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Technical Analysis
Simple Practical Applications

Many people can see that technical analysis can be useful;
but they are not sure how or where to start.

The information below explains some simple and practical applications.
The bottom line is: (a) better quality investing, and (b) smaller investment losses.

Warning - None of the information below is guaranteed to work, so take care!

You are here: Share Market Toolbox > Technical Analysis > Technical analysis - simple practical applications
Related links: Technical Analysis - Getting Started; Technical Analysis - What is it?;  Technical Analysis - The Proof;
 4 Windows approachTrends; Trends in multiple time frames; Stop Loss; Support and Resistance; Dow Theory

Introduction

Since the GFC (2008+) many investors have come around to seeing that there is some merit in utilising technical analysis; but perhaps they struggle with understanding how to make a start. The information below works through some of the basics of technical analysis, and some simple implementations. But first we consider why this is so vitally important.

Why is this important and useful?

Firstly, it is important to understand that:

Price charts summarise the underlying opinions and emotions of the market participants.
Every chart tells a story. It pays to understand the stories in the price charts.

This is important because if a company's share price is tending to rise over time (an uptrend), it tells us that there is an imbalance of supply and demand. That is, there is a greater demand for the shares than there is supply. For anything, when there is enough demand, the potential purchasers will try to outbid each other in order to secure a purchase. In bull market conditions, many stocks experience greater demand than supply, and so the share price rises. And this is captured in the price chart. The price chart has a story to tell us, and this can be very useful if only we know how to interpret the stories in the charts.

Therefore, at the simplest level we can find a stock with a share price in an uptrend, and we can buy a position and join the trend. Then when the uptrend is ending, we can sell the position to lock in profits and protect our capital from any possible downside. In the material below we look at the concept of a share price trend, and look at the idea of a Stop Loss and Exit Strategies.

However, as we proceed here, it is important to clearly state that we will usually miss the very start of a trend, and the very end. So we should not go looking for a turning point in anticipation of a possible uptrend - this is wishful thinking and speculation.

 

Step 1 - Find stocks in a rising price trend

The first challenge for everyone in this game is to find a good investment candidate. One approach is to find a stock in a rising trend, and to join the trend. This is because the experts say that the "trend is your friend". The only problem is that not every uptrend is going to be profitable. So we need to have a plan to close a position that is turning against us - an Exit Strategy.
 
However, being able to find an uptrending stock is very handy, and there are many ways to do that.
 

About price trends on the charts

The first notion to understand is the idea of a price trend - both the uptrend and the downtrend. This is important because once a trend is confirmed to exist, then it is likely to continue. This is because of the way the markets work, and the ways in which market participants take part in the buying and selling process in the markets. It's also to do with the investing/ trading emotion and psychology.
 
How to identify an uptrend or downtrend? - There are several ways to do this. Some people suggest that in basic terms, if the share price runs across the chart from the bottom left corner to the top right corner, then an uptrend must have been in place. However, a key approach used by technical analysts that is both precise and fairly simple is described in the following paragraphs.

Uptrend - Look at a simple line chart of a stock (like the sample shown at right). It could be a daily* chart, or a weekly* chart, or in fact any time period. On the price chart, an uptrend is defined as a series of Higher Peaks and Higher Troughs. To do this in practise, first identify a peak on the chart, and then look to the right for a higher peak. Likewise, identify a trough after the first peak, and look for a higher trough (note: it does not matter whether the first peak is before or after the first trough, because the important point is to identify the next peak and trough). A downtrend is defined as a series of Lower Peaks and Lower Troughs.
 
Once an uptrend is in place, it is likely to continue. That means that if we identify a stock with a share price in a rising trend (an uptrend), then we could buy into the stock and it is likely to continue rising (not guaranteed to keep rising, but is likely to continue rising). If it just happens that the uptrend is about to end, then we need to implement our exit strategy without delay.
 
