Overview
What is Technical Analysis?Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.
More Articles for New Chartists:Why Analyze Securities? - This article examines the three types of market analysts, what they believe about financial markets and why. It will help you understand the big picture when it comes to deciding the "best" way to invest.
Technical Analysis - This article explains what Technical Analysis is, how it works, and the general steps one should take when using technical charts and indicators to analyze stocks. It concludes with a look at the strengths and weaknesses of using charts to make investment decisions.
Fundamental Analysis - This article describes Fundamental Analysis and explains the general steps that a fundamental analyst takes when evaluating a stock. It also looks at the strengths and weaknesses of fundamental analysis.
[*]Random Walk Theory - Describes the Random Walk Theory of financial markets which is at odds with both Technical Analysis and Fundamental Analysis.
Why Analyze Securities?
Security Analysis - Does it Matter?Wall Street has scores of analysts, strategists and portfolio managers hired to do one thing: beat the market. Analysts are hired to find undervalued stocks. Strategists are hired to predict the direction of the market and various sectors. Portfolio managers are hired to put it all together and outperform their benchmark, usually measured as the S&P 500. Granted, there are many studies and disputes raging on the performance of equity mutual funds, but it is safe to assume that about 75% of equity mutual funds underperform the S&P 500. With these kinds of stats, individual investors would surely be better off simply investing in an index fund rather than attempting to beat the market wouldn't they?
The added value of analysis is in the eye of the beholder. A fundamental analyst believes that analyzing strategy, management, product, financial statistics and many other readily and not-so-readily quantifiable numbers will help choose stocks that will outperform the market. They are also likely to believe that there is little or no value in analyzing past prices and that technical analysts would be better off stargazing. (Humph!) The technical analyst believes that the chart, volume, momentum and an array of mathematical indicators hold the keys to superior performance. Technicians are just as likely to believe that fundamental data is hogwash pure and simple. And then there are the Random Walkers who believe that any attempt to try and outwit the market is futile.
So whom do we believe? Is fundamental analysis worth the time and effort? Are technicians a bunch of quacks? Or is it all a lesson in random futility? Let's start to clarify things by looking at the efficient market hypothesis and see where the fundamentalists, technicians and random walkers stand on the question of market efficiency. After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis and technical analysis.
Are Markets Efficient?The question concerning the value of analysis begins with the debate on market efficiency. Just what is represented by the current price of a security? Is a security's current price an accurate reflection of its fair value? Or, do anomalies exist that allow traders and investors the opportunity to beat the market by finding undervalued or overvalued securities?
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Aswath Damara, of the Stern Business School at New York University, defines an efficient market as one in which the market price is an unbiased estimate of the true value of the investment. Fair enough, but it is not quite that simple. In an efficient market, the current price of a security fully reflects all available information and is the fair value. "All" because the price is the sum value of all views (bullish, bearish or otherwise) held by market participants. It is the fair value because the market agreed on a price to buy and sell the security. As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling). In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random. Over the long run, the price should accurately reflect fair value.
The hypothesis further asserts that if markets are efficient, then it should be virtually impossible to outperform the market on a sustained basis. Even though deviations will occur and there will be periods when securities are overvalued or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them.
From experience, most of us would agree that the market is not perfectly efficient. Anomalies do exist and there are investors and traders that outperform the market. Therefore, there are varying degrees of market efficiency, which have been broken down into three levels. These three levels also happen to correspond to the beliefs of the fundamentalists, technicians and random walkers.
Strong-form: TechniciansThe strong-form of market efficiency theorizes that the current price reflects all information available. It does not matter if this information is available to the public or privy to top management; if it exists at all, it is reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are strong-form efficient and all information is reflected in the price.
Semi-Strong Form: Random WalkersThe semi-strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements and other relevant information that can be readily gathered. However, there is other information not readily available to the public that is not fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers or regulators, among others. Anomalies exist when information is withheld from the public and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously, so it is virtually impossible to profit from such news. The Random Walk theory is an example of the semi-strong form of market efficiency.
Weak-form: FundamentalistsThe weak-form of market efficiency theorizes that the current price does not reflect fair value and is only a reflection of past prices. Furthermore, the future price cannot be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of weak-form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value, and these models will help identify anomalies.
Which Form Exists in the Market Today?Many in academia, including Gordon Gemmill of the University of Warwick and Aswath Damara of NYU, believe that security prices are semi-strong efficient. Recall that semi-strong efficient implies that all public knowledge is reflected in the price and it is virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price. Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster with the Internet, and surprises are factored in instantly. Few will argue that a surprise, both positive and negative, can violently move the price of a security. A few examples include:
After Prue-announcing that earnings would come in below expectations on 6-Jan-00, Lucent fell from 59 to 43 in one day.
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After positive comments from an influential analyst on 23-Feb-00, Time Warner shot up 49 to 59 in 2 days.
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[*]After reporting earnings that were below expectations on 15-Feb, Ascribe and Fitch fell from 24 to 15.
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Even though these are but a few examples, it is obvious that new information can move the price of a security in non-random ways.
Technical Analysis
What is Technical Analysis?Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.
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Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low, or close for a given security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.
The Basis of Technical AnalysisAt the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:
Price Discounts Everything
Price Movements Are Not Totally Random
[*]What Is More Important than Why
Price Discounts EverythingThis theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
Prices Movements are not Totally RandomMost technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:
"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."
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A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
"What" is More Important than "Why"In his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, "A technical analyst knows the price of everything, but the value of nothing". Technicians, as technical analysts are called, are only concerned with two things:
What is the current price?
[*]What is the history of the price movement?
The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
General Steps to Technical EvaluationMany technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve three steps:
Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
Sector analysis to identify the strongest and weakest groups within the broader market.
[*]Individual stock analysis to identify the strongest and weakest stocks within select groups.
The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2 years. It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart. While this may sound easy, technical analysis is by no means easy. Success requires serious study, dedication and an open mind.
Chart AnalysisTechnical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.
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Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.
Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Strength of the current trend.
Maturity or stage of current trend.
Reward to risk ratio of a new position.
[*]Potential entry levels for new long position.
Top-Down Technical AnalysisFor each segment (market, sector and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong.
Strengths of Technical AnalysisAdvertisement
Focus on PriceIf the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, Demand, and Price ActionMany technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.
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The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
Support/ResistanceSimple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Pictorial Price HistoryEven if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:
Reactions prior to and after important events.
Past and present volatility.
Historical volume or trading levels.
[*]Relative strength of a stock versus the overall market.
Assist with Entry PointTechnical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
Weaknesses of Technical Analysis
Analyst BiasJust as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt.
Open to InterpretationFurthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, somewhat like economics. Is the cup half-empty or half-full? It is in the eye of the beholder.
Too LateTechnical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.
Always Another LevelEven after a new trend has been identified, there is always another "important" level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.
Trader's RemorseNot all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.
ConclusionsTechnical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
Fundamental Analysis
What is Fundamental Analysis?Advertisement
Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.
General Steps to Fundamental EvaluationEven though there is no one clear-cut method, a breakdown is presented below in the order an investor might proceed. This method employs a top-down approach that starts with the overall economy and then works down from industry groups to specific companies. As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. For example, a telecom operator (Verizon) would be compared to another telecom operator (SBC Corp), not to an oil company (ChevronTexaco).
Economic ForecastFirst and foremost in a top-down approach would be an overall evaluation of the general economy. The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market as well. Below is a chart of the S&P 500 and the yield on the 10-year note over the last 30 years. Although not exact, a correlation between stock prices and interest rates can be seen. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups.
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Group SelectionIf the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities and energy-related stocks.
To assess a industry group's potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock! The chart below shows that relative performance of 5 sectors over a 7-month time frame. As the chart illustrates, being in the right sector can make all the difference.
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Narrow Within the GroupOnce the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group. The first task is to identify the current business and competitive environment within a group as well as the future trends. How do the companies rank according to market share, product position and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it.
Company AnalysisWith a shortlist of companies, an investor might analyze the resources and capabilities within each company to identify those companies that are capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management and sound financials.
Business PlanThe business plan, model or concept forms the bedrock upon which all else is built. If the plan, model or concepts stink, there is little hope for the business. For a new business, the questions may be these: Does its business make sense? Is it feasible? Is there a market? Can a profit be made? For an established business, the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership?
ManagementIn order to execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management (AMD in semiconductors). Alternatively, even strong management can make for extraordinary success in a mature industry (Alcoa in aluminum). Some of the questions to ask might include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best to move on.
Financial AnalysisThe final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. Below is a list of potential inputs into a financial analysis.
Accounts Payable
Accounts Receivable
Acid Ratio
Amortization
Assets - Current
Assets - Fixed
Book Value
Brand
Business Cycle
Business Idea
Business Model
Business Plan
Capital Expenses
Cash Flow
Cash on hand
Current Ratio
Customer Relationships
Days Payable
Days Receivable
Debt
Debt Structure
Debt:Equity Ratio
Depreciation
Derivatives-Hedging
Discounted Cash Flow
Dividend
Dividend Cover
Earnings
EBITDA
Economic Growth
Equity
Equity Risk Premium
Expenses Good Will
Gross Profit Margin
Growth
Industry
Interest Cover
International
Investment
Liabilities - Current
Liabilities - Long-term
Management
Market Growth
Market Share
Net Profit Margin
Pageview Growth
Pageviews
Patents
Price/Book Value
Price/Earnings
PEG
Price/Sales
Product
Product Placement
Regulations
R & D
Revenues
Sector
Stock Options
Strategy
Subscriber Growth
Subscribers
Supplier Relationships
Taxes
Trademarks
Weighted Average Cost of Capital
The list can seem quite long and intimidating. However, after a while, an investor will learn what works best and develop a set of preferred analysis techniques. There are many different valuation metrics and much depends on the industry and stage of the economic cycle. A complete financial model can be built to forecast future revenues, expenses and profits or an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.
