http://www.investopedia.com/university/technical/?

partner=COTW01

Technical Analysis: Introduction

By Cory Janssen, Chad Langager and Casey Murphy

The methods used to analyze securities and make investment decisions fall into two very broad
categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the
characteristics of a company in order to estimate its value. Technical analysis takes a completely
different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians
(sometimes called chartists) are only interested in the price movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and
demand in a market in an attempt to determine what direction, or trend, will continue in the
future. In other words, technical analysis attempts to understand the emotions in the market by
studying the market itself, as opposed to its components. If you understand the benefits and
limitations of technical analysis, it can give you a new set of tools or skills that will enable you to
be a better trader or investor.

In this tutorial, we'll introduce you to the subject of technical analysis. It's a broad topic, so we'll
just cover the basics, providing you with the foundation you'll need to understand more advanced
concepts down the road.

Next: Technical Analysis: The Basic Assumptions

Table of Contents
1) Technical Analysis: Introduction
2) Technical Analysis: The Basic Assumptions
3) Technical Analysis: Fundamental Vs. Technical Analysis
4) Technical Analysis: The Use Of Trend
5) Technical Analysis: Support And Resistance
6) Technical Analysis: The Importance Of Volume
7) Technical Analysis: What Is A Chart?
8) Technical Analysis: Chart Types
9) Technical Analysis: Chart Patterns
10) Technical Analysis: Moving Averages
11) Technical Analysis: Indicators And Oscillators
12) Technical Analysis: Conclusion
What Is Technical Analysis?
Technical analysis is a method of evaluating securities by analyzing the statistics generated by market
activity, such as past prices and volume. Technical analysts do not attempt to measure a security's
intrinsic value, but instead use charts and other tools to identify patterns that can suggest future
activity.

Just as there are many investment styles on the fundamental side, there are also many different types
of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and
most use some combination of the two. In any case, technical analysts' exclusive use of historical price
and volume data is what separates them from their fundamental counterparts. Unlike fundamental
analysts, technical analysts don't care whether a stock is undervalued - the only thing that matters is a
security's past trading data and what information this data can provide about where the security might
move in the future.

The field of technical analysis is based on three assumptions:

1.     The market discounts everything.

2.     Price moves in trends.
3.     History tends to repeat itself.

1. The Market Discounts Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental
factors of the company. However, 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.

2. 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 as the trend than
to be against it. Most technical trading strategies are based on this assumption.

3. 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.
Not Just for Stocks
Technical analysis can be used on any security with historical trading data. This includes stocks, futures
and commodities, fixed-income securities, forex, etc. In this tutorial, we'll usually analyze stocks in our
examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical
analysis is more frequently associated with commodities and forex, where the participants are
predominantly traders.

Now that you understand the philosophy behind technical analysis, we'll get into explaining how it really
works. One of the best ways to understand what technical analysis is (and is not) is to compare it to
fundamental analysis. We'll do this in the next section. 

For further reading, check out Defining Active Trading, Day Trading Strategies For Beginners and What
Can Investors Learn From Traders?.

Next: Technical Analysis: Fundamental Vs. Technical Analysis

Technical analysis and fundamental analysis are the two main schools of thought in the financial
markets. As we've mentioned, technical analysis looks at the price movement of a security and uses this
data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic
factors, known as fundamentals. Let's get into the details of how these two approaches differ, the
criticisms against technical analysis and how technical and fundamental analysis can be used together to
analyze securities.

The Differences
Charts vs. Financial Statements
At the most basic level, a technical analyst approaches a security from the charts, while a fundamental
analyst starts with the financial statements. (For further reading, see Introduction To Fundamental
Analysis and Advanced Financial Statement Analysis.)

By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries
to determine a company's value. In financial terms, an analyst attempts to measure a company's
intrinsic value. In this approach, investment decisions are fairly easy to make - if the price of a stock
trades below its intrinsic value, it's a good investment. Although this is an oversimplification
(fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial, this
simple tenet holds true.

Technical traders, on the other hand, believe there is no reason to analyze a company's fundamentals
because these are all accounted for in the stock's price. Technicians believe that all the information they
need about a stock can be found in its charts.
Time Horizon
Fundamental analysis takes a relatively long-term approach to analyzing the market compared to
technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes,
fundamental analysis often looks at data over a number of years.

The different timeframes that these two approaches use is a result of the nature of the investing style to
which they each adhere. It can take a long time for a company's value to be reflected in the market, so
when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock's market price
rises to its "correct" value. This type of investing is called value investing and assumes that the short-
term market is wrong, but that the price of a particular stock will correct itself over the long run. This
"long run" can represent a timeframe of as long as several years, in some cases. (For more insight, read
Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)

Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time.
Financial statements are filed quarterly and changes in earnings per share don't emerge on a daily basis
like price and volume information. Also remember that fundamentals are the actual characteristics of a
business. New management can't implement sweeping changes overnight and it takes time to create
new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts
use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much
more slowly than the price and volume data used by technical analysts.

Trading Versus Investing

Not only is technical analysis more short term in nature that fundamental analysis, but the goals of a
purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used
for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they
believe can increase in value, while traders buy assets they believe they can sell to somebody else at a
greater price. The line between a trade and an investment can be blurry, but it does characterize a
difference between the two schools.

The Critics
Some critics see technical analysis as a form of black magic. Don't be surprised to see them question the
validity of the discipline to the point where they mock its supporters. In fact, technical analysis has only
recently begun to enjoy some mainstream credibility. While most analysts on Wall Street focus on the
fundamental side, just about any major brokerage now employs technical analysts as well.

Much of the criticism of technical analysis has its roots in academic theory - specifically the efficient
market hypothesis (EMH). This theory says that the market's price is always the correct one - any past
trading information is already reflected in the price of the stock and, therefore, any analysis to find
undervalued securities is useless. 

There are three versions of EMH. In the first, called weak form efficiency, all past price information is
already included in the current price. According to weak form efficiency, technical analysis can't
predict future movements because all past information has already been accounted for and,
therefore, analyzing the stock's past price movements will provide no insight into its future movements.
In the second, semi-strong form efficiency, fundamental analysis is also claimed to be of little use in
finding investment opportunities. The third is strong form efficiency, which states that all information in
the market is accounted for in a stock's price and neither technical nor fundamental analysis can provide
investors with an edge. The vast majority of academics believe in at least the weak version of EMH,
therefore, from their point of view, if technical analysis works, market efficiency will be called into
question. (For more insight, read What Is Market Efficiency? and Working Through The Efficient Market
Hypothesis.)

There is no right answer as to who is correct. There are arguments to be made on both sides and,
therefore, it's up to you to do the homework and determine your own philosophy.

Can They Co-Exist?

Although technical analysis and fundamental analysis are seen by many as polar opposites - the oil and
water of investing - many market participants have experienced great success by combining the two. For
example, some fundamental analysts use technical analysis techniques to figure out the best time to
enter into an undervalued security. Oftentimes, this situation occurs when the security is severely
oversold. By timing entry into a security, the gains on the investment can be greatly improved.

Alternatively, some technical traders might look at fundamentals to add strength to a technical signal.
For example, if a sell signal is given through technical patterns and indicators, a technical trader might
look to reaffirm his or her decision by looking at some key fundamental data. Oftentimes, having both
the fundamentals and technicals on your side can provide the best-case scenario for a trade.

While mixing some of the components of technical and fundamental analysis is not well received by the
most devoted groups in each school, there are certainly benefits to at least understanding both schools
of thought.

