Technical analysis employs three approaches for identifying changes in market moods over time: trend, signal and resistance analysis. Trend analysis assumes that past market behavior can be extrapolated into the future and that the trends of the past will repeat or persist in the future. Signal analysis may supplement trend analysis by assisting analysts to identify when the market will break out of a trend that it has followed in the recent past by identifying price-movement patterns. Resistance analysis is similar to signal analysis, except that it views the break points in terms of price price limits beyond which the market is unlikely to move.
Numerous types of trends can be identified in market price data including trends including increasing and decreasing price trends as well as range-bound or oscillating trends. As a general rule equity instruments tend to trend upwards over time, because of the preference of boards to retain earnings and grow the business rather paying out all the the surpluses or profits produced to equity holders. Businesses that are continuously making losses will deplete their reserves and their instruments will tend to fall in value over the long term. Shorter term trends may indicate a shift in market expectations from one level of earnings to another of from a change in the level of confidence and a trend analysis may seek to identify this trend as something distinct from the overall trend caused by the fundamental performance of the business.
There is a vital piece of information that is revealed when confirming support or resistance. It is the notion of a trend. An uptrend is a situation in which we experience rising prices in the form of new highs and shallow pullbacks. Similarly, a downtrend has lower peaks and prices continue to make new lows. If the price oscillates without any clear direction, it is said to be range-bound or in consolidation. Decreasing ranges between highs are lows are considered triangle patterns.
- uptrend / downtrend / oscillating / triangle examples -
The chart below is a plot of the price movement of the Apple Inc which made very good stride during March 2009 to May 2011. Strong uptrend can be seen from the movement. The stock price moved from 100 to 350 in about 2 years period.
Range-bound / Oscillating
The chart below is a plot of the price movement of the Reliance Industries (India) which stayed very much in a range during March 2009 to February 2011. This stock remained in the range of 900 to 1200 during this period.
At certain junctures, prices seem to accelerate either up or down and go for long stretches without a pause. This is considered an impulse, and often lead to incredible gains or drops in price. These impulses cannot continue indefinitely, and at some point must pause or reverse direction. During these periods, it lacks clear direction and is considered in a consolidation sequence. Even though it seems that prices should continue forever, these pauses are in fact quite healthy. They serve a vital role in forecasting price targets once the trend continues or reverses.
- chart delineating impulse vs. consolidation -
Much in the way that stars are strung together in different ways across the sky to create constellations, price spikes are examined to 'paint a picture' of a known configuration. Some of the most common patterns are channels and triangles. In both of these cases, a minimum of four points are required - two spike highs and two spike lows. The lines which connect the extremes are extended to the right (where no price history exists), so we have some notion of where prices should be at some time in the future. In some cases, the lines are almost horizontal, which implies a trading range. Parallel lines which slant up or down indicate a trend direction within a channel. If lines converge, it is considered a triangle, and there are special cases for each of the various slant directions - symmetrical, flat-topped or flat-bottomed, ascending or descending triangles, and rising or falling wedges.
- kiwi examples of theoretical stock movements -
If prices break above or below the bounds of either channels or triangles, then it can be said that one set of market participants have overwhelmed the other side. Traders call these breakouts and breakdowns. These breakouts or breakdowns are confirmed if there is more than usual volumes on that day. (Since at times due to some sporadic trades also give out small spikes on the charts.) These are particularly relevant if accompanied by an increase in volume. In essence, it gives credibility to the market direction and signifies that prices are ready to change their behavior. If prices are heading up, we say the price action is bullish. Tumbling lower is classified as bearish. In either case, the market is tipping its hat in a particular direction as investors, traders, and financial institutions pile onto the winning side. This behavior is the reason that trading desks chant 'the trend is your friend', in other words, don't get in the way of a mob rushing in either direction - join the winning side and trade in the direction of the trend.
- examples of triangle breakouts / breakdowns / volume (+ bull vs. bear) -
These patterns can be classified in two types.
There are continuation patterns which suggest that the stock will continue to do what it was doing earlier ie if it was moving up it would continue to move up. Various continuation patterns are
- Flag / pennant
I can usually identify Trendlines, Channels and at times triangle. While I am more comfortable with trendlines.
There are reversal patterns which suggest that the stock will now do the reverse of what it was doing earlier. If the stock price was moving moving up it would now move down.
When stock is in up trend:
- Double / Multiple top
- Head and shoulder
When the stock is in down trend:
- Double /Multiple bottom
- Inverted head and shoulder
There are patterns identified on candlestick charts which analyze the market forces getting balanced and can indicate start of reversal. There is good amount of information on wikipedia:candlestick pattern.
Support and Resistance
What most often stands out are price extremes, both high and low. At those junctures, one set of market participants will succeed in driving the prices in the other direction. It is often the inflection point at which expectations change on the underlying asset. These levels present the technicians with the first level of information - support and resistance. In the simplest terms, support is a price level at which a asset experiences buying and downward motion is halted, whereas resistance is a level at which one would expect profit taking and selling pressure, halting upward momentum. These prices can be determined by a number of factors, but most often produce a price extreme visible on the chart.
- insert charts with ring high / low here -
Some of the most powerful pieces of trading information are revealed when a price spike is retested. This is a bold statement, since it implies that tops and bottoms aren't ever really formed in isolation, but instead an attempt is made to revisit a previous price level. Market technicians make careful observations of how traders behave around previous support and/or resistance levels. If the price fails to break below a previous spike low, we can say that the support level has been confirmed. The same principal applies to resistance if rising prices fail to penetrate above a previous spike high.
- charts with retest / support / resistance here -
The final step is to put all this information together and examine how the patterns interact with one another, to determine the price structure and context. If there is a clear impulse leading into a channel or triangle, we can start talking about pennants, bull flags and bear flags. This is considered good market structure, since participants need to pause for a bit before resuming an impulse. The amount of price movement leading into the consolidation can be considered a target to reach once there is a breakout (in case of rising prices) or breakdown (declines before pausing). This is known as a measured move and is probably the most common target known to traders. If a stock appreciates +5 before forming a triangle, when it breaks above the upper bounds a technical analyst will call for a price target +5 higher from the breakout point.
- examples of good market structure / price targets -
So when can a technician determine that markets are in a bubble scenario? When it exhibits poor market structure, most often in the form of prices that seem to defy gravity and logarithmic scale, with little or no pauses for consolidation. A true one-sided exhibition of delusional behavior that this trend will continue forever. Psychologically, this is complete lack of fear and greed at its best without any consideration of reasonable expectations. In the end, for each seller there must be a buyer, and once the final marginal buyer is in, there is nothing left to buoy prices. A technical trader will look for the first correction after the meteoric rise to get out; after a pullback the rebound cannot reach the lofty price experienced at the peak, the first lower-high. Prices collapse in the sheer panic that ensues as behavior shifts to fear of losing.
- examples of poor market structure / air lifts -