Shares Online Course 11 - Technical Analysis

Course 11: Technical analysisCourse 11Technical analysisTopic 1: Introduction to technical analysis . 3Topic 2: Chart types . 4Line charts . 4Bar chart . 4Candle stick charts . 5Topic 3: Trend analysis . 6Defining an uptrend . 6Defining a downtrend . 6Recognising a change of trend . 7Topic 4: Resistance and support lines . 9Resistance and support lines . 9Resistance . 9Support . 9Volume . 10Chart patterns . 10Topic 5: Moving averages . 12The moving average . 12Summary . 14Version 5 November 20101

Course 11: Technical analysisInformation provided is for educational purposes and does not constitute financial product advice. Youshould obtain independent advice from an Australian financial services licensee before making anyfinancial decisions. Although ASX Limited ABN 98 008 624 691 and its related bodies corporate (“ASX”)has made every effort to ensure the accuracy of the information as at the date of publication, ASX doesnot give any warranty or representation as to the accuracy, reliability or completeness of the information.To the extent permitted by law, ASX and its employees, officers and contractors shall not be liable for anyloss or damage arising in any way (including by way of negligence) from or in connection with anyinformation provided or omitted or from any one acting or refraining to act in reliance on this information. Copyright 2010 ASX Limited ABN 98 008 624 691. All rights reserved 2010.All Ordinaries , All Ords , AllOrds , ASX , ASX100 , CHESS , ITS are registered trademarks ofASX Operations Pty Limited ABN 42 004 523 782 ("ASXO").ASX20 , ASX50 , ASX200 , ASX300 are trade marks of ASXO.S&P is a trademark of Standard and Poor’s, a division of The McGraw-Hill Companies Inc.Version 5 November 20102

Course 11: Technical analysisTopic 1: Introduction to technical analysisTechnical analysis is the study of the pastprice movements of an individual share orthe market as a whole. Charts are the keytool used in technical analysis.The argument in support of technicalanalysis is that all buying, selling, rumours,and information is going to be factored intothe price of a share as people act on thatinformation.By looking at the prices we can see whetherthere is good news associated with acompany resulting in buying and risingprices. We can also see if bad news hascome out, or if it's expected to be releasedbecause sellers will come into the marketand push prices lower.Forget the idea that charts can predict thefuture with any certainty. They can't andneither can fundamental analysis. So whatcan charts do for us?The first benefit that charts provide is theability to convert a table of data into an easyto interpret line graph. Take the exampleopposite, is it easier to tell the share'srecent price history by looking at the table orthe graph?The graph provides a quick snapshot ofhow the company's share price hastravelled over the recent past.This is charting in its simplest form, let'stake a look at how charting can be extendedto greater depth of detail.Version 5 November 20103

Course 11: Technical analysisTopic 2: Chart typesLine chartsLine charts are the most common type ofchart. Line charts plot a series of points tograph price movements. Line charts are anexcellent way to get a general guide on thedirection a price is moving.Line charts do have limitations in theamount of information that they represent.In the case of share price movements therecan be significant variation in a share priceover a single time period. Because a linechart only represents one point in that timeperiod (most commonly the daily closingprice) it does not fully represent thefluctuations in that share's price over thatperiod.In order to show more complete price rangeinformation, a bar chart can be used.Bar chartA bar chart simply takes the informationfrom the day's trading and plots thatinformation on a single 'bar'.On the right hand side of the graphicopposite is a single day's bar. Bar chartsplot price data as a vertical bar. A tab on theleft side of the bar represents the OPENprice, and a tab on the right of the barrepresents the CLOSE price. The top of thebar represents the day's HIGHEST priceand the bottom of the bar represents theday's LOWEST price.By plotting each day consecutively on achart the technical analyst develops apicture that helps to illustrate the interplaybetween supply (sellers) and demand(buyers). While we have drawn a daily barchart, it is just as easy to draw a weeklychart by capturing the open on Monday, thehighest high and the lowest low during theweek and finally the close on Fridayafternoon. We can also construct monthlybar charts and even 1-minute bar charts.Version 5 November 20104

Course 11: Technical analysisCandle stick chartsCandlestick charts originated in Japan andhave been used for centuries. They areconstructed using the same information as abar chart (open, high, low, and close).Instead of using a single line however, arectangle is used to represent the areabetween the open and the close.The rectangle or candle is left blank or aspecific colour like green for an up day andfilled or a different colour like red for a downday. The rectangle is called the body or thereal body and the single lines at the top orthe bottom, if they exist, are calledshadows, wicks or tails.The art of using bar charts and candle stickcharts comes in interpreting the shapes thatthey form and their combinations. There area myriad of documented combinations thatexist and the charting library on the ASXwebsite is a great place to start delving intothe world of charting.Version 5 November 20105