Ratio
Price/Book Value
Price/Earnings
Price/Earnings/Growth
Price/Sales
Price/Subscribers
Price/Lines
Price/Page views
Price/Promises Company Type
Oil
Retail
Networking
B2B
ISP or cable company
Telecom
Web site Biotech
This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value.
Putting it All TogetherAfter all is said and done, an investor will be left with a handful of companies that stand out from the pack. Over the course of the analysis process, an understanding will develop of which companies stand out as potential leaders and innovators. In addition, other companies would be considered laggards and unpredictable. The final step of the fundamental analysis process is to synthesize all data, analysis and understanding into actual picks.
Strengths of Fundamental Analysis
Long-term TrendsFundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.
Value SpottingSound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.
Business AcumenOne of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).
Knowing Who's WhoStocks move as a group. By understanding a company's business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations.
Weaknesses of Fundamental Analysis
Time ConstraintsFundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.
Industry/Company SpecificValuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.
SubjectivityFair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, a best-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. The chart below shows how stubbornly bullish many fundamental analysts can be.
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Analyst BiasThe majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, "there are lies, damn lies, and statistics." When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.
Definition of Fair ValueWhen market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions?
It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.
ConclusionsFundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don't happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.
Random Walk TheoryA Random Walk Down Wall Street, written by Burton Malkiel in 1973, has become a classic in investment literature. Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis. Malkiel puts both technical analysis and fundamental analysis to the test and reasons that both are largely a waste of time. In fact, he goes to great lengths to show that there is no proof to suggest that either can consistently outperform the market. Any success outperforming the market with technical analysis or fundamental analysis can be attributed to lady luck. If enough people try, some are bound to outperform the market, but most are still likely to underperform.
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The basic random walk premise is that price movements are totally random. Judging from the chart, the price movements of Newmont Mining (NEM)http://stockcharts.com/images/minilink_sc.gif over this 5-month period would appear to be quite random. Prices have no memory, therefore past and present prices cannot be used to predict future prices (as implied in technical analysis). Prices move at random and adjust to new information as it comes available. The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying to predict these (fundamental analysis) is also a lesson in futility.
Malkiel maintains that a buy and hold strategy is best and individuals should not attempt to time (or beat) the market. Attempts based on technical, fundamental or any other analysis are futile. Admittedly, he does have a point. Statistics have shown that the majority of equity mutual funds fail to outperform the market, as measured by the S&P 500. Investors can easily buy index-based securities with very low transactions costs.
Should Random Walkers Take a Hike?While there are some good points to be gleaned from the random walk theory, it appears to be a bit dated and does not accurately reflect the current investment climate.
Random walk theory was introduced over 25 years ago when institutions dominated the market. These institutions had superior access to resources and the individual was at the mercy of the large brokerage houses for quality research. With the advent of online trading, power and influence are shifting from institutions to the individual. Resources are now widely available to all at minimal cost, if not free. Not only can individuals access information, but the Internet ensures that everyone will receive it almost instantaneously. They also have access to real time data and can trade like the pros. With the availability of real time data and almost instant executions, individuals can act on information like never before.
As little as 5 years ago, transactions costs were high and figured into any investment or trading strategy. Again, with the advent of online trading, transactions costs have become minimal. This has increased the amount of trading volume and probably volatility. Higher volatility increases the possibility that anomalies will develop. With better trading resources and low commissions, more traders and investors than ever are able to capitalize on potential anomalies.
For obvious reasons, the Wall Street establishment is not thrilled about random walk theory. After all, Wall Street is in the business of analysis, strategy and money management. However, it is a fact that about 75% of equity mutual funds underperform the S&P 500 year after year. Some of this underperformance can be blamed on transaction costs and management fees. However, with the advent of index-linked securities, the onus will be on the money managers to figure out a way to outperform the market, or lose business.
In truth, 75% of equity mutual funds underperforming is not as bad as it sounds. When the Random Walk theory was introduced in 1973, or even 15 years ago, around 90% of equity mutual funds underperformed the market. Since this number seems to have risen, it would appear that either stock picking is getting better or fees are getting smaller, or both. 15 years ago, the stock market and mutual funds were much more homogeneous. Even though there were tech stocks, they did not exert nearly as much influence. With the explosion of the NASDAQ, tech stocks play a much larger role in today's market. Internet stocks, which have also come to the forefront, did not even exist 15 years ago. With an increase in specialty mutual funds catering to tech and Internet, the total number of mutual funds has proliferated over the last few years. With the increase in mutual funds has also come and increase in the diversity of such funds. There are funds for almost every sector, industry or index imaginable and investors have a wide array of choices. The more homogeneous mutual funds there are, the less chance there is to outperform. However, this specialization has created a hierarchy among mutual funds and helped to increase the percentage funds that outperform the S&P 500 from 10% to 25%.
History has proved that a buy and hold strategy outperforms most attempts to time the market in absolute returns. In risk-adjusted returns, the argument loses some of its credibility. Buy and hold may take the guesswork out of beating the market, but it does little to compensate for the risk associated with a continuous investment in the market. There is a direct correlation with risk and return: the higher the expected return, the higher the associated risk. A portfolio with a timing strategy that seeks to move into risk-free treasuries when a bear market is signaled (Dow Theory for example), significantly reduces the amount of risk associated with that portfolio.
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The New York Times on 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University, William Goetzmann of Yale, and Alok Kumar of the University of Notre Dame. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of outperformance would even be greater. Over the past 18 years, the Dow theory system has underperformed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market.
A Non-Random Walk Down Wall StreetThere is another school of thought that considers the markets efficient yet predictable. One of the leading proponents is Andrew Lo. Lo earned his Ph.D in economics at the University of Chicago and is currently a Professor of Finance at the Sloan School of Management at MIT. Lo is a bit of an odd ball among academics because of his beliefs regarding the efficient market hypothesis and his attraction to technical analysis. Lo and Mackinlay's book A Non-Random Walk Down Wall Street debunks many of the theories put forth in the 1973 classic with a similar name. (Remember that most academics subscribe to the random walk theory.) Lo's research concluded the following:
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Financial markets are predictable to some degree, but far from being a symptom of inefficiency or irrationality, predictability is the oil that lubricates the gears of capitalism.
It is not only plausible that markets are efficient, but participants can also profit from efficient markets. However, Lo asserts that even though it is possible to outperform the markets, it requires ongoing research, continuous improvement and constant innovation. Beating the market does not come easy, nor is it something that is easy to maintain. Lo likens the pursuit of above-average returns to that of a company trying to maintain its competitive advantage. After introducing a hot new product, a company cannot just sit back and wait for the money to roll in. In order to remain above the competition, management must be flexible and look for ways to continuously improve and innovate. Otherwise the competition will overtake them. Money managers, traders and investors who find ways to outperform the market must also remain flexible and innovative. Just because a method works today, does not mean it will work tomorrow. In an interview with Technical Analysis of Stocks and Commodities, Lo sums it up by stating:
"The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas."
ConclusionsThese rebuttals to random walk theory are not meant to suggest that the vast majority of individuals are going to suddenly start outperforming the market. Even though this may be true over the past 3 years, history suggests that it is not likely to be the case 10 years from now. In other words, history suggests that this is an anomaly and there will be a reversion to the mean. Nonetheless, the investment and trading landscape has changed drastically over the last 20 years, even over the last 5 years. Individuals have access to more information and tools, transactions costs are negligible, trades are executed almost instantaneously, equity mutual funds have improved their performance and the buy-and-hold strategy does not appear to be a profit maximizing strategy. It should come as no surprise that analysis can make a difference. The only question is which type: fundamental analysis, technical analysis or both?
What Are Charts?A price chart is a sequence of prices plotted over a specific time frame. In statistical terms, charts are referred to as time series plots.
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On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis with the most recent plot being the furthest right. The price plot for IBM extends from January 1, 1999 to March 13, 2000.
Technicians, technical analysts and chartists use charts to analyze a wide array of securities and forecast future price movements. The word "securities" refers to any tradable financial instrument or quantifiable index such as stocks, bonds, commodities, futures or market indices. Any security with price data over a period of time can be used to form a chart for analysis.
While technical analysts use charts almost exclusively, the use of charts is not limited to just technical analysis. Because charts provide an easy-to-read graphical representation of a security's price movement over a specific period of time, they can also be of great benefit to fundamental analysts. A graphical historical record makes it easy to spot the effect of key events on a security's price, its performance over a period of time and whether it's trading near its highs, near its lows, or in between.
How to Pick a Time FrameThe time frame used for forming a chart depends on the compression of the data: intraday, daily, weekly, monthly, quarterly or annual data. The less compressed the data is, the more detail is displayed.
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Daily data is made up of intraday data that has been compressed to show each day as a single data point, or period. Weekly data is made up of daily data that has been compressed to show each week as a single data point. The difference in detail can be seen with the daily and weekly chart comparison above. 100 data points (or periods) on the daily chart is equal to the last 5 months of the weekly chart, which is shown by the data marked in the rectangle. The more the data is compressed, the longer the time frame possible for displaying the data. If the chart can display 100 data points, a weekly chart will hold 100 weeks (almost 2 years). A daily chart that displays 100 days would represent about 5 months. There are about 20 trading days in a month and about 252 trading days in a year. The choice of data compression and time frame depends on the data available and your trading or investing style.
Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the time frame and the less compressed the data is, the more detail that is available. While long on detail, short-term charts can be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can affect volatility, which can distort the overall picture.
Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts (typically 1-4 years) cover a longer time frame with compressed data, price movements do not appear as extreme and there is often less noise.
[*]Others might use a combination of long-term and short-term charts. Long-term charts are good for analyzing the large picture to get a broad perspective of the historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months.
How Are Charts Formed?We will be explaining the construction of line, bar, candlestick and point & figure charts. Although there are other methods available, these are 4 of the most popular methods for displaying price data.
Line Charthttp://stockcharts.com/school/data/media/chart_school/overview/images/charts-3sunw-c.png
Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored. Line charts are also used when open, high and low data points are not available. Sometimes only closing data are available for certain indices, thinly traded stocks and intraday prices.
