Technical Analysis & Stock Charts
June 12, 2009
Technical analysis of stocks is defined by Investopedia as the “method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity”.
Technical Analysis
In the world of technical analysis, the men and women who become analysts play part historian, part weather man. They look at the past performance of an individual to try and predict what “might” happen in the future. There’s a reason why the disclaimer, “past performance is no guarantee of future results” though. This job is not easy and the professionals are wrong just as often as they are right. Analysts will end up being “early” or “late” in their predictions, but the one that nails it on a regular basis ends up on CNBC.
The foundation of technical analysis came from the writings of Charles Dow early in the 20th century. Three main points of the Dow Theory are:
It’s all inclusive
The price of a stock at any time is indicative of all the information available that can affect the stock. This is the launching point for technical analysis.
Stocks are trendy
Like skinny jeans, stock prices tend to follow a trend. While there can be some random movements, like baby boomers storming the closest Abercrombie & Fitch, generally stock prices will follow a trend for a period of time. The difficulty is in figuring out when the trend is over. Who wants to be the last guy walking around with a Michael Bolton haircut?
Even if we know history, we are doomed to repeat it
Based on investor behavior, stock movement tends to do the same thing when certain factors occur. One example would be the run on banks we saw in early 2008. Like the late 1920’s, people thought their money would disappear (not the case if you are within FDIC limits) and rushed to withdraw it all. Who would have thought we’d see a repeat of that?
Stock Charts
Next, let’s look at three different styles of stock charts that are used in technical analysis and an example of each.
Overlays
These charts are placed over the standard stock pricing chart. One use for this is to follow moving averages of a stock. When looking at a moving average of a stock price, it is based on a certain time frame and is the average price of that time frame. This can filter out short term spikes and pick up longer term trends.
In the chart above for Wells Fargo (WFC), the orange line is the 50 day moving average laid over the daily stock movement.
Price-Based Indicators
One price-based indicator used for technical analysis is the Relative Strength Index (RSI). This is a momentum oscillator that measures sharp movements in a stock price. This is an indicator that suggests if a stock is either oversold or overbought.
This is an RSI chart for WFC for the same timeframe as above. J. Welles Wilder, the man that developed this chart in 1978, believed that if the chart went above 70, the stock was overbought, and if it fell below 30, oversold.
Volume-Based Indicators
Money Flow Index (MFI) takes a look at the dollar volume in terms of shares traded.
MFI is used much in the same way as the RSI. The values to keep an eye on in this example are 80 and 20.
Technical traders never rely on just one of these charts, the idea is to use multiple indicators to come up with enough evidence to make a move one way or the other. Hopefully this was a useful overview into the concepts behind technical analysis, is you have any questions just leave them in the comments below.
It’s definitely very interesting to see investors or financial analysts make sense of all the data from stock trends.
However, past trends just show the past – the trick to getting figure out what the future trend is. Meaning what is in – what is popular – or what is going to become popular. That way you know when to buy and when to sell.