This article provides an introduction to Stock Charting and Other Indicators and the role that they play helping stock pickers make informed decisions in stock selection.
Stock Charting and Other Indicators
There are a number of significant stock charts patterns utilized by technicians in technical analysis, each of which is readily identifiable. A caveat to identifying stock charts patterns is that they usually take time to develop and the chartist may miss part of the anticipated price move as a result. Stock charts patterns also behave like a self-fulfilling prophecy. Remember, patterns are only one of the tools that may be utilized to analyze a stock. The individual investor should use more than one tool to analyze and select stocks.
Types of Stock Charting Patterns
Support and Resistance Patterns
The first and simplest patterns are support and resistance formations. These patterns are based on observed historic price action, and the principle of supply and demand. In support/resistance patterns, supply and demand manifest themselves as buying interest and selling pressure.
A support pattern is simply defined by a price level that has acted as a historic support level for the stock. Should the price of a stock decline to the historic support area, investors should emerge to purchase the stock, thereby supporting the price.
Conversely, a resistance level acts in the opposite manner. If the price of a stock has had difficulty moving higher, a resistance level forms. As the stock price approaches the resistance level, investors recognize that the stock has run to the top end of its trading range and sell the stock. This acts as resistance to further price gains.
An interesting characteristic of support and resistance levels is that they reverse their function should they be breached. If the support line is broken, then the previous support level reverses its function and becomes a resistance level. The same is true of resistance levels. Should a defined resistance level be broken, it then becomes the new support line.
Support and resistance levels may appear in many forms. They may be the result of key price levels for market participants, or they may result from intervention by a market agency or governing body. The majority may be summed up as follows:
- recent major highs and lows
- pivot points
- moving averages
- retracement levels for moves off recent highs and lows
- chart pattern areas
- congestion and high volume areas
Other useful levels may be taken from weekly trading charts, stock chart pattern objectives, or price levels that correspond to other technical indicators target prices.
If support and resistance levels emerge in a consistent and defined range over time, then a stock is considered stuck in a trading range. Some market players know a stock so well they simple trade the range of the stock. A trading range may exist in a “bull” market, a “bear” market or a neutral market. When a trading range exists in “bull” or “bear” markets, the formation is called a channel.
Reversal patterns are usually easily visible. They are double tops (bottoms), triple tops (bottoms), and head and shoulder formations. Each of these patterns looks like it sounds. Double and triple tops meet the same point of resistance on each successive move up, with increasing volume on the down leg. The increased volume on the down leg pushes the market into a bearish trend. Head and shoulder formations may exist in either a bear or bull market. They are similar to a triple top (bottom) formation, except there is a distinguishing push higher on the second move forming the head.
Head and Shoulders Formations
Moving averages are used in a similar manner as charting patterns, Dow theory, or Elliot Wave theory. However, it differs in that the patterns being charted are based on a moving average of a stock price activity, and thus a smoother trend is exhibited. The smoothing effect of moving averages removes some of the inter-day volatility, or trading noise, allowing the technician to interpret market trends more effectively. Moving averages are defined as an average that is recomputed each time a new observation occurs. Thus, an “n” day moving average of the stocks closing price would drop the observation from “n+1″ days ago and add the most recent observation. The new set of numbers is averaged using the number of observations in the set. The new number is the moving average for the most recent period.
Many technicians use a crossover method of interpreting moving averages. If a stock’s price crosses over a moving average line, then a trend reversal is likely. Moving averages are a useful technical tool in a trending market. However, should a market be trading in a consolidative manner (sideways), then many false signals are given by a moving average indicator. Moving averages may also act as support and resistance levels in a trending market.
Other Indicator Factors
Volume is the number of stocks traded during a trading session. Volume traded in a security is used in conjunction with charting methods. This allows the technician to confirm the intensity and pattern exhibited by the charts.
Using volume as a measure of the markets trend intensity, or momentum, is common. The rule-of-thumb for bull market patterns is that price and volume should increase in tandem. During corrections, volume should decrease as price action pulls back. For bear markets, volume should increase as price decreases. Corrections should see decreased volumes as price levels retrace. If volumes and prices do not behave in this general manner, a trend reversal may occur. This signal is called a “volume divergence.”
Patterns may be confirmed on a volume basis as well. The helpful hint that volume provides in pattern formation is the direction of a breakout from chart patterns, consolidation, or trend lines. The rule-of-thumb for breakouts is that the heavy volume direction of trade is likely to be the next trading direction. This is driven by the idea that directional players have anticipated the change in market sentiment and are accumulating a position.
Open interest refers to the total number of option contracts outstanding at the end of a trading period. This is represented by the number of long contracts outstanding divided by the number of short contracts outstanding, not the sum of them. The important measure from this indicator is the change in open interest. The change is a measure of capital flow in the market. During a market rally, the open interest should increase as new money is attracted into the market. The change in open interest reflects the strength of the up trend. However, if the open interest decreases as a market rallies, then it is likely that short positions are being covered. The bull run will likely come to an end once the shorts have been covered. The converse is true for bear markets.
The advance/decline line is a simple calculation used to measure market breadth. The formula is:
- A/D Line = (No. of Up Issues – No. of Down Issues) + Yesterday’s A/D Value
This provides a cumulative total that acts as a momentum indicator. The numbers should be analyzed on a relative basis, rather than an absolute basis. This will provide greater insight into the overall market trend.
For bull market direction to continue, growth must be broadly based across many stocks. If many stocks and sectors are participating in the rally, then the rally is likely to be sustainable. The advance/decline line is also an excellent divergence indicator. If the price of marginal stocks weakens while the price of blue chip stocks continues to grow, a trend reversal is likely. The converse is true for bear markets.