Bar ChartPerhaps the most popular charting method is the bar chart. The high, low and close are required to form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar. On a daily chart, each bar represents the high, low and close for a particular day. Weekly charts would have a bar for each week based on Friday's close and the high and low for that week.
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Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar. Whether or not a bar chart includes the open depends on the data available.
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Bar charts can be effective for displaying a large amount of data. Using candlesticks, 200 data points can take up a lot of room and look cluttered. Line charts show less clutter, but do not offer as much detail (no high-low range). The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars before the chart gets cluttered. If you are not interested in the opening price, bar charts are an ideal method for analyzing the close relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker. If you are interested in the opening price, candlestick charts probably offer a better alternative.
Candlestick ChartOriginating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.
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Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and the close. White (clear) candlesticks form when the close is higher than the open and black (solid) candlesticks form when the close is lower than the open. The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low.
Point & Figure ChartThe charting methods shown above, all, plot one data point for each period of time. No matter how much price movement, each day or week represented is one point, bar, or candlestick along the time scale. Even if the price is unchanged from day to day or week to week, a dot, bar, or candlestick is plotted to mark the price action. Contrary to this methodology, point & figure Charts are based solely on price movement, and do not take time into consideration. There is an x-axis but it does not extend evenly across the chart.
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The beauty of point & figure charts is their simplicity. Little or no price movement is deemed irrelevant and therefore not duplicated on the chart. Only price movements that exceed specified levels are recorded. This focus on price movement makes it easier to identify support and resistance levels, bullish breakouts and bearish breakdowns. This P&F article has a more detailed explanation of point & figure charts.
Price ScalingThere are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points (or dollars) as the same vertical distance no matter what the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 80 over a 6-month period, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80. Even though this move is the same in absolute terms, it is not the same in percentage terms.
A logarithmic scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale. Most charting programs refer to the logarithmic scale as a semi-log scale, because the time axis is still displayed arithmetically.
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The chart above uses the 4th-Quarter performance of VeriSign to illustrate the difference in scaling. On the semi-log scale, the distance between 50 and 100 is the same as the distance between 100 and 200. However, on the arithmetic scale, the distance between 100 and 200 is significantly greater than the distance between 50 and 100.
Key points on the benefits of arithmetic and semi-log scales:
Arithmetic scales are useful when the price range is confined within a relatively tight range.
Arithmetic scales are useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar.
Semi-log scales are useful when the price has moved significantly, be it over a short or extended time frame
Trend lines tend to match lows better on semi-log scales.
Semi-log scales are useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective.
[*]Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book. With this in mind, it also makes sense to analyze price movements in percentage terms.
ConclusionsEven though many different charting techniques are available, one method is not necessarily better than the other. The data may be the same, but each method will provide its own unique interpretation, with its own benefits and drawbacks. A breakout on the point & figure chart may not occur in unison with a breakout in a candlestick chart. Signals that are available on candlestick charts may not appear on bar charts. How the security's price is displayed, be it a bar chart or candlestick chart, with an arithmetic scale or semi-log scale, is not the most important aspect. After all, the data is the same and price action is price action. When all is said and done, it is the analysis of the price action that separates successful technicians from not-so-successful technicians. The choice of which charting method to use will depend on personal preferences and trading or investing styles. Once you have chosen a particular charting methodology, it is probably best to stick with it and learn how best to read the signals. Switching back and forth may cause confusion and undermine the focus of your analysis. Faulty analysis is rarely caused by the chart. Before blaming your charting method for missing a signal, first look at your analysis.
The keys to successful chart analysis are dedication, focus, and consistency:
Dedication: Learn the basics of chart analysis, apply your knowledge on a regular basis, and continue your development.
Focus: Limit the number of charts, indicators and methods you use. Learn how to use them, and learn how to use them well.
[*]Consistency: Maintain your charts on a regular basis and study them often (daily if possible).
Support and ResistanceSupport and resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. These terms are used interchangeably throughout this and other articles. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control.
What Is Support?Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.
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Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.
Where Is Support Established?Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. Technical analysis is not an exact science and it is sometimes difficult to set exact support levels. In addition, price movements can be volatile and dip below support briefly. Sometimes it does not seem logical to consider a support level broken if the price closes 1/8 below the established support level. For this reason, some traders and investors establish support zones.
What Is Resistance?Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.
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Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.
Where Is Resistance Established?Resistance levels are usually above the current price, but it is not uncommon for a security to trade at or near resistance. In addition, price movements can be volatile and rise above resistance briefly. Sometimes it does not seem logical to consider a resistance level broken if the price closes 1/8 above the established resistance level. For this reason, some traders and investors establish resistance zones.
Methods to Establish Support and Resistance?Support and resistance are like mirror images and have many common characteristics.
Highs and LowsSupport can be established with the previous reaction lows. Resistance can be established by using the previous reaction highs.
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The above chart for Halliburton (HAL)http://stockcharts.com/images/minilink_sc.gif shows a large trading range between Dec-99 and Mar-00. Support was established with the October low around 33. In December, the stock returned to support in the mid-thirties and formed a low around 34. Finally, in February the stock again returned to the support scene and formed a low around 33 1/2.
After each bounce off support, the stock traded all the way up to resistance. Resistance was first established by the September support break at 42.5. After a support level is broken, it can turn into a resistance level. From the October lows, the stock advanced to the new support-turned-resistance level around 42.5. When the stock failed to advance past 42.5, the resistance level was confirmed. The stock subsequently traded up to 42.5 two more times after that and failed to surpass resistance both times.
Support Equals ResistanceAnother principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.
The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.
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In this example of the NASDAQ 100 Index ($NDX)http://stockcharts.com/images/minilink_sc.gif, the stock broke resistance at 935 in May-97 and traded just above this resistance level for over a month. The ability to remain above resistance established 935 as a new support level. The stock subsequently rose to 1150, but then fell back to test support at 935. After the second test of support at 935, this level is well established.
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From the PeopleSoft (PSFT)http://stockcharts.com/images/minilink_sc.gif example, we can see that support can turn into resistance and then back into support. PeopleSoft found support at 18 from Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as the bears overpowered the bulls. When the stock rebounded (red oval), there was still overhead supply at 18 and resistance was met from Jun-99 to Oct-99.
Where does this overhead supply come from? Demand was obviously increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore, there were a lot of buyers in the stock around 18. When the price declined past 18 and to around 14, many of these buyers were probably still holding the stock. This left a supply overhang (commonly known as resistance) around 18. When the stock rebounded to 18, many of the green-oval-buyers (who bought around 18) probably took the opportunity to sell. When this supply was exhausted, the demand was able to overpower supply and advance above resistance at 18.
Trading RangeTrading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).
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After an extended advance from 27 to 64, WorldCom (WCOM)http://stockcharts.com/images/minilink_sc.gif entered into a trading range between 55 and 63 for about 5 months. There was a false breakout in mid-June when the stock briefly poked its head above 62 (red oval). This did not last long and a gap down a few days later nullified the breakout (black arrow). The stock then proceeded to break support at 55 in Aug-99 and trade as low as 50. Here is another example of support turned resistance as the stock bounced off 55 two more times before heading lower. While this does not always happen, a return to the new resistance level offers a second chance for longs to get out and shorts to enter the fray.
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In Nov/Dec-99, Lucent Technologies (LU)http://stockcharts.com/images/minilink_sc.gif formed a trading range that resembled a head and shoulders pattern (red oval). When the stock broke support at 60, there was little or no time to exit. Even though the there is a long black candlestick indicating an open at 59, the stock fell so fast that it was impossible to exit above 44. In hindsight, the support line could have been drawn as an upward sloping neckline (blue line), and the support break would have come at 61. This is only 1 point higher and a trader would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline, and it is something to consider when drawing support lines.
After Lucent declined, a trading range was established between 40.5 and 47.5 for almost two months (green oval). The resistance level of the trading range was well marked by three reaction peaks at 47.5. The support level was not as clearly marked, but appeared to be between 40 and 41. Some buying interest began to become evident around 44 in mid- to late-February. Notice the array of candlesticks with long lower shadows, or hammers, as they are known. The stock then proceeded to form two up gaps on 24-Feb and 25-Feb, and finally closed above resistance at 48. This was a clear indication of demand winning out over supply. There were still two more opportunities (days) to get in on the action. On the third day after the breakout, the stock gapped up and moved above 56.
Support and Resistance ZonesBecause technical analysis is not an exact science, it is useful to create support and resistance zones. This is contrary to the strategy mapped out for Lucent Technologies (LU), but it is sometimes the case. Each security has its own characteristics, and analysis should reflect the intricacies of the security. Sometimes, exact support and resistance levels are best, and, sometimes, zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are best suited. If a trading range spans many months and the price range is relatively large, then it is best to use support and resistance zones. These are only meant as general guidelines, and each trading range should be judged on its own merits.
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Returning to the analysis of Halliburton (HAL)http://stockcharts.com/images/minilink_sc.gif, we can see that the November high of the trading range (33 to 44) extended more than 20% past the low, making the range quite large relative to the price. Because the September support break forms our first resistance level, we are ready to set up a resistance zone after the November high is formed, probably around early December. At this point though, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming, and we are ready to set the support zone. As long as the stock trades within the boundaries set by the support and resistance zone, we will consider the trading range to be valid. Support may be looked upon as an opportunity to buy, and resistance as an opportunity to sell.
ConclusionIdentification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.
Trend LinesTechnical analysis is built on the assumption that prices trend. Trend Lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well. It is important that you understand all of the concepts presented in our Support and Resistance article before you continue.
Definitionhttp://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-1emc.png
Uptrend LineAn uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-2amzn.png
Downtrend LineA downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be imminent.
For a detailed explanation of trend changes, which are different than just trend line breaks, please see our article on the Dow Theory.