In the following sections, we'll take a more detailed look at technical analysis.

Next: Technical Analysis: The Use Of Trend

One of the most important concepts in technical analysis is that of trend. The meaning in finance
isn't all that different from the general definition of the term - a trend is really nothing more than
the general direction in which a security or market is headed. Take a look at the chart below:
 Figure 1

It isn't hard to see that the trend in Figure 1 is up. However, it's not always this easy to see a
trend:

Figure 2

There are lots of ups and downs in this chart, but there isn't a clear indication of which direction
this security is headed.

A More Formal Definition

Unfortunately, trends are not always easy to see. In other words, defining a trend goes well
beyond the obvious. In any given chart, you will probably notice that prices do not tend to move
in a straight line in any direction, but rather in a series of highs and lows. In technical analysis, it
is the movement of the highs and lows that constitutes a trend. For example, an uptrend is
classified as a series of higher highs and higher lows, while a downtrend is one of lower lows
and lower highs.

Figure 3

Figure 3 is an example of an uptrend. Point 2 in the chart is the first high, which is determined
after the price falls from this point. Point 3 is the low that is established as the price falls from
the high. For this to remain an uptrend, each successive low must not fall below the previous
lowest point or the trend is deemed a reversal.  

Types of Trend
There are three types of trend:

 Uptrends
 Downtrends 
 Sideways/Horizontal Trends As the names imply, when each successive peak and trough
is higher, it's referred to as an upward trend. If the peaks and troughs are getting lower,
it's a downtrend. When there is little movement up or down in the peaks and troughs, it's
a sideways or horizontal trend. If you want to get really technical, you might even say
that 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 really only trend in these three ways: up,
down or nowhere. (For more insight, see Peak-And-Trough Analysis.)

Trend Lengths
Along with these three trend directions, there are three trend classifications. A trend of
any direction can be classified as a long-term trend, intermediate trend or a short-term
trend. In terms of the stock market, a major 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 is
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. Take a look a Figure 4 to get a sense of how these three trend lengths
might look.
 Figure 4

When analyzing trends, it is important that the chart is constructed to best reflect the type
of trend being analyzed. To help identify long-term trends, weekly charts or daily charts
spanning a five-year period are used by chartists to get a better idea of the long-term
trend. Daily data charts are best used when analyzing both intermediate and short-term
trends. It is also important to remember that the longer the trend, the more important it is;
for example, a one-month trend is not as significant as a five-year trend. (To read more,
see Short-, Intermediate- And Long-Term Trends.)

Trendlines
A trendline is a simple charting technique that adds a line to a chart to represent the trend
in the market or a stock. Drawing a trendline is as simple as drawing a straight line that
follows a general trend. These lines are used to clearly show the trend and are also used
in the identification of trend reversals.

As you can see in Figure 5, an upward trendline is drawn at the lows of an upward trend.
This line represents the support the stock has every time it moves from a high to a low.
Notice how the price is propped up by this support. This type of trendline helps traders to
anticipate the point at which a stock's price will begin moving upwards again. Similarly,
a downward trendline is drawn at the highs of the downward trend. This line represents
the resistance level that a stock faces every time the price moves from a low to a high.
(To read more, see Support & Resistance Basics and Support And Resistance Zones -
Part 1 and Part 2.)
 Figure 5


Channels
A channel, or channel lines, is the addition of two parallel trendlines that act as strong
areas of support and resistance. The upper trendline connects a series of highs, while the
lower trendline connects a series of lows. A channel can slope upward, downward or
sideways but, regardless of the direction, the interpretation remains the same. Traders
will expect a given security to trade between the two levels of support and resistance until
it breaks beyond one of the levels, in which case traders can expect a sharp move in the
direction of the break. Along with clearly displaying the trend, channels are mainly used
to illustrate important areas of support and resistance.

Figure 6


Figure 6 illustrates a descending channel on a stock chart; the upper trendline has been
 placed on the highs and the lower trendline is on the lows. The price has bounced off of
these lines several times, and has remained range-bound for several months. As long as
the price does not fall below the lower line or move beyond the upper resistance, the
range-bound downtrend is expected to continue.

The Importance of Trend

It is important to be able to understand and identify trends so that you can trade with
rather than against them. Two important sayings in technical analysis are "the trend is
your friend" and "don't buck the trend," illustrating how important trend analysis is for
technical traders.

Next: Technical Analysis: Support And Resistance

 Once you understand the concept of a trend, the next major concept is that of support and
resistance. You'll often hear technical analysts talk about the ongoing battle between the bulls
and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by
the prices a security seldom moves above (resistance) or below (support).

Figure 1

As you can see in Figure 1, support is the price level through which a stock or market seldom
falls (illustrated by the blue arrows). Resistance, on the other hand, is the price level that a stock
or market seldom surpasses (illustrated by the red arrows).

Why Does it Happen?

These support and resistance levels are seen as important in terms of market psychology and
supply and demand. Support and resistance levels are the levels at which a lot of traders are
willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these
trendlines are broken, the supply and demand and the psychology behind the stock's
movements is thought to have shifted, in which case new levels of support and resistance will
likely be established.

Round Numbers and Support and Resistance

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 $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.

Role Reversal
Once a resistance or support level is broken, its role is reversed. If the price falls below a support
level, that level will become resistance. If the price rises above a resistance level, it will often
become support. As the price moves past a level of support or resistance, it is thought 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. (For further reading, see Retracement Or Reversal: Know The Difference.)

Figure 2

For example, as you can see in Figure 2, the dotted line is shown as a level of resistance that has
prevented the price from heading higher on two previous occasions (Points 1 and 2). However,
once the resistance is broken, it becomes a level of support (shown by Points 3 and 4) by
propping up the price and preventing it from heading lower again.

Many traders who begin using technical analysis find this concept hard to believe and don't
realize that this phenomenon occurs rather frequently, even with some of the most well-known
companies. For example, as you can see in Figure 3, this phenomenon is evident on the Wal-
Mart Stores Inc. (WMT) chart between 2003 and 2006. Notice how the role of the $51 level
changes from a strong level of support to a level of resistance.
 Figure 3

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. This is most often seen when a stock is
trading in a generally sideways manner as the price moves through successive peaks and troughs,
testing resistance and support.

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 security moves toward this point because it is unlikely that it
will move past this level.

Support and resistance levels both test and confirm trends and need to be monitored by anyone
who uses technical analysis. As long as the price of the share remains between these levels of
support and resistance, the trend is likely to continue. It is important to note, however, that a
break beyond a level of support or resistance does not always have to be a reversal. For example,
if prices moved above the resistance levels of an upward trending channel, the trend has
accelerated, not reversed. This means that the price appreciation is expected to be faster than it
was in the channel.

Being aware of these important support and resistance points should affect the way that you trade
a stock. Traders should avoid placing orders at these major points, as the area around them is
usually marked by a lot of volatility. If you feel confident about making a trade near a support or
resistance level, it is important that you follow this simple rule: do not place orders directly at the
support or resistance level. This is because in many cases, the price never actually reaches the
whole number, but flirts with it instead. So if you're bullish on a stock that is moving toward an
important support level, do not place the trade at the support level. Instead, place it above the
support level, but within a few points. On the other hand, if you are placing stops or short selling,
set up your trade price at or below the level of support.

Next: Technical Analysis: The Importance Of Volume

To this point, we've only discussed the price of a security. While price is the primary item of
concern in technical analysis, volume is also extremely important.

