Technical Analysis

What Is Technical Analysis?

Technical analysis is a trading discipline employed to evaluate investments and identify trading
opportunities by analyzing statistical trends gathered from trading activity, such as price
movement and volume. Unlike fundamental analysis, which attempts to evaluate a security's
value based on business results such as sales and earnings, technical analysis focuses on the
study of price and volume.
 Some history
The roots of modern-day technical analysis stem from the Dow Theory, developed around 1900
by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these roots include
such principles as the trending nature of prices, prices discounting all known information,
confirmation and divergence, volume mirroring changes in price, and support/resistance. And of
course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow
Theory.
 The future can be found in the past
If prices are based on investor expectations, then knowing what a security should sell for (i.e.,
fundamental analysis) becomes less important than knowing what other investors expect it to
sell for. That's not to say that knowing what a security should sell for isn't important--it is. But
there is usually a fairly strong consensus of a stock's future earnings that the average investor
cannot disprove.
Technical analysis is the process of analyzing a security's historical prices in an effort to
determine probable future prices. This is done by comparing current price action (i.e., current
expectations) with comparable historical price action to predict a reasonable outcome. The
devout technician might define this process as the fact that history repeats itself while others
would suffice to say that we should learn from the past.
 Charts
Line charts
◦ A line chart is the simplest type of chart. As shown in the chart of General Motors in Figure, the single
line represents the security's closing price on each day. Dates are displayed along the bottom of the
chart and prices are displayed on the side(s).
◦ A line chart's strength comes from its simplicity. It provides an uncluttered, easy to understand view of a
security's price. Line charts are typically displayed using a security's closing prices.
Bar charts
◦ A bar chart displays a security's open (if available), high, low, and closing prices. Bar charts are the most
popular type of security chart.
◦ As illustrated in the bar chart in Figure, the top of each vertical bar represents the highest price that the
security traded during the period, and the bottom of the bar represents the lowest price that it traded. A
closing "tick" is displayed on the right side of the bar to designate the last price that the security traded. If
opening prices are available, they are signified by a tick on the left side of the bar.
Volume bar chart
◦ Volume is usually displayed as a bar graph at the bottom of the chart (see Figure ). Most analysts only
monitor the relative level of volume and as such, a volume scale is often not displayed.
Other chart types Security prices can also be displayed using other types of charts, such as
candlestick, Equivolume, point & figure, etc.
 SUPPORT & RESISTANCE
Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a
bear (the seller). The bulls push prices higher and the bears push prices lower. The direction
prices actually move reveals who is winning the battle.
Using this analogy, consider the price action of Phillip Morris in Figure. During the period shown,
note how each time prices fell to the $45.50 level, the bulls (i.e., the buyers) took control and
prevented prices from falling further. That means that at the price of $45.50, buyers felt that
investing in Phillip Morris was worthwhile (and sellers were not willing to sell for less than
$45.50). This type of price action is referred to as support, because buyers are supporting the
price of $45.50.
Similar to support, a "resistance" level is the point at which sellers take control of prices and prevent
them from rising higher. Consider Figure . Note how each time prices neared the level of $51.50,
sellers outnumbered buyers and prevented the price from rising.
 Supply - Demand
There is nothing mysterious about support and resistance--it is classic supply and demand.