Scale SettingsHigh points and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 to $20 is a 100% gain, and would appear to be a much larger than a move from $100 to $110, which is only a 10% gain.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-3emc.png
In the case of EMChttp://stockcharts.com/images/minilink_sc.gif, there was a large price change over a long period of time. While there were not any false breaks below the uptrend line on the arithmetic scale, the rate of ascent appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trend line fits all the way up. On the arithmetic scale, three different trend lines were required to keep pace with the advance.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-4amzn.png
In the case of Amazon.com (AMZN)http://stockcharts.com/images/minilink_sc.gif, there were two false breaks above the downtrend line as the stock declined during 2000 and 2001. These false break outs could have led to premature buying as the stock continued to decline after each one. The stock lost 60% of its value three times over a two year period. The semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.
ValidationIt takes two or more points to draw a trend line The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-5msft.png
The chart of Microsoft (MSFT)http://stockcharts.com/images/minilink_sc.gif shows an uptrend line that has been touched 4 times. After the third touch in Nov-99, the trend line was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the soundness of the support level is enhanced even more. As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and that a change in trend could be imminent.
Spacing of PointsThe lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart, or too close together. The most suitable distance apart will depend on the time frame, the degree of price movement, and personal preferences. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line is made up of relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-6wmt.png
On the Wal-Mart (WMT)http://stockcharts.com/images/minilink_sc.gif example, the second high point appears to be too close to the first high point for a valid trend line; however, it would be feasible to draw a trend line beginning at point 2 and extending down to the February reaction high.
AnglesAs the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established it will often prove difficult.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-7yhoo.png
The trend line for Yahoo! (YHOO)http://stockcharts.com/images/minilink_sc.gif was touched four times over a 5-month period. The spacing between the points appears OK, but the steepness of the trend line is unsustainable, and the price is more likely than not to drop below the trend line. However, trying to time this drop or make a play after the trend line is broken is a difficult task. The amount of data displayed and the size of the chart can also affect the angle of a trend line. Short and wide charts are less likely to have steep trend lines than long and narrow charts. Keep that in mind when assessing the validity and sustainability of a trend line.
Internal Trend LinesSometimes there appears to be the possibility for drawing a trend line, but the exact points do not match up cleanly. The highs or lows might be out of whack, the angle might be too steep or the points might be too close together. If one or two points could be ignored, then a fitted trend line could be formed. With the volatility present in the market, prices can over-react, and produce spikes that distort the highs and lows. One method for dealing with over-reactions is to draw internal trend lines. Even though an internal trend line ignores price spikes, the ignoring should be within reason.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-8spx.png
The long-term trend line for the S&P 500 ($SPX)http://stockcharts.com/images/minilink_sc.gif extends up from the end of 1994, and passes through low points in Jul-96, Sept-98 and Oct-98. These lows were formed with selling climaxes, and represented extreme price movements that protrude beneath the trend line. By drawing the trend line through the lows, the line appears to be at a reasonable angle, and the other lows match up extremely well.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-9ko.png
Sometimes, there is a price cluster with a high or low spike sticking out. A price cluster is an area where prices are grouped within a tight range over a period of time. The price cluster can be used to draw the trend line, and the spike can be ignored. The Coca Cola (KO)http://stockcharts.com/images/minilink_sc.gif chart shows an internal trend line that is formed by ignoring price spikes and using the price clusters, instead. In October and November 1998, Coke formed a peak, with the November peak just higher than the October peak (1). If the November peak had been used to draw a trend line, then the slope would have been more negative, and there would have appeared to be a breakout in Dec-98 (gray line). However, this would have only been a two-point trend line, because the May-June highs are too close together (black arrows). Once the Dec-99 peak formed (green arrow), it would have been possible to draw an internal trend line based on the price clusters around the Oct/Nov-98 and the Dec-99 peaks (blue line). This trend line is based on three solid touches, and it accurately forecasts resistance in Jan-00 (blue arrow).
ConclusionTrend lines can offer great insight, but if used improperly, they can also produce false signals. Other items - such as horizontal support and resistance levels or peak-and-trough analysis - should be employed to validate trend line breaks. While trend lines have become a very popular aspect of technical analysis, they are merely one tool for establishing, analyzing, and confirming a trend. Trend lines should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/trend_lines/trendlines-10vrsn.png
The uptrend line for VeriSign (VRSN)http://stockcharts.com/images/minilink_sc.gif was touched 4 times, and seemed to be a valid support level. Even though the trend line was broken in Jan-00, the previous reaction low held, and did not confirm the trend line break. In addition, the stock recorded a new higher high prior to the trend line break.
Introduction to Chart PatternsAdvertisement
There are hundreds of thousands of market participants buying and selling securities for a wide variety of reasons: hope of gain, fear of loss, tax consequences, short-covering, hedging, stop-loss triggers, price target triggers, fundamental analysis, technical analysis, broker recommendations and a few dozen more. Trying to figure out why participants are buying and selling can be a daunting process. Chart Patterns put all buying and selling into perspective by consolidating the forces of supply and demand into a concise picture. As a complete pictorial record of all trading, chart patterns provide a framework to analyze the battle raging between bulls and bears. More importantly, chart patterns and technical analysis can help determine who is winning the battle, allowing traders and investors to position themselves accordingly.
In many waves, Chart patterns are simply more complex versions of trend lines. It is important that you read and understand our articles on Support and Resistance as well as Trend Lines before you continue.
Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly or monthly and the patterns can be as short as one day or as long as many years. Gaps and outside reversals may form in one trading session, while broadening tops and dormant bottoms may require many months to form.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/introduction_to_chart_patterns/patterns-1amzn.png
Amazon (AMZN)http://stockcharts.com/images/minilink_sc.gif
http://stockcharts.com/school/data/media/chart_school/chart_analysis/introduction_to_chart_patterns/patterns-2cien.png
CIENA (CIEN)http://stockcharts.com/images/minilink_sc.gif
An Oldie but GoodieMuch of our understanding of chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, Technical Analysis and Stock Market Profits, laid the foundations for modern pattern analysis. In Technical Analysis of Stock Trends (1948), Edwards and Magee credit Schabacker for most of the concepts put forth in the first part of their book. We would also like to acknowledge Messrs. Schabacker, Edwards and Magee, and John Murphy as the driving forces behind these articles and our understanding of chart patterns.
Pattern analysis may seem straightforward, but it is by no means an easy task. Schabacker states:
The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula.
Even though Schabacker refers to "the science of chart reading", technical analysis can at times be less science and more art. In addition, pattern recognition can be open to interpretation, which can be subject to personal biases. To defend against biases and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions drawn. While many patterns may seem similar in nature, no two patterns are exactly alike. False breakouts, bogus reads and exceptions to the rule are all part of the ongoing education.
Careful and constant study are required for successful chart analysis. On the AMZN chart above, the stock broke resistance from a head and shoulders reversal. While the trend is now bearish, analysis must continue to confirm the bearish trend.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/introduction_to_chart_patterns/patterns-3nvls.png
Novellus (NVLS)http://stockcharts.com/images/minilink_sc.gif
Some analysts might have labeled the NVLS chart as a head and shoulders patterns with neckline support around 17.50. Whether or not this is robust remains open to debate. Even though the stock broke neckline support at 17.50, it repeatedly moved back above its support break. This refusal might have been taken as a sign of strength and justify a reassessment of the pattern.
Two Dominant GroupsTwo basic tenets of technical analysis are that prices trend and that history repeats itself. An uptrend indicates that the forces of demand (bulls) are in control and a downtrend that the forces of supply (bears) are in control. However, prices do not trend forever and as the balance of power shifts, a chart pattern begins to emerge. Certain patterns, such as a parallel channel, denote a strong trend. However, the vast majority of chart patterns fall into two main groups: reversal and continuation. Reversal patterns indicate a change of trend and can be broken down into top and bottom formations. Continuation patterns indicate a pause in trend and indicate that the previous direction will resume after a period of time.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/introduction_to_chart_patterns/patterns-4msft.png
Microsoft (MSFT)http://stockcharts.com/images/minilink_sc.gif
Just because a pattern forms after a significant advance or decline does not mean it is a reversal pattern. Many patterns, such as a rectangle, can be classified as either reversal or continuation. Much depends on the previous price action, volume and other indicators as the pattern evolves. This is where the science of technical analysis becomes the art of technical analysis.
For detailed explanations of specific chart patterns, see the Chart Analysis page in the Chart School.
Double Top (Reversal)The double top is a major reversal pattern that forms after an extended uptrend. As its name implies, the pattern is made up of two consecutive peaks that are roughly equal, with a moderate trough in-between.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/double_top_reversal/doubletop-g.png
Although there can be variations, the classic double top marks at least an intermediate change, if not long-term change, in trend from bullish to bearish. Many potential double tops can form along the way up, but until key support is broken, a reversal cannot be confirmed. To help clarify, we will look at the key points in the formation and then walk through an example.
Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double top, a significant uptrend of several months should be in place.
First Peak: The first peak should mark the highest point of the current trend. As such, the first peak is fairly normal and the uptrend is not in jeopardy (or in question) at this time.
Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%. Volume on the decline from the first peak is usually inconsequential. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand.
Second Peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected. Even after meeting resistance, only the possibility of a double top exists. The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. Usually a peak within 3% of the previous high is adequate.
Decline from Peak: The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the forces of demand are weaker than supply and a support test is imminent.
Support Break: Even after trading down to support, the double top and trend reversal are still not complete. Breaking support from the lowest point between the peaks completes the double top. This too should occur with an increase in volume and/or an accelerated descent.
Support Turned Resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short.
[*]Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would infer that the bigger the formation is, the larger the potential decline.
While the double top formation may seem straightforward, technicians should take proper steps to avoid deceptive double tops. The peaks should be separated by about a month. If the peaks are too close, they could just represent normal resistance rather than a lasting change in the supply/demand picture. Ensure that the low between the peaks declines at least 10%. Declines less than 10% may not be indicative of a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. If the trough drags on a bit and has trouble moving back up, demand could be drying up. When the security does advance, look for a contraction in volume as a further indication of weakening demand.