What is Volume?
Volume is simply the number of shares or contracts that trade over a given period of time,
usually a day. The higher the volume, the more active the security. To determine the movement
of the volume (up or down), chartists look at the volume bars that can usually be found at the
bottom of any chart. Volume bars illustrate how many shares have traded per period and show
trends in the same way that prices do. (For further reading, see Price Patterns - Part 3, Gauging
Support And Resistance With Price By Volume.) 

Why Volume is Important

Volume is an important aspect of technical analysis because it is used to confirm trends and chart
patterns. Any price movement up or down with relatively high volume is seen as a stronger,
more relevant move than a similar move with weak volume. Therefore, if you are looking at a
large price movement, you should also examine the volume to see whether it tells the same story.
Say, for example, that a stock jumps 5% in one trading day after being in a long downtrend. Is
this a sign of a trend reversal? This is where volume helps traders. If volume is high during the
day relative to the average daily volume, it is a sign that the reversal is probably for real. On the
other hand, if the volume is below average, there may not be enough conviction to support a true
trend reversal. (To read more, check out Trading Volume - Crowd Psychology.)

Volume should move with the trend. If prices are moving in an upward trend, volume should
increase (and vice versa). If the previous relationship between volume and price movements
starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an
uptrend but the up trading days are marked with lower volume, it is a sign that the trend is
starting to lose its legs and may soon end.

When volume tells a different story, it is a case of divergence, which refers to a contradiction
between two different indicators. The simplest example of divergence is a clear upward trend on
declining volume. (For additional insight, read Divergences, Momentum And Rate Of Change.)

Volume and Chart Patterns

The other use of volume is to confirm chart patterns. Patterns such as head and shoulders,
triangles, flags and other price patterns can be confirmed with volume, a process which we'll
describe in more detail later in this tutorial. In most chart patterns, there are several pivotal points
that are vital to what the chart is able to convey to chartists. Basically, if the volume is not there
to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern
is weakened.

Volume Precedes Price

Another important idea in technical analysis is that price is preceded by volume. Volume is
closely monitored by technicians and chartists to form ideas on upcoming trend reversals. If
volume is starting to decrease in an uptrend, it is usually a sign that the upward run is about to
end.

Now that we have a better understanding of some of the important factors of technical analysis,
we can move on to charts, which help to identify trading opportunities in prices movements.

Next: Technical Analysis: What Is A Chart?

In technical analysis, charts are similar to the charts that you see in any business setting. A chart
is simply a graphical representation of a series of prices over a set time frame. For example, a
chart may show a stock's price movement over a one-year period, where each point on the graph
represents the closing price for each day the stock is traded:
 Figure 1

Figure 1 provides an example of a basic chart. It is a representation of the price movements of a

stock over a 1.5 year period. The bottom of the graph, running horizontally (x-axis), is the date
or time scale. On the right hand side, running vertically (y-axis), the price of the security is
shown. By looking at the graph we see that in October 2004 (Point 1), the price of this stock was
around $245, whereas in June 2005 (Point 2), the stock's price is around $265. This tells us that
the stock has risen between October 2004 and June 2005.

Chart Properties
There are several things that you should be aware of when looking at a chart, as these factors can
affect the information that is provided. They include the time scale, the price scale and the price
point properties used.

The Time Scale

The time scale refers to the range of dates at the bottom of the chart, which can vary from
decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly,
quarterly and annually. The shorter the time frame, the more detailed the chart. Each data point
can represent the closing price of the period or show the open, the high, the low and the close
depending on the chart used.

Intraday charts plot price movement within the period of one day. This means that the time scale
could be as short as five minutes or could cover the whole trading day from the opening bell to
the closing bell.

Daily charts are comprised of a series of price movements in which each price point on the chart
is a full day’s trading condensed into one point. Again, each point on the graph can be simply the
closing price or can entail the open, high, low and close for the stock over the day. These data
points are spread out over weekly, monthly and even yearly time scales to monitor both short-
term and intermediate trends in price movement.
Weekly, monthly, quarterly and yearly charts are used to analyze longer term trends in the
movement of a stock's price. Each data point in these graphs will be a condensed version of what
happened over the specified period. So for a weekly chart, each data point will be a
representation of the price movement of the week. For example, if you are looking at a chart of
weekly data spread over a five-year period and each data point is the closing price for the week,
the price that is plotted will be the closing price on the last trading day of the week, which is
usually a Friday.

The Price Scale and Price Point Properties

The price scale is on the right-hand side of the chart. It shows a stock's current price and
compares it to past data points. This may seem like a simple concept in that the price scale goes
from lower prices to higher prices as you move along the scale from the bottom to the top. The
problem, however, is in the structure of the scale itself. A scale can either be constructed in a
linear (arithmetic) or logarithmic way, and both of these options are available on most charting
services.

If a price scale is constructed using a linear scale, the space between each price point (10, 20, 30,
40) is separated by an equal amount. A price move from 10 to 20 on a linear scale is the same
distance on the chart as a move from 40 to 50. In other words, the price scale measures moves in
absolute terms and does not show the effects of percent change.

Figure 2

If a price scale is in logarithmic terms, then the distance between points will be equal in terms of
percent change. A price change from 10 to 20 is a 100% increase in the price while a move from
40 to 50 is only a 25% change, even though they are represented by the same distance on a linear
scale. On a logarithmic scale, the distance of the 100% price change from 10 to 20 will not be the
same as the 25% change from 40 to 50. In this case, the move from 10 to 20 is represented by a
larger space one the chart, while the move from 40 to 50, is represented by a smaller space
because, percentage-wise, it indicates a smaller move. In Figure 2, the logarithmic price scale on
the right leaves the same amount of space between 10 and 20 as it does between 20 and 40
because these both represent 100% increases.

Next: Technical Analysis: Chart Types

There are four main types of charts that are used by investors and traders depending on the
information that they are seeking and their individual skill levels. The chart types are: the line
chart, the bar chart, the candlestick chart and the point and figure chart. In the following sections,
we will focus on the S&P 500 Index during the period of January 2006 through May 2006.
Notice how the data used to create the charts is the same, but the way the data is plotted and
shown in the charts is different.

Line Chart
The most basic of the four charts is the line chart because it represents only the closing prices
over a set period of time. The line is formed by connecting the closing prices over the time
frame. Line charts do not provide visual information of the trading range for the individual points
such as the high, low and opening prices. However, the closing price is often considered to be the
most important price in stock data compared to the high and low for the day and this is why it is
the only value used in line charts.

Figure 1: A line chart

Bar Charts
The bar chart expands on the line chart by adding several more key pieces of information to each
data point. The chart is made up of a series of vertical lines that represent each data point. This
vertical line represents the high and low for the trading period, along with the closing price. The
close and open are represented on the vertical line by a horizontal dash. The opening price on a
bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely,
the close is represented by the dash on the right. Generally, if the left dash (open) is lower than
the right dash (close) then the bar will be shaded black, representing an up period for the stock,
which means it has gained value. A bar that is colored red signals that the stock has gone down
in value over that period. When this is the case, the dash on the right (close) is lower than the
dash on the left (open).