Remembering "Econ 101" class, supply/demand lines show what the supply and demand will be
at a given price.
The "supply" line shows the quantity (i.e., the number of shares) that sellers are willing to supply
at a given price. When prices increase, the quantity of sellers also increases as more investors
are willing to sell at these higher prices.
The "demand" line shows the number of shares that buyers are willing to buy at a given price.
When prices increase, the quantity of buyers decreases as fewer investors are willing to buy at
higher prices.
At any given price, a supply/demand chart (see Figure) shows how many buyers and sellers there
are. For example, the following chart shows that, at the price of 42-1/2, there will be 10 buyers and
25 sellers.
Support occurs at the price where the supply line touches the left side of the chart (e.g., 27-1/2 on
the above chart). Prices can't fall below this amount, because no sellers are willing to sell at these
prices. Resistance occurs at the price where the demand line touches the left side of the chart (e.g.,
47-1/2). Prices can't rise above this amount, because there are no buyers willing to buy at these
prices.
In a free market these lines are continually changing. As investor expectations change, so do the
prices buyers and sellers feel are acceptable. A breakout above a resistance level is evidence of an
upward shift in the demand line as more buyers become willing to buy at higher prices. Similarly, the
failure of a support level shows that the supply line has shifted downward.
The foundation of most technical analysis tools is rooted in the concept of supply and demand.
Charts of security prices give us a superb view of these forces in action.
 Resistance becomes support
When a resistance level is successfully penetrated, that level becomes a support level. Similarly,
when a support level is successfully penetrated, that level becomes a resistance level.
An example of resistance changing to support is shown in Figure. When prices broke above the
resistance level of $45.00, the level of $45.00 became the new support level.
This is because a new "generation" of bulls who didn't buy when prices were less than $45 (they
didn't have bullish expectations then) are now anxious to buy anytime prices return near the
$45 level.
Similarly, when prices drop below a support level, that level often becomes a resistance level
that prices have a difficult time penetrating. When prices approach the previous support
level, investors seek to limit their losses by selling.
 TRENDS
In the preceding section, we saw how support and resistance levels can be penetrated by a
change in investor expectations (which results in shifts of the supply/demand lines). This type of
a change is often abrupt and "news based."
In this section, we'll review "trends." A trend represents a consistent change in prices (i.e., a
change in investor expectations). Trends differ from support/resistance levels in that trends
represent change, whereas support/resistance levels represent barriers to change.
As shown in Figure, a rising trend is defined by successively higher low-prices. A rising trend can
be thought of as a rising support level-the bulls are in control and are pushing prices higher.
Figure shows a falling trend. A falling trend is defined by successively lower highprices. A falling trend
can be thought of as a falling resistance level--the bears are in control and are pushing prices lower.
Just as prices penetrate support and resistance levels when expectations change, prices can
penetrate rising and falling trendlines. Figure shows the penetration of Merck's falling trendline as
investors no longer expected lower prices.
Note in Figure how volume increased when the trendline was penetrated. This is an important
confirmation that the previous trend is no longer intact.
As with support and resistance levels, it is common to have traders' remorse
following the penetration of a trendline. This is illustrated in Figure
Again, volume is the key to determining the significance of the penetration of a
trend. In the above example, volume increased when the trend was penetrated, and
was weak as the bulls tried to move prices back above the trendline.
INDICATORS
 Moving Averages