Course 11: Technical analysisTopic 3: Trend analysisNow that we have some background on thedifferent chart types, line, bar and candlestick, we need to use some basic rules toprovide us with guidance as to whetherprices are rising, falling or have no cleartrend.Defining an uptrendThe diagram opposite illustrates how easy itis to define an uptrend.Notice that each subsequent high is higherthan the previous high, while eachsubsequent low is also higher than theprevious low. This is how an uptrend isdefined. You must have higher highs ANDhigher lows. You need both to have anuptrend. If you do not have both a higherhigh and a higher low you do not have anuptrend. You might not have a downtrendeither. Let's look at the alternatives.Defining a downtrendThe diagram opposite describes adowntrend. The definition of a downtrend islower lows AND lower highs. If you look atthe diagram you can see that each high islower than the previous one and each low islower than the previous one.From a technical analyst's perspective youare doing yourself a disservice if youpurchase stocks that are in a downtrend. Itis deemed prudent to wait until an uptrendemerges. Markets however are not assimple as the diagrams and there areperiods when the market is neither in anuptrend nor a downtrend. The next diagramhelps illustrate this point.Version 5 November 20106

Course 11: Technical analysisIn the diagram opposite, prices never reacha point where there is a higher high AND ahigher low. After the market registered thesecond higher high, notice that the marketthen made a lower low. There is neither anuptrend, nor a downtrend, the market ismerely trading sideways with little indicationof clear direction.There are technical analysis tools availableto allow you to trade in a sideways trendingmarket, though these are not covered in thiscourse. For most investors, a sidewaystrending market represents a time to standaside and do nothing.Recognising a change of trendWe have now defined an uptrend and adowntrend as well as a period of rangetrading or sideways movement. How do wemake use of them in the market place?Obviously we would like to get out ofdowntrends as soon as they develop andwe would like to enter into uptrends as soonas they are confirmed. Now that we knowwhat these things are, let's look atidentifying a change in trend.Version 5 November 20107

Course 11: Technical analysisIn the diagram opposite it is easy to see thatinitially there was an uptrend in place. Thereis a series of higher highs (H1, H2) AND aseries of higher lows (L1, L2, and L3).Notice however that H3 is LOWER than theprevious high. This is the first warning, asthe criteria for an uptrend is no longer beingmet.The market is no longer in a clear uptrend.At point H3, we still have higher lows but alower high. We need both higher lows andhigher highs. At point H3, there is no trendeither up or down. We may describe themarket as neutral or range bound.The price then turned lower and broke thelevel marked by L3. Now if you lookcarefullysomethingsignificanthashappened. We have a lower high at H3 andwe have a lower low once L3 is breached.We now have a lower high AND a lowerlow. A downtrend is in place at the pointmarked by the arrow.Version 5 November 20108

Course 11: Technical analysisTopic 4: Resistance and support linesResistance and support linesLet's look at using support and resistancelevels to help define the buying and sellingpoints in the market.ResistanceBy drawing a line that connects all of thehighs we create what is described bytechnical analysts as a resistance line. Atthis level the market RESISTS going higherbecause there are sellers who enter themarket to sell more shares when the sharetrades at this price.The weight of their cumulative sellingprevents the price from rising. If the pricewere to break through this resistance as ithas in the second diagram opposite, it couldsuggest that the selling at this price iscomplete or the seller has decided not tosell any more of the stock for the time being.Either way it could be supportive for thestock and may even reflect the release ofgood news, which has resulted in the sellersat the resistance price holding off orchanging their mind. Technical analysts seea break of resistance as a buy signal.SupportBy drawing a line that connects the lows ofthe range we can define support. The priceis supported from going lower by thepresence of a buyer or buyers at this price.Each time the price drops to this supportlevel a buyer or buying emerges that is ofsufficient volume to absorb the selling andprevent the price from falling through.Suppose that the price does break throughthe support level. What would this indicate?The first conclusion we may draw is that thebuyer at the previous support price is nolonger present (at that price at least).Version 5 November 20109

Course 11: Technical analysisThe buying has dried up and the selling iscontinuing now at lower prices. This sellingat lower prices suggests that the sellers arebecoming more aggressive.VolumeVolume is an important tool for the technicalanalyst. Rising volume at the time of abreak of support or resistance is generallyregarded as further confirmation that thebreak is legitimate and that the price isexpected to continue moving in the samedirection.This could be for a number of reasons, forexample the higher volumes suggest moresophisticated and knowledgeable investorsmight be establishing positions in thedirection of the market's move or it could besimply because more individuals arediscovering the particular factors that makean investment or trade in this shareattractive.Chart patternsThere are a multitude of textbooks availablefor the classic technical analyst. These textslook at the variety of 'patterns' that themarket prices form. These patterns aretraded by classic technical analysts and likeall tools in trading and investing do not workall the time.The diagram opposite describes one patternknown as a rising triangle. There are manyothers and if you are interested in doingfurther research on this subject you shouldconsider some of the many texts on thesubject that are available.Version 5 November 201010