Figure 2: A bar chart

Candlestick Charts
The candlestick chart is similar to a bar chart, but it differs in the way that it is visually
constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the
period's trading range. The difference comes in the formation of a wide bar on the vertical line,
which illustrates the difference between the open and close. And, like bar charts, candlesticks
also rely heavily on the use of colors to explain what has happened during the trading period. A
major problem with the candlestick color configuration, however, is that different sites use
different standards; therefore, it is important to understand the candlestick configuration used at
the chart site you are working with. There are two color constructs for days up and one for days
that the price falls. When the price of the stock is up and closes above the opening trade, the
candlestick will usually be white or clear. If the stock has traded down for the period, then the
candlestick will usually be red or black, depending on the site. If the stock's price has closed
above the previous day’s close but below the day's open, the candlestick will be black or filled
with the color that is used to indicate an up day. (To read more, see The Art Of Candlestick
Charting - Part 1, Part 2, Part 3 and Part 4.)
 Figure 3: A candlestick chart

Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has had a long
history of use dating back to the first technical traders. This type of chart reflects price
movements and is not as concerned about time and volume in the formulation of the points. The
point and figure chart removes the noise, or insignificant price movements, in the stock, which
can distort traders' views of the price trends. These types of charts also try to neutralize
the skewing effect that time has on chart analysis. (For further reading, see Point And Figure
Charting.)

Figure 4: A point and figure chart

When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs
represent upward price trends and the Os represent downward price trends. There are also
numbers and letters in the chart; these represent months, and give investors an idea of the date.
Each box on the chart represents the price scale, which adjusts depending on the price of the
stock: the higher the stock's price the more each box represents. On most charts where the price
is between $20 and $100, a box represents $1, or 1 point for the stock. The other critical point of
a point and figure chart is the reversal criteria. This is usually set at three but it can also be set
according to the chartist's discretion. The reversal criteria set how much the price has to move
away from the high or low in the price trend to create a new trend or, in other words, how much
the price has to move in order for a column of Xs to become a column of Os, or vice versa.
When the price trend has moved from one trend to another, it shifts to the right, signaling a trend
change.

Conclusion
Charts are one of the most fundamental aspects of technical analysis. It is important that you
clearly understand what is being shown on a chart and the information that it provides. Now that
we have an idea of how charts are constructed, we can move on to the different types of chart
patterns.

Next: Technical Analysis: Chart Patterns

A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future
price movements. Chartists use these patterns to identify current trends and trend reversals and to
trigger buy and sell signals.

In the first section of this tutorial, we talked about the three assumptions of technical analysis,
the third of which was that in technical analysis, history repeats itself. The theory behind chart
patters is based on this assumption. The idea is that certain patterns are seen many times, and that
these patterns signal a certain high probability move in a stock. Based on the historic trend of a
chart pattern setting up a certain price movement, chartists look for these patterns to identify
trading opportunities.

While there are general ideas and components to every chart pattern, there is no chart pattern that
will tell you with 100% certainty where a security is headed. This creates some leeway and
debate as to what a good pattern looks like, and is a major reason why charting is often seen as
more of an art than a science. (For more insight, see Is finance an art or a science?)

There are two types of patterns within this area of technical analysis, reversal and continuation.
A reversal pattern signals that a prior trend will reverse upon completion of the pattern. A
continuation pattern, on the other hand, signals that a trend will continue once the pattern is
complete. These patterns can be found over charts of any timeframe. In this section, we will
review some of the more popular chart patterns. (To learn more, check out Continuation
Patterns - Part 1, Part 2, Part 3 and Part 4.)
Head and Shoulders 
This is one of the most popular and reliable chart patterns in technical analysis. Head and
shoulders is a reversal chart pattern that when formed, signals that the security is likely to move
against the previous trend. As you can see in Figure 1, there are two versions of the head and
shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern that is
formed at the high of an upward movement and signals that the upward trend is about to end.
Head and shoulders bottom, also known as inverse head and shoulders (shown on the right) is the
lesser known of the two, but is used to signal a reversal in a downtrend.

Figure 1: Head and shoulders top is shown on the left. Head and shoulders bottom, or
inverse head and shoulders, is on the right.

Both of these head and shoulders patterns are similar in that there are four main parts: two
shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a high
and a low. For example, in the head and shoulders top image shown on the left side in Figure 1,
the left shoulder is made up of a high followed by a low. In this pattern, the neckline is a level of
support or resistance. Remember that an upward trend is a period of successive rising highs and
rising lows. The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by
showing the deterioration in the successive movements of the highs and lows. (To learn more,
see Price Patterns - Part 2.)

Cup and Handle

A cup and handle chart is a bullish continuation pattern in which the upward trend has paused
but will continue in an upward direction once the pattern is confirmed.
 Figure 2

As you can see in Figure 2, this price pattern forms what looks like a cup, which is preceded by
an upward trend. The handle follows the cup formation and is formed by a generally
downward/sideways movement in the security's price. Once the price movement pushes above
the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging
time frame for this type of pattern, with the span ranging from several months to more than a
year.

Double Tops and Bottoms

This chart pattern is another well-known pattern that signals a trend reversal - it is considered to
be one of the most reliable and is commonly used. These patterns are formed after a sustained
trend and signal to chartists that the trend is about to reverse. The pattern is created when a price
movement tests support or resistance levels twice and is unable to break through. This pattern is
often used to signal intermediate and long-term trend reversals.

Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown
on the right.
In the case of the double top pattern in Figure 3, the price movement has twice tried to move
above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend
reverses and the price heads lower. In the case of a double bottom (shown on the right), the price
movement has tried to go lower twice, but has found support each time. After the second bounce
off of the support, the security enters a new trend and heads upward. (For more in-depth reading,
see The Memory Of Price and Price Patterns - Part 4.)

Triangles
Triangles are some of the most well-known chart patterns used in technical analysis. The three
types of triangles, which vary in construct and implication, are the symmetrical triangle,
ascending and descending triangle. These chart patterns are considered to last anywhere from a
couple of weeks to several months.

Figure 4

The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward each
other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a
trend in that direction. In an ascending triangle, the upper trendline is flat, while the bottom
trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists
look for an upside breakout. In a descending triangle, the lower trendline is flat and the upper
trendline is descending. This is generally seen as a bearish pattern where chartists look for a
downside breakout.
Flag and Pennant
These two short-term chart patterns are continuation patterns that are formed when there is a
sharp price movement followed by a generally sideways price movement. This pattern is then
completed upon another sharp price movement in the same direction as the move that started the
trend. The patterns are generally thought to last from one to three weeks.

Figure 5

As you can see in Figure 5, there is little difference between a pennant and a flag. The main
difference between these price movements can be seen in the middle section of the chart pattern.
In a pennant, the middle section is characterized by converging trendlines, much like what is
seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a
channel pattern, with no convergence between the trendlines. In both cases, the trend is expected
to continue when the price moves above the upper trendline.

Wedge
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a
symmetrical triangle except that the wedge pattern slants in an upward or downward direction,
while the symmetrical triangle generally shows a sideways movement. The other difference is
that wedges tend to form over longer periods, usually between three and six months.

Figure 6

The fact that wedges are classified as both continuation and reversal patterns can make reading
signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge
is bearish. In Figure 6, we have a falling wedge in which two trendlines are converging in a
downward direction. If the price was to rise above the upper trendline, it would form a
continuation pattern, while a move below the lower trendline would signal a reversal pattern.

Gaps
A gap in a chart is an empty space between a trading period and the following trading period.
This occurs when there is a large difference in prices between two sequential trading periods. For
example, if the trading range in one period is between $25 and $30 and the next trading period
opens at $40, there will be a large gap on the chart between these two periods. Gap price
movements can be found on bar charts and candlestick charts but will not be found on point and
figure or basic line charts. Gaps generally show that something of significance has happened in
the security, such as a better-than-expected earnings announcement.