Perhaps the most important aspect of a double top is to avoid jumping the gun. Wait for support to be broken in a convincing manner, and usually with an expansion of volume. A price or time filter can be applied to differentiate between valid and false support breaks. A price filter might require a 3% support break before validation. A time filter might require the support break to hold for 3 days before considering it valid. The trend is in force until proven otherwise. This applies to the double top as well. Until support is broken in a convincing manner, the trend remains up.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/double_top_reversal/doubletop-f.png
The double top in Ford took about 5 months to form. Even after the support break, there was another test of newfound resistance almost 4 months later.
From a low near 10 in Mar-97, Ford advanced to 36 by Dec-98. The trend line extending up from Mar-97 is an internal trend line and Ford held above it until the break in May-99.
From the first peak, the stock declined around 15% to form the trough.
After reaching a low near 30 1/2 in early February, the trough formed over the next 2 months, and there wasn't a rally until early April. This long-drawn-out low suggested tepid demand.
The decline from 36.80 occurred with two gaps down and increased volume. Furthermore, Chaikin Money Flow promptly moved below -10%. The speed with which money flows deteriorated indicated a serious increase in selling pressure.
In late May and early June, the stock traded for about 3 weeks at support from the previous low. During this time, money flows declined below -20%. Even though the situation looked ominous, the double formation would not be complete until support was broken.
[*]Support was broken in early June when the stock fell below 28 1/2, which was more than 3% below support at 30 1/2. After this sharp drop, there was an equally sharp advance back above the newfound resistance level. While a test of broken support can be expected, it is usually not quite this early. The advance to 32 in late June may have triggered some unpleasant short covering for those who jumped in on the first support break. The stock fell to 25, and then began the retracement advance that would ultimately test support.
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On the second chart, 30 3/4 marked the support turned resistance level, and 31 marked a 50% retracement of the decline from 36.80 to 25. Combined with the price action in early June and early July, a resistance zone could probably be established between 31 and 32. The stock subsequently formed a lower high at 30 in Jan-00, and declined to around 22 by mid-March.
Double Bottom (Reversal)The double bottom is a major reversal pattern that forms after an extended downtrend. As its name implies, the pattern is made up of two consecutive troughs that are roughly equal, with a moderate peak in-between.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/double_bottom_reversal/doublebot-utx.png
Although there can be variations, the classic double bottom usually marks an intermediate or long-term change in trend. Many potential double bottoms can form along the way down, but until key resistance is broken, a reversal cannot be confirmed. To help clarify, we will look at the key points in the formation and then walk through an example.
Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double bottom, a significant downtrend of several months should be in place.
First Trough: The first trough should mark the lowest point of the current trend. As such, the first trough is fairly normal in appearance and the downtrend remains firmly in place.
Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. Volume on the advance from the first trough is usually inconsequential, but an increase could signal early accumulation. The high of the peak is sometimes rounded or drawn out a bit from the hesitation to go back down. This hesitation indicates that demand is increasing, but still not strong enough for a breakout.
Second Trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid.
Advance from Trough: Volume is more important for the double bottom than the double top. There should clear evidence that volume and buying pressure are accelerating during the advance off of the second trough. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment.
Resistance Break: Even after trading up to resistance, the double top and trend reversal are still not complete. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/or an accelerated ascent.
Resistance Turned Support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long.
[*]Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate a target. This would imply that the bigger the formation is, the larger the potential advance.
It is important to remember that the double bottom is an intermediate to long-term reversal pattern that will not form in a few days. Even though formation in a few weeks is possible, it is preferable to have at least 4 weeks between lows. Bottoms usually take longer than tops to form and patience can often be a virtue. Give the pattern time to develop and look for the proper clues. The advance off of the first trough should be 10-20%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Volume indicators such as Chaikin Money Flow, OBV and Accumulation/Distribution can be used to look for signs of buying pressure. Just as with the double top, it is paramount to wait for the resistance breakout. The formation is not complete until the previous reaction high is taken out.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/double_bottom_reversal/doublebot-pfe.png
After trending lower for almost a year, PFE formed a double bottom and broke resistance with an expansion in volume.
From a high near 50 in April-99, PFE declined to 30 in November-99, which was a new 52-week low.
The stock advanced over 20% off of its low and formed a reaction high around 37 1/2. Volume expanded and the 13-Jan advance (green arrow) occurred on the highest volume since 5-Nov.
After a short pullback, there was another attempt to break above resistance, but this failed. Even so, volume on advancing days was generally higher than on declining days. The ability of the stock to remain in the mid-thirties for an extended period of time indicated some strengthening in demand.
The decline from 37 1/2 back to 30 was sharp, but downside volume did not expand materially. There were two days when volume on a decline exceeded the 60-day SMA and Chaikin Money Flow dipped near -10% twice. However, money flows indicated accumulation throughout the decline by remaining mostly above zero with periodic movements above +10%.
The second trough formed with a low exactly equal to the previous low (30) and a little over 2 months separated the lows.
The advance off of the second low witnessed an accelerated move with an expansion of volume. After the second low at 30, 5 of the next 6 advancing days saw volume well above the 60-day SMA. Chaikin Money Flow, which never really weakened, moved above +20% within 6 days of the low.
[*]Resistance at 37 1/2 was broken with a gap up on the open and another volume expansion. After running from 30 to 40 in a few weeks, the stock pulled back to the resistance break at 37 1/2, which now turned into support. There was a brief chance to get in on the pullback and the stock quickly advanced past 45.
Head and Shoulders Top (Reversal)A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/head_and_shoulders_top_reversal/hs-basicflat-cnet.png
As its name implies, the Head and Shoulders reversal pattern is made up of a left shoulder, a head, a right shoulder, and a neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance. We will look at each part individually, and then put them together with some examples.
Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a Head and Shoulders reversal pattern (or any reversal pattern for that matter).
Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend intact.
Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.
Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.
Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.
Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.
Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.
Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.
[*]Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/head_and_shoulders_top_reversal/hs-basicupslope-adm.png
Archer Daniels Midland Company (ADM)http://stockcharts.com/images/minilink_sc.gif formed a Head and Shoulders reversal with a slightly upward sloping neckline. Key points include:
The low at 17 1/2 marked the end of the left shoulder and the beginning of the head (1).
During the advance to 20 1/2, volume was still high, but not as high as during the left shoulder advance. However, during the next advance to 20, volume tapered off significantly.
Volume continued to decline until the breaking of the neckline. (Note red line on volume bars.)
The decline from 20 1/2 to 17 1/2 formed the second low point (2).
During the decline of the right shoulder and neckline break, volume expanded (red oval), and Chaikin Money Flow turned negative.
After the initial decline, there was a return to the neckline break (black arrow). Even during this decline, Chaikin Money Flow remained negative. The subsequent decline took the stock below 11.
[*]The measurement from neckline to the top of the head was 3. With the neckline break at 17 1/2, this would imply a move to around 14 1/2. The July '98 low was 13 1/2. After a decline from 20 1/2, at least, a short reaction rally could have been expected.
The head and shoulders pattern is one of the most common reversal formations. It is important to remember that it occurs after an uptrend and usually marks a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. Identification of neckline support and volume confirmation on the break can be the most critical factors. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in supply. The combination can be lethal, and sometimes, there is no second chance return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedence.
Head and Shoulders Bottom (Reversal)The Head and Shoulders bottom is referred to sometimes as an Inverse Head and Shoulders. The pattern shares many common characteristics with its comparable partner, but relies more heavily on volume patterns for confirmation.
As a major reversal pattern, the Head and Shoulders Bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance, or a neckline.
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The price action forming both Head and Shoulders Top and Head and Shoulders Bottom patterns remains roughly the same, but reversed. The role of volume marks the biggest difference between the two. Generally speaking, volume plays a larger role in bottom formations than top formations. While an increase in volume on the neckline breakout for a Head and Shoulders Top is welcomed, it is absolutely required for a bottom. We will look at each part of the pattern individually, keeping volume in mind, and then put the parts together with some examples.
Prior Trend: It is important to establish the existence of a prior downtrend for this to be a reversal pattern. Without a prior downtrend to reverse, there cannot be a Head and Shoulders Bottom formation.
Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1). The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact.
Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.
Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete.
Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern's degree of bullishness: an upward slope is more bullish than downward slope.
Volume: While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough.
Volume levels during the first half of the pattern are less important than in the second half. Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. The intensity of selling can even continue during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances.
[*]The advance from the low of the head should show an increase in volume and/or better indicator readings, e.g., CMF > 0 or rise in OBV. After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied with light volume. It is normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback, indicators like CMF and OBV should remain strong. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid, there needs to be an expansion of volume on the advance and during the breakout.
Neckline Break: The Head and Shoulders Bottom pattern is not complete, and the downtrend is not reversed until neckline resistance is broken. For a Head and Shoulders Botom, this must occur in a convincing manner, with an expansion of volume.
Resistance Turned Support: Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break, and offer a second chance to buy.
[*]Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered, as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages.
Alaska Air Group, Inc. (ALK) formed a head and shoulders bottom with a downward sloping neckline.Key points include:
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/head_and_shoulders_bottom_reversal/hs-botslopedn-alk.png
The stock began a downtrend in early July, and declined from 60 to 26.
The low of the left shoulder formed with a large spike in volume on a sharp down day (red arrows).
The reaction rally at around 42 1/2 formed the first point of the neckline (1). Volume on the advance was respectable with many gray bars exceeding the 60-day SMA. (Note: gray bars denote advancing days, black bars declining days and the thin red horizontal is the 60-day SMA).
The decline from 42 1/2 to 26 (head) was quite dramatic, but volume did not get out of hand. Chaikin Money Flow was mostly positive when the lows around 26 were forming.
The advance off of the low saw a large expansion of volume (green oval) and gap up. The strength behind the move indicated that a significant low formed.
After the reaction high around 39, the second point of the neckline could be drawn (2).
