This guide is written to help you with only one type of analysis, and that is the use and interpretation of charts. No system, technical or otherwise is infallible, but reading charts and seeing trends and formations can often put you on the road to profit.
As any investor knows, the study of the stock market in action is a very complex subject. We can simplify matters a bit by stating a truth about the market: prices move in trends. These trends can be portrayed graphically on a chart. There are also formations which can be seen on these charts. What follows are several of the ways investors use stock charts.
You will find explanations and illustrations of formations and technical indicators like support levels, resistance levels, channels, head & shoulders, cup & handle, and Fibonacci Retracement.
Sometimes a chart looks like the price is rising as if there was a floor beneath them. Usually this indicates that many people in the market firmly believe that the stock is intrinsically “worth it” based perhaps on a previous low, or on the company’s book value.
In the chart below, R continues to trade above trendline support. Each successful test of the trendline demonstrates that the long-term upward trend is intact. A break below trendline support would be a sign of weakness and potentially signal a trend reversal.
In the chart below, the 39-week moving average has provided dependable support for UNP, with numerous successful tests since July ‘09. The stock continues to rally after pullbacks to the moving average, whereas a break below it could suggest a trend reversal.
Resistance Level’s are ceilings, which are just like floors – but in reverse. The price of a certain stock may come up to, but will not exceed the resistance level. This level may be arbitrary , or it may have been set by the collective calculations of many investors on the basis of P/E ratio or previous highs.
In the chart below, FMC appears to be trading below trendline resistance originating in Feb ‘09 and currently at $70. Another failure to break above the trendline would suggest another pullback or more sideways action, whereas a break above the trendline would be a bullish event.
If a stock’s price fluctuates around a common line, a channel formation exists. A channel is defined by drawing one line connecting all the recent tops and another connecting all recent bottoms, usually in a diagonal pattern. Characteristically, a stock will continue to fluctuate within the channel lines. There are up and down channels, as well as channels inside a longer channel. Technical theory says that if the stock’s price breaks out of the channel, it will continue in the direction of the breakout, rather than continuing to fluctuate.
In the chart below, BHI appears to be trading within an upward-sloping trading channel. Additionally, the 39-week moving average also appears to be providing support and resistance within the channel, dictating bounces back to the channel top (July, Sept, Dec ‘09) or breaks to channel bottom (May ‘10). The July ’10 break above 39-week moving average suggests a move to the channel top at $60 (and rising.)
In the chart below, AMGN appears to be trading within two trading channels: a long-term ascending channel and a shorter-term descending channel. It tested and held at both long-term and short-term channel bottom support at $49 and appears aimed for a test of its shorter-term channel top resistance at $60. A break above $60 clears the way for a move to $70, while a failed test suggests a pullback, possibly to form the right shoulder of an inverse head & shoulders similar to 12 months ago. Additionally, AMGN’s relative performance line is showing strength compared to the general market, as its recent low in price did not produce a low in the performance line – a bullish divergence.
Head and Shoulders
Perhaps one of the most famous of the technical indicators – the head and shoulders pattern – is said to indicate a sharp price decline, a bearish pattern. Presumably, one can notice the pattern early enough to allow selling during the right shoulder rally if one has missed the head top. Obviously, the pattern is easiest to detect in hindsight.
In the chart below, AA appears to have formed a bearish head & shoulders top pattern with a break below neckline support at $12.50 in May. The pattern has a downside objective of $7. A break back above the neckline (now acting as resistance) would negate the pattern before reaching its objective, whereas failure to break above the neckline would further support the formation of the pattern.
Cup and Handle
A cup-and-handle pattern resembles the shape of a tea cup on a chart. This is a bullish pattern where the upward trend has paused, and traded down, but will continue in an upward direction upon the completion of the pattern. This pattern can range from several months to a year, but its general form remains the same.
In the chart below, DOW provides an example of a bullish cup & handle pattern that fully formed and played out. It broke above neckline resistance at $19 (July ‘09), reached its actual pattern objective of $32, and tested it twice before pulling back (Jan ’10, April ‘10).
Fibonacci retracement is based on the key numbers identified by mathematician Leonardo Fibonacci in the 13th century. However, Fibonacci’s sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series. In technical analysis, Fibonacci retracement is created by taking two extreme points (a peak and low point) on a stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels.
In the chart below, DOW went from a Mar ‘09 low of 6 to an April ’10 high of 32, a move of 26. It then pulled back to 22 in July ‘10, a move of 10. 10/26 = 38.4% retracement. Key Fibonacci retracements are 38.2%, 50% and 61.8%. Stocks will often pull back to a Fibonacci retracement level just before resuming their current trend.
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