There are three main types of gaps, breakaway, runaway (measuring) and exhaustion. A
breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend
and an exhaustion gap forms near the end of a trend. (For more insight, read Playing The Gap.)

Triple Tops and Bottoms

Triple tops and triple bottoms are another type of reversal chart pattern in chart analysis. These
are not as prevalent in charts as head and shoulders and double tops and bottoms, but they act in
a similar fashion. These two chart patterns are formed when the price movement tests a level of
support or resistance three times and is unable to break through; this signals a reversal of the
prior trend.

Figure 7

Confusion can form with triple tops and bottoms during the formation of the pattern because they
can look similar to other chart patterns. After the first two support/resistance tests are formed in
the price movement, the pattern will look like a double top or bottom, which could lead a chartist
to enter a reversal position too soon.
Rounding Bottom
A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that
signals a shift from a downward trend to an upward trend. This pattern is traditionally thought to
last anywhere from several months to several years.

Figure 8

A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle.
The long-term nature of this pattern and the lack of a confirmation trigger, such as the handle in
the cup and handle, makes it a difficult pattern to trade.

We have finished our look at some of the more popular chart patterns. You should now be able
to recognize each chart pattern as well the signal it can form for chartists. We will now move on
to other technical techniques and examine how they are used by technical traders to gauge price
movements.

Next: Technical Analysis: Moving Averages

Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to
get an idea of a security's overall trend. One simple method traders use to combat this is to apply
moving averages. A moving average is the average price of a security over a set amount of time. By
plotting a security's average price, the price movement is smoothed out. Once the day-to-day
fluctuations are removed, traders are better able to identify the true trend and increase the probability
that it will work in their favor. (To learn more, read the Moving Averages tutorial.)

Types of Moving Averages

There are a number of different types of moving averages that vary in the way they are
calculated, but how each average is interpreted remains the same. The calculations only differ in
regards to the weighting that they place on the price data, shifting from equal weighting of each
price point to more weight being placed on recent data. The three most common types of moving
averages are simple, linear and exponential.

Simple Moving Average (SMA)

This is the most common method used to calculate the moving average of prices. It simply takes
the sum of all of the past closing prices over the time period and divides the result by the number
of prices used in the calculation. For example, in a 10-day moving average, the last 10 closing
prices are added together and then divided by 10. As you can see in Figure 1, a trader is able to
make the average less responsive to changing prices by increasing the number of periods used in
the calculation. Increasing the number of time periods in the calculation is one of the best ways
to gauge the strength of the long-term trend and the likelihood that it will reverse.

Figure 1

Many individuals argue that the usefulness of this type of average is limited because each point
in the data series has the same impact on the result regardless of where it occurs in the sequence.
The critics argue that the most recent data is more important and, therefore, it should also have a
higher weighting. This type of criticism has been one of the main factors leading to the invention
of other forms of moving averages.

Linear Weighted Average

This moving average indicator is the least common out of the three and is used to address the
problem of the equal weighting. The linear weighted moving average is calculated by taking the
sum of all the closing prices over a certain time period and multiplying them by the position of
the data point and then dividing by the sum of the number of periods. For example, in a five-day
linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on
until the first day in the period range is reached. These numbers are then added together and
divided by the sum of the multipliers.

Exponential Moving Average (EMA)

This moving average calculation uses a smoothing factor to place a higher weight on recent data
points and is regarded as much more efficient than the linear weighted average. Having an
understanding of the calculation is not generally required for most traders because most charting
packages do the calculation for you. The most important thing to remember about the
exponential moving average is that it is more responsive to new information relative to the
simple moving average. This responsiveness is one of the key factors of why this is the moving
average of choice among many technical traders. As you can see in Figure 2, a 15-period EMA
rises and falls faster than a 15-period SMA. This slight difference doesn’t seem like much, but it
is an important factor to be aware of since it can affect returns.

Figure 2

Major Uses of Moving Averages

Moving averages are used to identify current trends and trend reversals as well as to set up
support and resistance levels.

Moving averages can be used to quickly identify whether a security is moving in an uptrend or a
downtrend depending on the direction of the moving average. As you can see in Figure 3, when a
moving average is heading upward and the price is above it, the security is in an uptrend.
Conversely, a downward sloping moving average with the price below can be used to signal a
downtrend.

Figure 3

Another method of determining momentum is to look at the order of a pair of moving averages.
When a short-term average is above a longer-term average, the trend is up. On the other hand, a
long-term average above a shorter-term average signals a downward movement in the trend.

Moving average trend reversals are formed in two main ways: when the price moves through a
moving average and when it moves through moving average crossovers. The first common signal
is when the price moves through an important moving average. For example, when the price of a
security that was in an uptrend falls below a 50-period moving average, like in Figure 4, it is a
sign that the uptrend may be reversing.

Figure 4

The other signal of a trend reversal is when one moving average crosses through another. For
example, as you can see in Figure 5, if the 15-day moving average crosses above the 50-day
moving average, it is a positive sign that the price will start to increase.

Figure 5

If the periods used in the calculation are relatively short, for example 15 and 35, this could signal
a short-term trend reversal. On the other hand, when two averages with relatively long time
frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.
Another major way moving averages are used is to identify support and resistance levels. It is not
uncommon to see a stock that has been falling stop its decline and reverse direction once it hits
the support of a major moving average. A move through a major moving average is often used as
a signal by technical traders that the trend is reversing. For example, if the price breaks through
the 200-day moving average in a downward direction, it is a signal that the uptrend is reversing.

Figure 6

Moving averages are a powerful tool for analyzing the trend in a security. They provide useful
support and resistance points and are very easy to use. The most common time frames that are
used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The
200-day average is thought to be a good measure of a trading year, a 100-day average of a half a
year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of
two weeks.

Moving averages help technical traders smooth out some of the noise that is found in day-to-day
price movements, giving traders a clearer view of the price trend. So far we have been focused
on price movement, through charts and averages. In the next section, we'll look at some other
techniques used to confirm price movement and patterns.

Next: Technical Analysis: Indicators And Oscillators

Indicators are calculations based on the price and the volume of a security that measure such things as
money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual
price movements and add additional information to the analysis of securities. Indicators are used in two
main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell
signals.

There are two main types of indicators: leading and lagging. A leading indicator precedes price
movements, giving them a predictive quality, while a lagging indicator is a confirmation tool
because it follows price movement. A leading indicator is thought to be the strongest during
periods of sideways or non-trending trading ranges, while the lagging indicators are still useful
during trending periods.

There are also two types of indicator constructions: those that fall in a bounded range and those
that do not. The ones that are bound within a range are called oscillators - these are the most
common type of indicators. Oscillator indicators have a range, for example between zero and
100, and signal periods where the security is overbought (near 100) or oversold (near zero). Non-
bounded indicators still form buy and sell signals along with displaying strength or weakness,
but they vary in the way they do this.

The two main ways that indicators are used to form buy and sell signals in technical analysis is
through crossovers and divergence. Crossovers are the most popular and are reflected when
either the price moves through the moving average, or when two different moving averages cross
over each other.The second way indicators are used is through divergence, which happens when
the direction of the price trend and the direction of the indicator trend are moving in the opposite
direction. This signals to indicator users that the direction of the price trend is weakening.

