out too early and would thus be looking for a chance to get into a position again at or around the support area.

The traders who were previously undecided on which side they wanted to be on would likely decide to want to enter the market on the long side after observing the advance in prices. As such, they would be looking to enter whenever there is a good buying opportunity, which is at or around the support area.

These traders now all have the same resolve to buy should a good opportunity present itself and should prices decline to the support area, there would be buying taking place by all four groups which would result in prices being pushed up.

ROLE REVERSAL

Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level may become resistance. If the price rises above a resistance level, it may often become support. As the price moves past a level of support or resistance, it is believed that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.

In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels.

NUMERICAL WAY TO CALCULATE SUPPORT AND RESISTANCE

There are many ways to calculate levels of support and resistance (Pivot point method, Moving averages, Fibonacci numbers etc). One of the most common is to use a series of formulas to calculate “pivot points”, described herein

Calculate the pivot point as follows, using the previous day’s high, low, and close:

  • Pivot or P = (High + Low + Close) / 3
  • Calculate the first support point (S1)      = (P x 2) – H
  • Calculate the second support point (S2)  = P – (High – Low)
  • Calculate the first resistance point   (R1)  = (P x 2) – Low
  • Calculate the second resistance point( R2)     = P + (High – Low)

Adjusted Pivots

Many traders adjust their value for P as follows:

  • O = Today’s Opening Price
  • P = O + (H + L + C) / 4  (where H, L & C are from the previous day’s stock details)

Pivot points are short-term indicators, and ultimately it is the trader’s responsibility to use them wisely, in conjunction with other confirming indicators. Pivot points keep changing everyday since it’s based on daily data.

That’s about support and resistance. in the ent article we will discuss about the importance of ‘volume’ in technical analysis.

till then ,

have a nice day !!

2 Comments

Trendlines

TREND

‘Trend’ in technical analysis means direction. It is one of the most important concepts in technical analysis. After plotting the stock prices on a chart, a line is drawn through the price movement to identify the direction of price. It’s called ‘trendline’ and it could slope either downwards or upwards.

A principle of technical analysis is that once a trend has been formed, it will remain intact until it’s broken. When there is little movement up or down it’s a ‘sideways’ or ‘horizontal trend’ .If you observe financial magazines or channels you might recall experts saying about ‘sideways movement’ in stocks  A sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction. In any case, the market can move only in these three ways: up, down or nowhere.

LENGTH OR TIME FRAME OF A TREND

Trend lines can move in a same direction for any length of time until something major happens in the market that brings a change in the demand -supply balance and hence a change in price direction.  A trend of any direction can be classified as a long-term trend, intermediate trend or a short-term trend depending on the time frame we are talking about.

In terms of the stock market, a major trend (long term trend) is generally categorized as one lasting longer than a year. An intermediate trend is considered to last between one and three months and a near-term trend is anything less than a month.

A long-term trend may be composed of several intermediate trends, which often move against the direction of the major trend. If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend. The short-term trends are components of both major and intermediate trends. See the graph below:

As explained earlier, a long term trend is one which lasts for a year or more .So in order to analyze the long term direction of a stock you need to take the stock chart of a year or more. Similarly to analyze a medium term trend you need to check the graph for a 6 month period or so. Short term trend can be analyzed by taking the graph for a short period ,say 10 or 30 days . In short, a stock chart should be constructed to best reflect the type of trend being analyzed.

DRAWING A TREND LINE

Drawing trend lines are the basics of technical analysis. The explanation on how to draw may be confusing to a learner, but in actual practice it’s no big deal.  In an uptrend analysis, draw a line from the lowest low, up and to the highest minor low point preceding the highest high, so that the line does not pass though prices between the two low points. This when completed will be an ‘upward trend line’ similarly , To draw a downward trend line ,  draw a line from the highest high, down and to the lowest minor high point preceding the lowest low, so that the line does not pass though prices between the two low points .

You may also refer to the figure given above. The blue line starts from the lowest low and up to the ‘highest minor low’  point preceding the highest high and the downward trend line represented by the red line starts from the highest high and down to the lowest minor high point preceding the lowest low point.

That’s about trend lines. Drawing trendlines is just the beginning. To move further, you need to learn something called ‘support and resistance levels’ more about that in our next section.