A Moving Average is an indicator that shows the average value of a security's

price over a period of time. When calculating a moving average, a mathematical
analysis of the security's average value over a predetermined time period is
made. As the security's price changes, its average price moves up or down.
The most popular method of interpreting a moving average is to compare the
relationship between a moving average of the security's price with the security's
price itself. A buy signal is generated when the security's price rises above its
moving average and a sell signal is generated when the security's price falls
below its moving average.
Simple Moving Average – SMA
◦ A simple moving average is the simplest type of moving average. Basically, a simple moving average is
calculated by summing the closing prices over the number of time periods “x” and dividing it by “x”.
On the chart above, you can see 3 different SMA lines. As you can see, the SMA for a longer period is
the line that lags behind the price. Notice that the 62SMA is further away from the current price
than the 30 and 5 SMA. Because with the 62 SMA you sum the closing prices of the 62 periods and
divide by 62. Your use of a higher number of time periods works to reflect slower price movements.
The SMA in this chart shows you the overall feel of the market over time. Instead of just looking at
the current market price, moving averages give us a broader view and we can make future price
predictions.
Exponential Moving Average – EMA
◦ Although the SMA is a great tool, there is one major drawback. The SMA line is very easy to disable. Let me
give an example of this:
◦ We draw a 5-day SMA on the daily chart of EUR/USD and the closing prices of the last 5 days as follows:
◦ Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
◦ SMA = (1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
◦ Accurate enough? What if Monday's price is 1.2300? The result of the SMA will be a little lower and this gives
you the idea that the price is going down, when in fact day 2 could be just one event at a time.
The EMA is more influenced for the latest time periods. In the example above, the EMA will be
heavily weighted on day 3 to day 5, meaning that the spike on day 2 will be less valuable and won't
affect the moving average much. The EMA is more focused on the current action of the traders.
Buy Signal: A buy signal occurs when the short-term line crosses above the long-term line.
◦ Price line crosses above SMA20
◦ Price line crosses above SMA50
◦ SMA20 crosses above SMA50 (long term signal identifies long term uptrend)
◦ The Price Line crossed above the SMA20 and the SMA20 crossed the SMA50 (the uptrend is evident when
the 3 lines touch each other and move up)
Sell Signal: A buy signal occurs when the short-term line descends onto the long-term line.
◦ The Price line crosses down the SMA20
◦ The Price line crosses down the SMA50
◦ SMA20 crosses down SMA50 (long term signal identifies long term downtrend)
◦ The Price line crosses down the SMA20 line and the SMA20 line crosses down the SMA50 line (the
downtrend is evident when the 3 lines touch each other and turn down)
 Moving average convergency
divergency - MACD
MACD is a very popular market indicator when using technical analysis tools. It is composed of 3
main components.
◦ 1. MACD line: EMA (12): The average price of the last 12 sessions Minus EMA (26): The moving average
of the last 26 sessions
◦ 2. MACD signal line: is the EMA (9) of the line MACD
◦ 3. MACD histogram: is the MACD minus the signal line MACD
The MACD indicator is a very effective and versatile tool. There are 3 main ways of using the MACD
indicator:
◦ - The crossover of the moving average price.
◦ - MACD Histogram
◦ - divergence of MACD
MACD and moving average crossover
(MA)
The first method to use this is to study the phenomenon of crossovers of moving averages.
◦ When the short-term EMA (12) crosses and is above the long-term EMA (26), this is equivalent to the
MACD crossing and above the zero line.
◦ When the short-term EMA (12) crosses and is below the long-term EMA (26), this is equivalent to the
MACD crossing and below the zero line.
 ◦ Buy signal: A buy signal occurs when the MACD line crosses and is above the zero line.
◦ Sell signal: When the MACD crosses and is below the zero line, a sell signal appears

These warning signals usually appear very late. If using the crossover of the signal line and the MACD
line, the buy and sell signal will appear sooner and faster.
◦ Buy signal: Appears when the MACD line crosses and is above the signal line of the MACD.
◦ Sell signal: appears when the MACD line crosses and is below the signal line of the MACD.
 MACD Histogram
The MACD histogram is a fairly simple form, it tells the difference between the MACD line and
the signal line of the MACD.
There are two important things in the MACD histogram:
◦ - Convergence: The MACD histogram is shrinking, this means that the change in the direction of the
price line is slowing down. The MACD line tends to approach the signal line of the MACD.
◦ - Divergence: The MACD histogram is expanding or increasing in height (regardless of whether it is
negative or positive), this means that the direction of the upward price trend is fast and certain.
When the price line moves with the price trend strongly, the MACD histogram will increase in height.
When the MACD histogram does not increase in height or it begins to shrink, the market has a slight
downward trend and warns that there is a high possibility that the price line will reverse in the near
future.
◦ Buy signal: When the MACD histogram is below the zero line and begins to converge towards the zero line.
◦ Sell signal: When the MACD histogram is above the zero line and begins to converge towards the zero line.
Bollinger Bands
Bollinger Bands is a tool that allows users to compare volatility and related price levels over a period
of time. This instrument consists of three lines designed to enclose the majority of a stock's price
action.
◦ A moving average in the middle
◦ An upper line (SMA plus 2 standard deviations)
◦ One line below (SMA minus 2 standard deviations)