Indicators that are used in technical analysis provide an extremely useful source of additional
information. These indicators help identify momentum, trends, volatility and various other
aspects in a security to aid in the technical analysis of trends. It is important to note that while
some traders use a single indicator solely for buy and sell signals, they are best used in
conjunction with price movement, chart patterns and other indicators.

Accumulation/Distribution Line
The accumulation/distribution line is one of the more popular volume indicators that measures
money flows in a security. This indicator attempts to measure the ratio of buying to selling by
comparing the price movement of a period to the volume of that period.

Calculated:

Acc/Dist = ((Close - Low) - (High - Close)) / (High -

Low) * Period's Volume

This is a non-bounded indicator that simply keeps a running sum over the period of the security.
Traders look for trends in this indicator to gain insight on the amount of purchasing compared to
selling of a security. If a security has an accumulation/distribution line that is trending upward, it
is a sign that there is more buying than selling.

Average Directional Index

The average directional index (ADX) is a trend indicator that is used to measure the strength of a
current trend. The indicator is seldom used to identify the direction of the current trend, but can
identify the momentum behind trends.

The ADX is a combination of two price movement measures: the positive directional indicator
(+DI) and the negative directional indicator (-DI). The ADX measures the strength of a trend but
not the direction. The +DI measures the strength of the upward trend while the -DI measures the
strength of the downward trend. These two measures are also plotted along with the ADX line.
Measured on a scale between zero and 100, readings below 20 signal a weak trend while
readings above 40 signal a strong trend.

Aroon
The Aroon indicator is a relatively new technical indicator that was created in 1995. The Aroon
is a trending indicator used to measure whether a security is in an uptrend or downtrend and the
magnitude of that trend. The indicator is also used to predict when a new trend is beginning.

The indicator is comprised of two lines, an "Aroon up" line (blue line) and an "Aroon down" line
(red dotted line). The Aroon up line measures the amount of time it has been since the highest
price during the time period. The Aroon down line, on the other hand, measures the amount of
time since the lowest price during the time period. The number of periods that are used in the
calculation is dependent on the time frame that the user wants to analyze.

Figure 1
Aroon Oscillator
An expansion of the Aroon is the Aroon oscillator, which simply plots the difference between the
Aroon up and down lines by subtracting the two lines. This line is then plotted between a range
of -100 and 100. The centerline at zero in the oscillator is considered to be a major signal line
determining the trend. The higher the value of the oscillator from the centerline point, the more
upward strength there is in the security; the lower the oscillator's value is from the centerline, the
more downward pressure. A trend reversal is signaled when the oscillator crosses through the
centerline. For example, when the oscillator goes from positive to negative, a downward trend is
confirmed. Divergence is also used in the oscillator to predict trend reversals. A reversal warning
is formed when the oscillator and the price trend are moving in an opposite direction.

The Aroon lines and Aroon oscillators are fairly simple concepts to understand but yield
powerful information about trends. This is another great indicator to add to any technical trader's
arsenal.

Moving Average Convergence

The moving average convergence divergence (MACD) is one of the most well known and used
indicators in technical analysis. This indicator is comprised of two exponential moving averages,
which help to measure momentum in the security. The MACD is simply the difference between
these two moving averages plotted against a centerline. The centerline is the point at which the
two moving averages are equal. Along with the MACD and the centerline, an exponential
moving average of the MACD itself is plotted on the chart. The idea behind this momentum
indicator is to measure short-term momentum compared to longer term momentum to help signal
the current direction of momentum.

MACD= shorter term moving average - longer

term moving average

When the MACD is positive, it signals that the shorter term moving average is above the longer
term moving average and suggests upward momentum. The opposite holds true when the MACD
is negative - this signals that the shorter term is below the longer and suggest downward
momentum. When the MACD line crosses over the centerline, it signals a crossing in the moving
averages. The most common moving average values used in the calculation are the 26-day and
12-day exponential moving averages. The signal line is commonly created by using a nine-day
exponential moving average of the MACD values. These values can be adjusted to meet the
needs of the technician and the security. For more volatile securities, shorter term averages are
used while less volatile securities should have longer averages.

Another aspect to the MACD indicator that is often found on charts is the MACD histogram. The
histogram is plotted on the centerline and represented by bars. Each bar is the difference between
the MACD and the signal line or, in most cases, the nine-day exponential moving average. The
higher the bars are in either direction, the more momentum behind the direction in which the bars
point. (For more on this, see Moving Average Convergence Divergence - Part 1 and Part 2, and
Trading The MACD Divergence.)

As you can see in Figure 2, one of the most common buy signals is generated when the MACD
crosses above the signal line (blue dotted line), while sell signals often occur when the MACD
crosses below the signal.
 Figure 2

Relative Strength Index

The relative strength index (RSI) is another one of the most used and well-known momentum
indicators in technical analysis. RSI helps to signal overbought and oversold conditions in a
security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to
suggest that a security is overbought, while a reading below 30 is used to suggest that it is
oversold. This indicator helps traders to identify whether a security’s price has been
unreasonably pushed to current levels and whether a reversal may be on the way.

Figure 3

The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet
the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more
volatile and will be used for shorter term trades. (To read more, see Momentum And The Relative
Strength Index, Relative Strength Index And Its Failure-Swing Points and Getting To Know
Oscillators - Part 1 and Part 2.)

On-Balance Volume
The on-balance volume (OBV) indicator is a well-known technical indicator that reflect
movements in volume. It is also one of the simplest volume indicators to compute and
understand.

The OBV is calculated by taking the total volume for the trading period and assigning it a
positive or negative value depending on whether the price is up or down during the trading
period. When price is up during the trading period, the volume is assigned a positive value, while
a negative value is assigned when the price is down for the period. The positive or negative
volume total for the period is then added to a total that is accumulated from the start of the
measure.

It is important to focus on the trend in the OBV - this is more important than the actual value of
the OBV measure. This measure expands on the basic volume measure by combining volume
and price movement. (For more insight, see Introduction To On-Balance Volume.)

Stochastic Oscillator
The stochastic oscillator is one of the most recognized momentum indicators used in technical
analysis. The idea behind this indicator is that in an uptrend, the price should be closing near the
highs of the trading range, signaling upward momentum in the security. In downtrends, the price
should be closing near the lows of the trading range, signaling downward momentum.

The stochastic oscillator is plotted within a range of zero and 100 and signals overbought
conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two
lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of
momentum behind the oscillator. The second line is the %D, which is simply a moving average
of the %K. The %D line is considered to be the more important of the two lines as it is seen to
produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its
calculation but can be adjusted to meet the needs of the user. (To read more, check out Getting
To Know Oscillators - Part 3.)
 Figure 4

Next: Technical Analysis: Conclusion

This introductory section of the technical analysis tutorial has provided a broad overview of
technical analysis.