Bye for now ..

have a nice day !!

6 Comments

Types of Charts

We said in the first section that Charts are the working tools of the technical analyst and they have been developed in various forms and styles to represent graphically almost anything and everything that takes place in the stock market.

There are three main types of charts that are used to analyse price movements. They are – the line chart, the bar chart and the candlestick chart.

LINE CHART

Line chart is the simplest of the three charts. A simple line chart draws a line from one closing price to the next closing price. When strung together with a line, it reveals the general price movement of a share over a period of time.

BAR CHARTS

The most basic tool of technical analysis is the bar chart. This chart displays basic market price data over a defined period of time. Daily bar charts note the open, high, low and closing price of an asset. Rising vertically, the bar marks the high and the low of a given time period, with the starting price marked by a horizontal line, or tick, to the left and the ending or closing price marked by a tick to the right.

Structure of a bar chart

CANDLESTICK CHART

Another type of chart used in technical analysis is the candlestick chart, so called because the main component of the chart representing prices looks like a candlestick, with a thick ‘body’ and usually a line extending above and below it, called the upper shadow and lower shadow, respectively. The top of the upper shadow represents the high price, while the bottom of the lower shadow represents the low price. Patterns are formed both by the  body and the shadows. Candlestick patterns are most useful over short periods of time, and mostly have significance at the top of an uptrend or the bottom of a downtrend, when the patterns most often signify a reversal of the trend.

While the candlestick chart shows basically the same information as the bar chart, certain patterns are more apparent in the candlestick chart. The candlestick chart emphasizes opening and closing prices. The top and bottom of the real body represents the opening and closing prices. Whether the top represents the opening or closing price depends on the color of the real body—if it is white/ blue/green, then the top represents the close; black / red or some other dark color, indicates that the top was the opening price. The length of the real body shows the difference between the opening and closing prices. Obviously, white/green/blue real bodies indicate bullishness, while black/red real bodies indicate bearishness, and their pattern is easily observable in a candlestick chart.

Structure of a candlestick chart

CONCLUSION

What we know so far is about the types of charts. While line charts are the simplest form of charts, candlesticks are more advanced and they reveal stories not detected with other charts. Whether you use a line chart or candlestick chart, you need to draw trend lines to find out direction of the stock prices. More about that in the next section- trend lines.

1 Comment

Technical Analysis

MEANING

Technical analysis is  a completely different approach to stock market investing-  it doesn’t try to find the intrinsic value  of a company or try to find whether a share is mis-priced or undervalued. A technical analyst is interested only in the price movements in the market. So, it all about analyzing the demand and supply or a price volume analysis.

TECHS VS FUNDAS

Technical analysis is a study of supply and demand in a market to determine what direction, or trend, will continue in the future. Investors who follow fundamentals try to spot shares that has the potential to  increase in value, while investors who follow technical analysis buy assets they believe they can sell to somebody else at a greater price.

Although technical analysis and fundamental analysis are seen by many as polar opposites – many market participants have experienced great success by combining the two. There are distinct advantages for both the schools of thought. it’s better to be versed with the pros and cons of both and take advantage of both the schools.

The purpose of mentioning technical trading tools here is to help you understand the relevance of technical terms used by experts in the stock recommendations. Technical analysis requires special charting software to accumulate data and convert it into information. Generally, online trading software offered by leading brokers has options to do technical analysis.

CHARTS -WORKING TOOLS OF A TECHNICAL ANALYST.

A technical analyst works with the help of ‘charts’. A chart is nothing but a graphical representation of the current price movement of a stock. There are various forms and styles of charts and it represents graphically almost anything and everything that takes place in the stock market.

BASIC ASSUMPTIONS

Technical analysis is based on three assumptions:

MARKETS DISCOUNTS EVERYTHING.

Technical analysis assumes that, at any given time, a stock’s price reflects everything that has or could affect the company – including fundamental factors. Technical analysts believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

PRICE MOVES IN TRENDS

In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction unless something happens to change the supply -demand balance. Such changes will take time and are usually detectable in the action of the market itself. Most technical trading strategies are based on this assumption.

HISTORY TENDS TO REPEAT ITSELF

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

we check more about technical analysis in the next series of articles..

Till then ..

Bye.. have a nice day !!

0 Comments