Standard deviation is a statistical unit of measure that provides an assessment of the volatility of
price charts. Using standard deviation ensures that the Bollinger lines will respond quickly to price
movements and respond to high or low volatility. A sudden increase or decrease in price will form a
wide band.
In addition to determining the relationship between price levels and volatility, Bollinger Bands can be
combined with price movements and other tools to provide signals and forecast important
movements.
The price line goes down to the lower Bollinger band: a buy signal is formed when the price line goes
down and touches the lower Bollinger band, the possibility of a rebound of the price line may
appear.
The price line rises to the upper Bollinger band: a sell signal is formed when the price line rises and
touches the upper Bollinger band, the possibility of a bounce down of the price line may appear.
Double Buy Signal: A Double Bottom Buy signal is generated when the price crosses the lower
bollinger line and stays above the lower bollinger line after making the next low. The low can be
higher or lower than the previous low. It is important that the second low is above the lower
Bollinger line. The price move to an uptrend is determined when the price moves above the middle
Bollinger line.
Double Sell Signal : A Double Top Sell signal is generated when the price crosses the upper bollinger
line and the top of the next rally fails to cross the upper bollinger line. The price move to a
downtrend is determined when the price moves below the middle Bollinger line.
Bollinger Bands Narrow: Bollinger Bands narrow before strong volatility
Money flow index - MFI
Money flow Index (MFI) is a technical indicator used to measure the strength of the cash flow in
and out of a security during the analysis period.
The MFI also shows a divergence between the index and the price action. When the price tends
to go high and the MFI tends to go low (or vice versa), a reversal is possible.
should sell when the MFI is above 80 points and buy when the MFI is below 20 points or sell
when the MFI has a down signal and buy when the MFI shows an up signal for short term
surfers. However, it is necessary to consider more RSI, Momentum, ADX and PSAR and market
trends for more accurate judgment.
 Average Directional Movement Index - ADX
Directional Movement Index (DMI)
◦ DMI is part of the ADX indicator. DMI includes 2 lines DI+ and DI-, simply understood as DI+ for buy signal and
DI- for sell signal.
◦ Buy signal: When DI+ crosses and goes above DI-
◦ Sell signal: When DI- cuts and goes below DI+
When using a DMI crossover to identify buy or sell signals, these signals are often misleading. To fix
it, we will use the ADX indicator to confirm the crossover of the DMI. The ADX (Average Directional
Movement Index) indicator is an important and indispensable part when using the DMI indicator.
Average Directional Movement Index (ADX)
◦ ADX is an indicator technique that shows whether the market is in a trending or non-trending state. When
the ADX has confirmed a trend, the DMI indicator will show more solid buying and selling signals.

ADX:
◦ Below 20: market is not trending.
◦ Increase from bottom to above 20: signal the start of a new trend. Now start thinking about buying or selling
in the current short-term trend.
◦ Oscillation between 20 – 40: If ADX increases in the direction from 20 to 40; it implies a strong confirmation
of the new trend that was formed earlier and continued moving in the direction it started. This means that
investors can use orders to buy or sell short (short-sell) depending on the direction of the market trend.
During this period, investors must limit the use of Oscillator and trend continuation indicators such as MA.
◦ Above 40: The current trend is very strong.
◦ Cross 50 in the up direction: extremely strong trend.
◦ Cut to the upside above 70: Champion (power trend), this happens very rarely
 PSAR - Parabolic SAR
PSAR is an indicator that indicates very early (very sensitively) the emergence of a trend. Its
downside is the up or down indicator. It does not represent a non-trending state of the market.
Unfortunately, this state takes up quite a long time.
◦ PSAR reverses below the price line (buy signal)
◦ PSAR reverses above the price line (sell signal)
 RSI - RELATIVE STRENGTH INDEX
The RSI is used to measure the relative strength or weakness of a security as it compares with itself
over a certain period of time (usually 14 days). The RSI is an oscillator whose upper and lower
bounds range from 0 to 100 (Bottom of the chart above: RSI – 14 days). The 50 gray middle moving
average. The RSI histogram has the following notable key lines:
The 50 line in the middle, is a sign that the security is about to increase or decrease in price. If the
RSI line rises above this line, it is a sign that the price of that security has bullish expectations
(Bullish). Conversely, if the RSI line falls below this line, it is a sign that the price of that security has
bearish expectations (Bearish).
The upper 70 line is considered an overbought, which means that the buying loss is too
much compared to the market balance. At that time, investors will sell less to return to the
equilibrium level, causing the price to decrease). Usually when the RSI line falls below 70, it
is a sign that the price of that security is about to fall.
Rules for opening a trade : BUY when the RSI line crosses below 30, forming a bottom and then turns
up to cut through 30. Conversely, SELL when the RSI line crosses above 70, forms a top and then
turns down to cut through 70.