Here's a brief summary of what we've covered:

 Technical analysis is a method of evaluating securities by analyzing the statistics

generated by market activity. It is based on three assumptions: 1) the market discounts
everything, 2) price moves in trends and 3) history tends to repeat itself.
 Technicians believe that all the information they need about a stock can be found in its
charts.
 Technical traders take a short-term approach to analyzing the market.
 Criticism of technical analysis stems from the efficient market hypothesis, which states
that the market price is always the correct one, making any historical analysis useless.
 One of the most important concepts in technical analysis is that of a trend, which is the
general direction that a security is headed. There are three types of trends: uptrends,
downtrends and sideways/horizontal trends.
 A trendline is a simple charting technique that adds a line to a chart to represent the trend
in the market or a stock.
 A channel, or channel lines, is the addition of two parallel trendlines that act as strong
areas of support and resistance.
 Support is the price level through which a stock or market seldom falls. Resistance is the
price level that a stock or market seldom surpasses.
 Volume is the number of shares or contracts that trade over a given period of time,
usually a day. The higher the volume, the more active the security.
 A chart is a graphical representation of a series of prices over a set time frame.
 The time scale refers to the range of dates at the bottom of the chart, which can vary from
decades to seconds. The most frequently used time scales are intraday, daily, weekly,
monthly, quarterly and annually.
 The price scale is on the right-hand side of the chart. It shows a stock's current price and
compares it to past data points. It can be either linear or logarithmic.
 There are four main types of charts used by investors and traders: line charts, bar charts,
candlestick charts and point and figure charts.
 A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a
sign of future price movements. There are two types: reversal and continuation.
 A head and shoulders pattern is reversal pattern that signals a security is likely to move
against its previous trend.
 A cup and handle pattern is a bullish continuation pattern in which the upward trend has
paused but will continue in an upward direction once the pattern is confirmed.
 Double tops and double bottoms are formed after a sustained trend and signal to chartists
that the trend is about to reverse. The pattern is created when a price movement tests
support or resistance levels twice and is unable to break through.
 A triangle is a technical analysis pattern created by drawing trendlines along a price range
that gets narrower over time because of lower tops and higher bottoms. Variations of a
triangle include ascending and descending triangles.
 Flags and pennants are short-term continuation patterns that are formed when there is a
sharp price movement followed by a sideways price movement.
 The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a
symmetrical triangle except that the wedge pattern slants in an upward or downward
direction.
 A gap in a chart is an empty space between a trading period and the following trading
period. This occurs when there is a large difference in prices between two sequential
trading periods.
 Triple tops and triple bottoms are reversal patterns that are formed when the price
movement tests a level of support or resistance three times and is unable to break
through, signaling a trend reversal.

 A rounding bottom (or saucer bottom) is a long-term reversal pattern that signals a shift
from a downward trend to an upward trend.
 A moving average is the average price of a security over a set amount of time. There are
three types: simple, linear and exponential.
 Moving averages help technical traders smooth out some of the noise that is found in
day-to-day price movements, giving traders a clearer view of the price trend.
 Indicators are calculations based on the price and the volume of a security that measure
such things as money flow, trends, volatility and momentum. There are two types:
leading and lagging.
 The accumulation/distribution line is a volume indicator that attempts to measure the
ratio of buying to selling of a security.
 The average directional index (ADX) is a trend indicator that is used to measure the
strength of a current trend.
  The Aroon indicator is a trending indicator used to measure whether a security is in an
uptrend or downtrend and the magnitude of that trend.
 The Aroon oscillator plots the difference between the Aroon up and down lines by
subtracting the two lines.
 The moving average convergence divergence (MACD) is comprised of two exponential
moving averages, which help to measure a security's momentum.
 The relative strength index (RSI) helps to signal overbought and oversold conditions in a
security.
 The on-balance volume (OBV) indicator is one of the most well-known technical
indicators that reflects movements in volume.
 The stochastic oscillator compares a security's closing price to its price range over a given
time period.

Sharpening Your Trading Skills: Using Bollinger Bands

By Jim Wyckoff
Of Kitco News www.kitco.com

The Bollinger Bands (B-Bands) technical study was created by John Bollinger, the president of
Bollinger Capital Management Inc., based in Manhattan Beach, California. Bollinger is well
respected in the futures and equities industries.

Traders generally use B-Bands to determine overbought and oversold zones, to confirm
divergences between prices and other technical indicators, and to project price targets. The wider
the B-bands on a chart, the greater the market volatility; the narrower the bands, the less market
volatility.

B-Bands are lines plotted on a chart at an interval around a moving average. They consist of a
moving average and two standard deviations charted as one line above and one line below the
moving average. The line above is two standard deviations added to the moving average. The
line below is two standard deviations subtracted from the moving average.

Some traders use B-Bands in conjunction with another indicator, such as the Relative Strength
Index (RSI). If the market price touches the upper B-band and the RSI does not confirm the
upward move (i.e. there is divergence between the indicators), a sell signal is generated. If the
indicator confirms the upward move, no sell signal is generated, and in fact, a buy signal may be
indicated.

If the price touches the lower B-band and the RSI does not confirm the downward move, a buy
signal is generated. If the indicator confirms the downward move, no buy signal is generated, and
in fact, a sell signal may be indicated.

Another strategy uses the Bollinger Bands without another indicator. In this approach, a chart top
occurring above the upper band followed by a top below the upper band generates a sell signal.
Likewise, a chart bottom occurring below the lower band followed by a bottom above the lower
band generates a buy signal.

B-Bands also help determine overbought and oversold markets. When prices move closer to the
upper band, the market is becoming overbought, and as the prices move closer to the lower band,
the market is becoming oversold.

Importantly, the market’s price momentum should also be taken into account. When a market
enters an overbought or oversold area, it may become even more so before it reverses. You
should always look for evidence of price weakening or strengthening before anticipating a
market reversal.

Bollinger Bands can be applied to any type of chart, although this indicator works best with daily
and weekly charts. When applied to a weekly chart, the Bands carry more significance for long-
term market changes. John Bollinger says periods of less than 10 days do not work well for B-
Bands. He says that the optimal period is 20 or 21 days.

Like most computer-generated technical indicators, I use B-Bands as mostly an indicator of

overbought and oversold conditions, or for divergence--but not as a specific generator of buy and
sell signals for my trading opportunities. It's just one more "secondary" trading tool, as opposed
to my "primary" trading tools that include chart patterns and trend lines and fundamental
analysis.

Sharpening Your Trading Skills: The MACD Indicator

By Jim Wyckoff
Of Kitco News www.kitco.com

The Moving Average Convergence Divergence (MACD) indicator has the past few years
become one of the more popular computer-generated technical indicators.

The MACD, developed by Gerald Appel, is both a trend follower and a market momentum
indicator (an oscillator). The MACD is the difference between a fast exponential moving average
and a slow exponential moving average. An exponential moving average is a weighted moving
average that usually assigns a greater weight to more recent price action.

The name “Moving Average Convergence Divergence” originated from the fact that the fast
exponential moving average is continually converging toward or diverging away from the slow
exponential moving average. A third, dotted exponential moving average of the MACD (the
"trigger" or the signal line) is then plotted on top of the MACD.

Parameters:

Mov1: The time period for the first exponential moving average. The default value is usually 12,
referring to 12 bars of whatever timeframe plotted on the chart. (This is the fast moving average.)
Mov2: The time period for the subtracted exponential moving average. The default value is
usually 26, referring to 26 bars. (This is the slow moving average.)

Trigger: The period of 9 bars for the signal line representing an additional exponential moving
average.

(Note: For a graphic example of the MACD indicator, send me an email at [email protected]
and I will email you back with the picture example.)

The MACD study can be interpreted like any other trend-following analysis: One line crossing
another indicates either a buy or sell signal. When the MACD crosses above the signal line, an
uptrend may be starting, suggesting a buy. Conversely, the crossing below the signal line may
indicate a downtrend and a sell signal. The crossover signals are more reliable when applied to
weekly charts, though this indicator may be applied to daily charts for short-term trading.

The MACD can signal overbought and oversold trends, if analyzed as an oscillator that
fluctuates above and below a zero line. The market is oversold (buy signal) when both lines are
below zero, and it is overbought (sell signal) when the two lines are above the zero line.