The decline from 39 to 33 occurred on light volume until the final two days, when volume reached its highest point in a month. Even though there are two long black (down) volume bars, these are surrounded by above-average gray (up) volume bars. Also notice how trend line resistance near 35 became support around 33 on the price chart.
The advance off of the low of the right shoulder occurred with above average volume. Chaikin Money Flow was at its highest levels, and surpassed +20% shortly after neckline resistance was broken.
[*]After breaking neckline resistance, the stock returned to this newfound support with a successful test around 35 (green arrow).
AT&T (T) formed a head and shoulders bottom with a flat neckline. The shoulders are a bit shallow, but the neckline and head are well pronounced. Key points include:
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The stock established a 6-month downtrend with the trend line extending down from Mar-98.
After a head fake above the trend line in late June, the stock fell from 66 to 50 with a sharp increase in volume to form the left shoulder.
The rally to 61 met resistance from the trend line, and the reaction high became the first point of the neckline.
The decline from 61 to 48 finished with a piercing pattern to form the low of the head. Even though volume was heavy when the long black candlestick formed, the subsequent reversal occurred on even higher volume. This reversal was followed with a number of strong advances and up gaps. Also notice that Chaikin Money Flow was above +10% when the low of the head formed.
The advance from the low of the head broke above the trend line, extending down from Mar-98, and met resistance around 61. This reaction high formed the second point of the neckline.
The right shoulder was quite short and shallow. The low was recorded at 57 and Chaikin Money Flow remained above +10% the whole time. Support was found from the trend line that offered resistance a few weeks earlier.
The stock advanced sharply off of lows that formed the right shoulder, and volume increased three straight days (blue arrow). This is a bit early, but volume remained just above average for the neckline breakout a few days later. Also Chaikin Money Flow remained above +10% the whole time.
[*]After the break of neckline resistance, the stock tested this newfound support twice while consolidating recent gains. The power arrived a few weeks later with a strong move off support and a huge increase in volume. The stock subsequently advanced from the low sixties to the low eighties.
Head and Shoulder Bottoms are one of the most common and reliable reversal formations. It is important to remember that they occur after a downtrend and usually mark a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. Shoulders can be different widths as well as different heights. Keep in mind that technical analysis is more an art than a science. If you are looking for the perfect pattern, it may be a long time coming.
Analysis of the Head and Shoulders Bottom should focus on correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful read, and by extension a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force, and the price is being affected.
As seen from the examples, traders do not always have to chase a stock after the neckline breakout. Often, but certainly not always, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture.
Falling Wedge (Reversal)The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price action forms a cone that slopes down as the reaction highs and reaction lows converge. In contrast to symmetrical triangles, which have no definitive slope and no bias, falling wedges definitely slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout.
The falling wedge can also fit into the continuation category. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing uptrend. As a reversal pattern, the falling wedge slopes down and with the prevailing trend. Regardless of the type (reversal or continuation), falling wedges are regarded as bullish patterns.
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Prior Trend: To qualify as a reversal pattern, there must be a prior trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low. The pattern usually forms over a 3-6 month period and the preceding downtrend should be at least 3 months old.
Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be lower than the previous highs.
Lower Support Line: At least two reaction lows are required to form the lower support line. Each reaction low should be lower than the previous lows.
Contraction: The upper resistance line and lower support line converge to form a cone as the pattern matures. The reaction lows still penetrate the previous lows, but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line.
Resistance Break: Bullish confirmation of the pattern does not come until the resistance line is broken in convincing fashion. It is sometimes prudent to wait for a break above the previous reaction high for further confirmation. Once resistance is broken, there can sometimes be a correction to test the newfound support level.
[*]Volume: While volume is not particularly important on rising wedges, it is an essential ingredient to confirm a falling wedge breakout. Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure.
As with rising wedges, the falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. When lower highs and lower lows form, as in a falling wedge, a security remains in a downtrend. The falling wedge is designed to spot a decrease in downside momentum and alert technicians to a potential trend reversal. Even though selling pressure may be diminishing, demand does not win out until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis to confirm signals.
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FCX provides a textbook example of a falling wedge at the end of a long downtrend.
Prior Trend: The downtrend for FCX began in the third quarter of 1997. There was a brief advance in Mar-98, but the downtrend resumed and the stock was trading at new lows by Feb-99.
Upper Resistance Line: The upper resistance line formed with four successively lower peaks.
Lower Support Line: The lower support line formed with four successive lower lows.
Contraction: The upper resistance line and lower support line converged as the pattern matured. Even though each low is lower than the previous low, these lows are only slightly lower. The shallowness of the new lows indicates that demand is stepping almost immediately after a new low is recorded. The supply overhang remains, but slope of the upper resistance line is more negative than the lower support line.
Resistance Break: In contrast to the three previous lows, the late February low was flat and consolidated just above 9 for a few weeks. The subsequent breakout in March occurred with a series of strong advances. In addition, there was a positive divergence in the PPO.
Volume: After the large volume decline on 24-Feb (red arrow), upside volume began to increase. Above-average volume continued on advancing days and when the stock broke trend line resistance. Money flows confirmed the strength by surpassing their Nov-98 high and moving to their highest level since Apr-98.
[*]After the trend line breakout, there was a brief pullback to support from the trend line extension. The stock consolidated for a few weeks and then advanced further on increased volume again.
Rising Wedge (Reversal)The rising wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias.
Even though this article will focus on the rising wedge as a reversal pattern, the pattern can also fit into the continuation category. As a continuation pattern, the rising wedge will still slope up, but the slope will be against the prevailing downtrend. As a reversal pattern, the rising wedge will slope up and with the prevailing trend. Regardless of the type (reversal or continuation), rising wedges are bearish.
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Prior Trend: In order to qualify as a reversal pattern, there must be a prior trend to reverse. The rising wedge usually forms over a 3-6 month period and can mark an intermediate or long-term trend reversal. Sometimes the current trend is totally contained within the rising wedge; other times the pattern will form after an extended advance.
Upper Resistance Line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be higher than the previous high.
Lower Support Line: At least two reaction lows are required to form the lower support line. Each reaction low should be higher than the previous low.
Contraction: The upper resistance line and lower support line converge as the pattern matures. The advances from the reaction lows (lower support line) become shorter and shorter, which makes the rallies unconvincing. This creates an upper resistance line that fails to keep pace with the slope of the lower support line and indicates a supply overhang as prices increase.
Support Break: Bearish confirmation of the pattern does not come until the support line is broken in a convincing fashion. It is sometimes prudent to wait for a break of the previous reaction low. Once support is broken, there can sometimes be a reaction rally to test the newfound resistance level.
[*]Volume: Ideally, volume will decline as prices rise and the wedge evolves. An expansion of volume on the support line break can taken as bearish confirmation.
The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets.
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ANN provides a good example of the rising wedge as a reversal pattern that forms in the face of weakening momentum and money flow.
Prior Trend: From a low around 10 in Oct-98, ANN surpassed 23 in less than 7 months. The final leg up was a sharp advance from below 15 in Feb. to 23.5 in mid-April.
Upper Resistance Line: The upper resistance line formed with three successively higher peaks.
Lower Support Line: The lower support line formed with three successive higher lows.
Contraction: The upper resistance line and lower support line converged as the pattern matured. A visual assessment confirms that the slope of the lower support line is steeper than that of the upper resistance line. Less slope in the upper resistance line indicates that momentum is waning as the stock makes new highs.
Support Break: The stock hugged the support line for over a week before finally breaking with a sharp decline. The previous reaction low was broken a few days later with long black candlestick (red arrow).
Volume: Chaikin Money Flow turned negative in late April and was well below -10% when the support line was broken. There was an expansion of volume when the previous reaction low was broken.
[*]Support from the April reaction low around 20 turned into resistance and the stock tested this level in early July before declining further.
Rounding Bottom (Reversal)The rounding bottom is a long-term reversal pattern that is best suited for weekly charts. It is also referred to as a saucer bottom, and represents a long consolidation period that turns from a bearish bias to a bullish bias.
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Prior Trend: In order to be a reversal pattern, there must be a prior trend to reverse. Ideally, the low of a rounding bottom will mark a new low or reaction low. In practice, there are occasions when the low is recorded many months earlier and the security trades flat before forming the pattern. When the rounding bottom does finally form, its low may not be the lowest low of the last few months.
Decline: The first portion of the rounding bottom is the decline that leads to the low of the pattern. This decline can take on different forms: some are quite jagged with a number of reaction highs and lows, while others trade lower in a more linear fashion.
Low: The low of the rounding bottom can resemble a "V' bottom, but should not be too sharp and should take a few weeks to form. Because prices are in a long-term decline, the possibility of a selling climax exists that could create a lower spike.
Advance: The advance off of the lows forms the right half of the pattern and should take about the same amount of time as the prior decline. If the advance is too sharp, then the validity of a rounding bottom may be in question.
Breakout: Bullish confirmation comes when the pattern breaks above the reaction high that marked the beginning of the decline at the start of the pattern. As with most resistance breakouts, this level can become support. However, rounding bottoms represent long-term reversal and this new support level may not be that significant.
[*]Volume: In an ideal pattern, volume levels will track the shape of the rounding bottom: high at the beginning of the decline, low at the end of the decline and rising during the advance. Volume levels are not too important on the decline, but there should be an increase in volume on the advance and preferably on the breakout.
A rounding bottom could be thought of as a head and shoulders bottom without readily identifiable shoulders. The head represents the low and is fairly central to the pattern. The volume patterns are similar and confirmation comes with a resistance breakout. While symmetry is preferable on the rounding bottom, the left and right side do not have to be equal in time or slope. The important thing is to capture the essence of the pattern.
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AMGN provides an example of a rounding bottom that formed after a long consolidation period. Throughout 1996, the stock traded in a tight range bound by 16.63 and 12.83. The trading range continued the first half of 1997 and the stock broke support by falling to a low of 12 in August.