The MACD can also help identify divergences between the indicator and price activity, which
may signal trend reversals or trend losing momentum. A bearish divergence occurs when the
MACD is making new lows while prices fail to reach new lows. This can be an early signal of a
downtrend losing momentum. A bullish divergence occurs when the MACD is making new
highs while prices fail to reach new highs. Both of these signals are most serious when they
occur at relatively overbought/oversold levels. Weekly charts are more reliable than daily for
divergence analysis with the MACD indicator.

For more details on the MACD, Appel has a book in print, entitled: "The Moving Average
Convergence-Divergence Trading Method."

As with most other computer-generated technical indicators, the MACD is a "secondary"

indicator in my trading toolbox. It is not as important as my "primary" technical indicators, such
as trend lines, chart gaps, chart patterns and fundamental analysis. I use the MACD to help me
confirm signals that my primary indicators may be sending.

Sharpening Your Trading Skills: Moving Averages

By Jim Wyckoff
Of Kitco News www.kitco.com

I take a “toolbox” approach to analyzing and trading markets. The more technical and analytical
tools I have in my trading toolbox at my disposal, the better my chances for success in trading.
One of my favorite "secondary" trading tools is moving averages. First, let me give you an
explanation of moving averages, and then I’ll tell you how I use them.
Moving averages are one of the most commonly used technical tools. In a simple moving
average, the mathematical median of the underlying price is calculated over an observation
period. Prices (usually closing prices) over this period are added and then divided by the total
number of time periods. Every day of the observation period is given the same weighting in
simple moving averages. Some moving averages give greater weight to more recent prices in the
observation period. These are called exponential or weighted moving averages. In this
educational feature, I’ll only discuss simple moving averages.

The length of time (the number of bars) calculated in a moving average is very important.
Moving averages with shorter time periods normally fluctuate and are likely to give more trading
signals. Slower moving averages use longer time periods and display a smoother moving
average. The slower averages, however, may be too slow to enable you to establish a long or
short position effectively.

Moving averages follow the trend while smoothing the price movement. The simple moving
average is most commonly combined with other simple moving averages to indicate buy and sell
signals. Some traders use three moving averages. Their lengths typically consist of short,
intermediate, and long-term moving averages. A commonly used system in futures trading is 4-,
9-, and 18-period moving averages. Keep in mind a time interval may be ticks, minutes, days,
weeks, or even months. Typically, moving averages are used in the shorter time periods, and not
on the longer-term weekly and monthly bar charts.

The normal moving average “crossover” buy/sell signals are as follows: A buy signal is
produced when the shorter-term average crosses from below to above the longer-term average.
Conversely, a sell signal is issued when the shorter-term average crosses from above to below
the longer-term average.

Another trading approach is to use closing prices with the moving averages. When the closing
price is above the moving average, maintain a long position. If the closing price falls below the
moving average, liquidate any long position and establish a short position.

Here is the important caveat about using moving averages when trading futures markets: They do
not work well in choppy or non-trending markets. You can develop a severe case of whiplash
using moving averages in choppy, sideways markets. Conversely, in trending markets, moving
averages can work very well.

In futures markets, my favorite moving averages are the 9- and 18-day. I have also used the 4-,
9- and 18-day moving averages on occasion.

When looking at a daily bar chart, you can plot different moving averages (provided you have
the proper charting software) and immediately see if they have worked well at providing buy and
sell signals during the past few months of price history on the chart.

I said I like the 9-day and 18-day moving averages for futures markets. For individual stocks, I
have used (and other successful veterans have told me they use) the 100-day moving average to
determine if a stock is bullish or bearish. If the stock is above the 100-day moving average, it is
bullish. If the stock is below the 100-day moving average, it is bearish. I also use the 100-day
moving average to gauge the health of stock index futures markets.

One more bit of sage advice: A veteran market watcher told me the “commodity funds” (the big
trading funds that many times seem to dominate futures market trading) follow the 40-day
moving average very closely--especially in the grain futures. Thus, if you see a market that is
getting ready to cross above or below the 40-day moving average, it just may be that the funds
could become more active.

I said earlier that simple moving averages are a "secondary" tool in my trading toolbox. My
primary (most important) tools are basic chart patterns, trend lines and fundamental analysis.

Sharpening Your Trading Skills: The Relative Strength Index (RSI)

By Jim Wyckoff
Of Kitco News www.kitco.com

One of the more popular computer-generated technical indicators is the Relative Strength Index
(RSI) oscillator. (An oscillator, defined in market terms, is a technical study that attempts to
measure market price momentum—such as a market being overbought or oversold.)

I’ll define and briefly discuss the RSI, and then I’ll tell you how I use it in my market analysis
and trading decisions.

The Relative Strength Index (RSI ) is a J. Welles Wilder, Jr. trading tool. The main purpose of
the study is to measure the market's strength or weakness. A high RSI, above 70, suggests an
overbought or weakening bull market. Conversely, a low RSI, below 30, implies an oversold
market or dying bear market. While you can use the RSI as an overbought and oversold
indicator, it works best when a failure swing occurs between the RSI and market prices. For
example, the market makes new highs after a bull market setback, but the RSI fails to exceed its
previous highs.

Another use of the RSI is divergence. Market prices continue to move higher/lower while the
RSI fails to move higher/lower during the same time period. Divergence may occur in a few
trading intervals, but true divergence usually requires a lengthy time frame, perhaps as much as
20 to 60 trading intervals.

Selling when the RSI is above 70 or buying when the RSI is below 30 can be an expensive
trading system. A move to those levels is a signal that market conditions are ripe for a market top
or bottom. But it does not, in itself, indicate a top or a bottom. A failure swing or divergence
accompanies the best trading signals.

The RSI exhibits chart formations as well. Common bar chart formations readily appear on the
RSI study. They are trendlines, head and shoulders, and double tops and bottoms. In addition, the
study can highlight support and resistance zones.
How I employ the RSI

As you just read above, some traders use these oscillators to generate buy and sell signals in
markets-—and even as an overall trading system. However, I treat the RSI as just one trading
tool in my trading toolbox. I use it in certain situations, but only as a “secondary” tool. I tend to
use most computer-generated technical indicators as secondary tools when I am analyzing a
market or considering a trade. My “primary” trading tools include chart patterns, fundamental
analysis and trend lines.

Oscillators tend not to work well in markets that are in a strong trend. They can show a market at
either an overbought or oversold reading, while the market continues to trend strongly. Another
example of oscillators not working well is when a market trades into the upper boundary of a
congestion area on the chart and then breaks out on the upside of the congestion area. At that
point, it’s likely that an oscillator such as the RSI would show the market as being overbought
and possibly generate a sell signal—when in fact, the market is just beginning to show its real
upside power.

I do look at oscillators when a market has been in a decent trend for a period of time, but not an
overly strong trend. I can pretty much tell by looking at a bar chart if a market is “extended”
(overbought or oversold), but will employ the RSI to confirm my thinking. I also like to look at
the oscillators when a market has been in a longer-term downtrend. If the readings are extreme-
—say a reading of 10 or below on the RSI-—that is a good signal the market is well oversold
and could be due for at least an upside correction. However, I still would not use an oscillator,
under this circumstance, to enter a long-side trade in straight futures, as that would be trying to
bottom-pick.

Oscillators are not perfect and are certainly not the “Holy Grail” that some traders continually
seek. However, the RSI is a useful tool to employ under certain market conditions.