Prior Trend: With the break of support at 12.83, it appeared that a downtrend had begun. Even though the decline was not that sharp, the new reaction low represented a 52-week low. AMGN was clearly not in an uptrend.
Decline: The stock declined from 17 to a low of 11.22 and a pair of hammers formed in Oct-98 to mark the end of the decline (red arrow).
Low: Prior to the hammers, the stock traded around 12 for the previous 6 weeks. When the gap up with high volume followed the hammers, it appeared that a low had been formed. After a short rally, there was another test of the low and a higher low formed at 11.66.
Advance: From the second low at 11.66, the advance began in earnest and volume started to increase. In March, there was a large advance with the highest volume in 4 months (green arrow).
May-97 resistance at 17 represented the confirmation line for the pattern. The stock broke resistance in Jul-98 with a further expansion of volume. This breakout was also confirmed with a new high in OBV.
[*]After breaking resistance, there was a test of support and the stock actually fell back below 17. The stock had advanced from 11.66 to 19.84 in 6 months and some sort of pullback could have been expected.
Triple Top (Reversal)The triple top is a reversal pattern made up of three equal highs followed by a break below support. In contrast to the triple bottom, triple tops usually form over a shorter time frame and typically range from 3 to 6 months. Generally speaking, bottoms take longer to form than tops. We will first examine the individual parts of the pattern and then look at an example.
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Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple top, an uptrend or long trading range should be in place. Sometimes there will be a definitive uptrend to reverse. Other times the uptrend will fade and become many months of sideways trading.
Three Highs: All three highs should be reasonable equal, well spaced and mark significant turning points. The highs do not have to be exactly equal, but should be reasonably equivalent to each other.
Volume: As the triple top develops, overall volume levels usually decline. Volume sometimes increases near the highs. After the third high, an expansion of volume on the subsequent decline and at the support break greatly reinforces the soundness of the pattern.
Support Break: As with many other reversal patterns, the triple top is not complete until a support break. The lowest point of the formation, which would be the lowest of the intermittent lows, marks this key support level.
Support Turns Resistance: Broken support becomes potential resistance, and there is sometimes a test of this newfound resistance level with a subsequent reaction rally.
[*]Price Target: The distance from the support break to highs can be measured and subtracted from the support break for a price target. The longer the pattern develops, the more significant is the ultimate break. Triple tops that are 6 or more months old represent major tops and a price target is less likely to be effective.
Throughout the development of the triple top, it can start to resemble a number of patterns. Before the third high forms, the pattern may look like a double top. Three equal highs can also be found in an ascending triangle or rectangle. Of these patterns mentioned, only the ascending triangle has bullish overtones; the others are neutral until a break occurs. In this same vein, the triple top should also be treated as a neutral pattern until a breakout occurs. The inability to break above resistance is bearish, but the bears have not won the battle until support is broken. Volume on the last decline off resistance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a support break increase.
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When looking for patterns, it is important to keep in mind that technical analysis is more art and less science. Pattern interpretations should be fairly specific, but not overly exacting as to obstruct the spirit of the pattern. A pattern may not fit the description to the letter, but that should not detract from its robustness. For example: it can be difficult to find a triple top with three highs that are exactly equal. However, if the highs are within reasonable proximity and other aspects of the technical analysis picture jibe, it would embody the spirit of a triple top. The spirit is three attempts at resistance, followed by a breakdown below support, with volume confirmation. ROK illustrates an example of a triple top that does not fit exactly, but captures the spirit of the pattern.
The stock was in an uptrend and remained above the trend line extending up from Oct-98 until the break in late August 1999.
Over a period of about 4 months, the stock bounced off resistance around 23. The first attempt happened in May, the second in July and the third in August.
The decline from the third high broke trend line support and the stock continued to fall past support from the previous lows. Triple top support should be drawn from the lowest low of the pattern, which would be the May low around 19.80.
Volume expanded after the stock broke trend line support. The stock paused for a few days when support at 19.80 was reached, but volume accelerated when this support level was broken in late September (gray dotted vertical line). In addition, the Chaikin Money Flow turned negative and broke below -10%.
After the support break, there was a test of the newfound resistance a few weeks later. Money flows continued to indicate selling pressure and volume expanded when the stock began to fall again.
[*]The projected decline was 3.2 points, from 19.80 down to 16.60, and the stock reached this target soon after the resistance test.
Triple Bottom (Reversal)The triple bottom is a reversal pattern made up of three equal lows followed by a breakout above resistance. While this pattern can form over just a few months, it is usually a long-term pattern that covers many months. Because of its long-term nature, weekly charts can be best suited for analysis. We will first examine the individual parts of the pattern and then look at an example.
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Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple bottom, a downtrend or long trading range should be in place. Sometimes there will be a definitive downtrend to reverse. Other times the downtrend will fade away after many months of sideways trading.
Three Lows: All three lows should be reasonable equal, well spaced and mark significant turning points. The lows do not have to be exactly equal, but should be reasonably equivalent.
Volume: As the triple bottom develops, overall volume levels usually decline. Volume sometimes increases near the lows. After the third low, an expansion of volume on the advance and at the resistance breakout greatly reinforces the soundness of the pattern.
Resistance Break: As with many other reversal patterns, the triple bottom is not complete until a resistance breakout. The highest point of the formation, which would be the highest of the intermittent highs, marks resistance.
Resistance Turns Support: Broken resistance becomes potential support, and there is sometimes a test of this newfound support level with the first correction. Because the triple bottom is a long-term pattern, the test of newfound support may occur many months later.
[*]Price Target: The distance from the resistance breakout to lows can be measured and added to the resistance break for a price target. The longer the pattern develops, the more significant is the ultimate breakout. Triple bottoms that are 6 or more months in duration represent major bottoms and a price target is less likely to be effective.
As the triple bottom develops, it can start to resemble a number of patterns. Before the third low forms, the pattern may look like a double bottom. Three equal lows can also be found in a descending triangle or rectangle. Of these patterns mentioned, only the descending triangle has bearish overtones; the others are neutral until a breakout occurs. Similarly, the triple bottom should also be treated as a neutral pattern until a breakout occurs. The ability to hold support is bullish, but demand has not won the battle until resistance is broken. Volume on the last advance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a breakout increase.
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After a failed double bottom breakout, ANDW formed a large triple bottom. While the new reaction high (black arrow) and potential double bottom breakout seemed bullish, the stock subsequently fell back to support.
Technically, the downtrend ended when the stock formed a higher low in Mar-99 and surpassed its Jan-99 high by closing above 20 in Jul-99 (black arrow). Even though the downtrend ended, it would have been difficult to label the trend bullish after the third test of support around 11.
Over a 13-month timeframe, three relatively equal lows formed in Oct-98, Mar-99 and Nov-99. When the Jul-00 high surpassed the Jan-99 high, the possibility of a rectangle pattern was ruled out.
Resistance at 22 1/2 was broken in Jan-00. The stock closed above this key level for 5 consecutive weeks to confirm the breakout.
Even though volume expanded near the second and third lows, the 10-day EMA of volume declined between the lows. The advance off the third low saw a dramatic expansion of volume that lasted many weeks. The Accumulation/Distribution Line formed a positive divergence in 1999 and broke to new highs with the stock in Jan-00.
After the resistance break, the stock fell below 22 1/2 twice over the next 2 months. Based on the Feb-00 and Apr-00 lows, a new support level was established at 20 and. Because upside movement was limited after the breakout (a high of 25 1/2), a pullback below 22 1/2 might have been expected. Based on Oct-99 resistance, critical support could have been marked at 18 1/2.
[*]ANDW built a base over a 13-month period. Even though the height of the pattern is relatively impressive, it pales in comparison to the length of the base. The length of this pattern and subsequent breakout suggest a long-term change of sentiment.
Bump and Run Reversal (Reversal)As the name implies, the Bump and Run Reversal (BARR) is a reversal pattern that forms after excessive speculation drives prices up too far, too fast. Developed by Thomas Bulkowski, the pattern was introduced in the June-97 issue of Technical Analysis of Stocks and Commodities and also included in his recently published book, the Encyclopedia of Chart Patterns.
The pattern was originally named the Bump and Run Formation, or BARF. Bulkowski decided that Wall Street was not ready for such an acronym and changed the name to Bump and Run Reversal. Bulkowski identified three main phases to the pattern: lead-in, bump and run. We will examine these phases and also look at volume and pattern validation.
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Lead-in Phase: The first part of the pattern is a lead-in phase that can last 1 month or longer and forms the basis from which to draw the trend line. During this phase, prices advance in an orderly manner, and there is no excess speculation. The trend line should be moderately steep. If it is too steep, then the ensuing bump is unlikely to be significant enough. If the trend line is not steep enough, then the subsequent trend line break will occur too late. Bulkowski advises that an angle of 30 to 45 degrees is preferable. The size of the angle will depend on the scaling (semi-log or arithmetic) and the size of the chart. It is probably easier to judge the soundness of the trend line with a visual assessment.
Bump Phase: The bump forms with a sharp advance, and prices move further away from the lead-in trend line. Ideally, the angle of the trend line from the bump's advance should be about 50% greater than the angle of the trend line extending up from the lead-in phase. Roughly speaking, this would call for an angle between 45 and 60 degrees. If it is not possible to measure the angles, then a visual assessment will suffice.
Bump Validity: It is important that the bump represent a speculative advance that cannot be sustained for a long time. Bulkowski developed what he calls an "arbitrary" measuring technique to validate the level of speculation in the bump. The distance from the highest high of the bump to the lead-in trend line should be at least twice the distance from the highest high in the lead-in phase to the lead-in trend line. These distances can be measured by drawing a vertical line from the highest highs to the lead-in trend line. An example is provided below.
Bump Rollover: After speculation dies down, prices begin to peak and a top forms. Sometimes, a small double top or a series of descending peaks forms. Prices begin to decline towards the lead-in trend line, and the right side of the bump forms.
Volume: As the stock advances during the lead-in phase, volume is usually average and sometimes low. When the speculative advance begins to form the left side of the bump, volume expands as the advance accelerates.
Run Phase: The run phase begins when the pattern breaks support from the lead-in trend line. Prices will sometimes hesitate or bounce off the trend line before breaking through. Once the break occurs, the run phase takes over, and the decline continues.
[*]Support Turns Resistance: After the trend line is broken, there is sometimes a retracement that tests the newfound resistance level. Potential support-turned-resistance levels can also be identified from the reaction lows within the bump.
The Bump and Run Reversal pattern can be applied to daily, weekly or monthly charts. As stated above, the pattern is designed to identify speculative advances that are unsustainable for a long period. Because prices rise very fast to form the left side of the bump, the subsequent decline can be just as ferocious.
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Level Three Communications (LVLT) formed a Bump and Run Reversal pattern after prices advanced in a speculative frenzy at the beginning of 2000. Prices advanced from 72 to 132 in 2 months and this advance ultimately proved unsustainable.
The lead-in phase formed over a 3 month period from early Oct-99 to early Jan-00. Volume during this phase was relatively subdued, and actually declined during the November and December advance.
The trend line extending up from the lead-in phase lows formed a 34 degree angle. A visual assessment also reveals that this trend line is neither too steep nor too flat.
The bump phase began in early January when the advance accelerated with a large increase in volume. A conservatively drawn trend line formed a 51 degree angle that was exactly 50% larger than the angle from the lead-in trend line.
The distance from the lead-in phase's highest high to the trend line. was 13. The distance from the Bump Phase's highest high to the trend line was 38. This is almost three times larger, and validates the speculative excesses in the bump.
After reaching a high around 132, prices declined sharply, and bounced off the lead-in trend line. A lower high formed around 115 (red arrow), and the trend line was soon broken.
[*]The decline continued after the trend line break, and reached 67 before a reaction rally began. The reaction rally advanced to around 95, but fell just short of the horizontal support line before falling back to new lows.
Flag, Pennant (Continuation)Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.
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Sharp Move: To be considered a continuation pattern, there should be evidence of a prior trend. Flags and pennants require evidence of a sharp advance or decline on heavy volume. These moves usually occur on heavy volume and can contain gaps. This move usually represents the first leg of a significant advance or decline and the flag/pennant is merely a pause.
Flagpole: The flagpole is the distance from the first resistance or support break to the high or low of the flag/pennant. The sharp advance (or decline) that forms the flagpole should break a trend line or resistance/support level. A line extending up from this break to the high of the flag/pennant forms the flagpole.
Flag: A flag is a small rectangle pattern that slopes against the previous trend. If the previous move was up, then the flag would slope down. If the move was down, then the flag would slope up. Because flags are usually too short in duration to actually have reaction highs and lows, the price action just needs to be contained within two parallel trend lines.
Pennant: A pennant is a small symmetrical triangle that begins wide and converges as the pattern matures (like a cone). The slope is usually neutral. Sometimes there will not be specific reaction highs and lows from which to draw the trend lines and the price action should just be contained within the converging trend lines.
Duration: Flags and pennants are short-term patterns that can last from 1 to 12 weeks. There is some debate on the timeframe and some consider 8 weeks to be pushing the limits for a reliable pattern. Ideally, these patterns will form between 1 and 4 weeks. Once a flag becomes more than 12 weeks old, it would be classified as a rectangle. A pennant more than 12 weeks old would turn into a symmetrical triangle. The reliability of patterns that fall between 8 and 12 weeks is debatable.
Break: For a bullish flag or pennant, a break above resistance signals that the previous advance has resumed. For a bearish flag or pennant, a break below support signals that the previous decline has resumed.
Volume: Volume should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance (support) break lends credence to the validity of the formation and the likelihood of continuation.
[*]Targets: The length of the flagpole can be applied to the resistance break or support break of the flag/pennant to estimate the advance or decline.
Even though flags and pennants are common formations, identification guidelines should not be taken lightly. It is important that flags and pennants are preceded by a sharp advance or decline. Without a sharp move, the reliability of the formation becomes questionable and trading could carry added risk. Look for volume confirmation on the initial move, consolidation and resumption to augment the robustness of pattern identification.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/flagpennant-hwp.png
HWPhttp://stockcharts.com/images/minilink_sc.gif provides an example of a flag that forms after a sharp and sudden advance.
Sharp Move: After consolidating for three months, HWP broke above resistance at 28 to begin a sharp advance. The 5-April high and 16-Feb trend line marked resistance and the breakout occurred with a volume expansion. The stock advanced from 28 to 38 in a mere 4 weeks. (Note: It is also possible that a small pennant formed in early May with resistance around 31).
Flagpole: The distance from the breakout at 28 to the flag's high at 38 formed the flagpole.
Flag: Price action was contained within two parallel trend lines that sloped down.
Duration: From a high at 38 to the breakout at 36, the flag formed over a 23-day period.
Breakout: The first break above the flag's upper trend line occurred on 21-June without an expansion of volume. However, the stock gapped up a week later and closed strong with above-average volume (red arrows)
Volume: To recap - volume expanded on the sharp advance to form the flagpole, contracted during the flag's formation and expanded right after the resistance breakout.
[*]Targets: The length of the flagpole measured 10 points and was applied to the resistance breakout at 36 to project a target of 46.
Symmetrical Triangle (Continuation)The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. When these points are connected, the lines converge as they are extended and the symmetrical triangle takes shape. You could also think of it as a contracting wedge, wide at the beginning and narrowing over time.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/symmetrical_triangle_continuation/symtri-conti-sun2.png
While there are instances when symmetrical triangles mark important trend reversals, they more often mark a continuation of the current trend. Regardless of the nature of the pattern, continuation or reversal, the direction of the next major move can only be determined after a valid breakout. We will examine each part of the symmetrical triangle individually, and then provide an example with Conseco.
Trend: In order to qualify as a continuation pattern, an established trend should exist. The trend should be at least a few months old and the symmetrical triangle marks a consolidation period before continuing after the breakout.
Four (4) Points: At least 2 points are required to form a trend line and 2 trend lines are required to form a symmetrical triangle. Therefore, a minimum of 4 points are required to begin considering a formation as a symmetrical triangle. The second high (2) should be lower than the first (1) and the upper line should slope down. The second low (2) should be higher than the first (1) and the lower line should slope up. Ideally, the pattern will form with 6 points (3 on each side) before a breakout occurs.
Volume: As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the quiet before the storm, or the tightening consolidation before the breakout.
Duration: The symmetrical triangle can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months.
Breakout Time Frame: The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern's development or time-span. The time-span of the pattern can be measured from the apex (convergence of upper and lower lines) back to the beginning of the lower trend line (base). A break before the 1/2 way point might be premature and a break too close to the apex may be insignificant. After all, as the apex approaches, a breakout must occur sometime.
Breakout Direction: The future direction of the breakout can only be determined after the break has occurred. Sound obvious enough, but attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case.
Breakout Confirmation: For a break to be considered valid, it should be on a closing basis. Some traders apply a price (3% break) or time (sustained for 3 days) filter to confirm validity. The breakout should occur with an expansion in volume, especially on upside breakouts.
Return to Apex: After the breakout (up or down), the apex can turn into future support or resistance. The price sometimes returns to the apex or a support/resistance level around the breakout before resuming in the direction of the breakout.
[*]Price Target: There are two methods to estimate the extent of the move after the breakout. First, the widest distance of the symmetrical triangle can be measured and applied to the breakout point. Second, a trend line can be drawn parallel to the pattern's trend line that slopes (up or down) in the direction of the break. The extension of this line will mark a potential breakout target.
Edwards and Magee suggest that roughly 75% of symmetrical triangles are continuation patterns and the rest mark reversals. The reversal patterns can be especially difficult to analyze and often have false breakouts. Even so, we should not anticipate the direction of the breakout, but rather wait for it to happen. Further analysis should be applied to the breakout by looking for gaps, accelerated price movements, and volume for confirmation. Confirmation is especially important for upside breakouts.
Prices sometimes return to the breakout point of apex on a reaction move before resuming in the direction of the breakout. This return can offer a second chance to participate with a better reward to risk ratio. Potential reward price targets found by measurement and parallel trend line extension are only meant to act as rough guidelines. Technical analysis is dynamic and ongoing assessment is required. In the first example above, SUNW may have fulfilled its target (42) in a few months, but the stock gave no sign of slowing down and advanced above 100 in the following months.
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Conseco (CNCEQ)http://stockcharts.com/images/minilink_sc.gif formed a rather large symmetrical triangle over a 5-month period before breaking out on the downside.
The stock declined from 50 in Mar-98 to 22 in Oct-98 before beginning to firm and consolidate. The low at 22 probably was an over-reaction, but the long-term trend was down and established for almost a year.
After the first 4 points formed, the lines of the symmetrical triangle were draw. The stock traded within the boundaries for another 2 months to form the last 2 points.
After the gap up from point 3 to point 4, volume slowed over the next few months. There was some increase in volume in late June, but the 60-day SMA remained in a downtrend as the pattern took shape.
The red square marks the ideal breakout time-span from 50% to 75% of the pattern. The breakout occurred a little over 2 weeks later, but proved valid nonetheless. While it is preferable to have an ideal pattern develop, it is also quite rare.
After points 5 and 6 formed, the price action moved to the lower boundary of the pattern. Even at this point, the direction of the breakout was still a guess and its was prudent to wait. The break occurred with an increase in volume and accelerated price decline. Chaikin Money Flow declined past -30% and volume exceeded the 60-day SMA for an extended period.
After the decline from 29 1/2 to 25 1/2, the stock rebounded, but failed to reach potential resistance from the apex. The weakness of the reaction rally foreshadowed the sharpness of the decline that followed.
[*]The widest point on the pattern extended 10 1/2 points. With a break of support at 29 1/2, the measured decline was estimated to around 19. By drawing a trend line parallel to the upper boundary of the pattern, the extension estimates a decline to around 20.