Beware! - Trends don't last forever - It is important to understand that a price trend will not last forever. So at some point it might be very appropriate to reduce a position, or even sell out of the stock completely. It is very important to be clear about the conditions that might trigger a sell decision - an Exit Strategy. Before we enter a position, we do have to be clear about the exit - more details below.
 
   
 
Uptrend
An uptrend - A sequence of
Higher Peaks (HP) and Higher Troughs (HT)
(click on the image for a larger version) 

* About daily and weekly price charts.
A daily price chart (like the sample above) shows
the close price at the end of every trading day,
all joined together with short straight-line
segments. It is normal to only show the trading
days - normally Monday to Friday each
week, and with public holidays not shown.

A weekly price chart shows the close price at the
end of each week, all joined together with short
straight line segments. A monthly price chart is likewise. And none of these show any detail about
the range in share price during the period (during
the day, week or month).

A candlestick chart shows the range in price during
each period - during each day, or week, or month.
See some deatisl about candlestick charts.

Example uptrend - The chart at right is a weekly line chart of Commonwealth Bank (CBA) showing a Trough in September 2011, followed by a Peak in October, then a series of Higher Peaks (HP) and Higher Troughs (HT). The green line sitting under the price is the uptrend line, with all price action sitting above the line to confirm the uptrend. However, the share price fell below this line in April 2012 indicating that the uptrend had finished.
 
[By definition, an uptrend line sits under the price action, and is touched at least twice but preferably three times by the price line.]


Downtrend - The next image at right is a simple weekly price chart of National Australia Bank (NAB) from its peak of about $43 in November 2007, to its low of about $17 in March 2009. In this chart, note the sequence of lower peaks with one exception from March to May 2008 (this is about a third of the way across the chart, and when most of the stocks in the market rallied for about 8 weeks).
 
We have said above that once a trend is in place, it is likely to continue. So once a downtrend is confirmed (the first Lower Peak and Lower Trough), it is considered likely to continue.
 
** WARNING ** Anyone who suggests that a stock in a downtrend is a buy, should be asked for a money-back guarantee that it won't fall further. If a stock's share price seems to be cheap, and a downtrend is still in place, then the price might get even cheaper. Buying a stock whilst it is downtrending in the hope that the price might soon rise is only wishful thinking. Some professionals will suggest that dollar cost averaging will allow you to average out the costs; but this in an absurd idea, because an uptrend or a downtrend is likely to continue until it is confirmed to be over. If a stock is downtrending, the downtrend might continue for a long time, and the price might fall a lot further. This even happens to some blue chip stocks - see the disappointing details.
 
See more about price trends.
 
A down trend.
A downtrend - A sequence of
Lower Peaks and Lower Troughs
(click on the image for a larger version)

Case Study example - SDF

The price chart below is a good example of an uptrend. Note the key points below.
 
SDF - Sample uptrend explained
Weekly price chart of SDF in an uptrend
Key points for the above price chart:
  1. This is a simple weekly line chart. The thick black line shows the close price each Friday, each one joined to the next one with a short straight line segment. (It does not show anything about the range in price during the week.)
  2. Almost the first half of the chart (until the vertical red dotted line) indicates the share price trading up and down but within a finite range. There are two peaks at about $1.55, indicating a weekly resistance price level.
  3. From about the date of the vertical red dotted line the price has taken off and rallied higher with a series of higher peaks, and higher troughs - an uptrend according to our definition.
  4. The red and blue lines are Exponential Moving Averages (EMA). The red one is a 30-week EMA, and the blue one is a 15-week EMA. Note that they were basically flat (horizontal) across the first portion of the chart. The share price jumped above them in early February, and the two EMA curves turned upwards and rose consistently higher. This is very relevant to Stan Weinstein's teachings.
  5. The two sets of dots that rise across the chart are the Wilson ATR Trailing Stop chart indicator (more on Stop Loss and Trailing Stop below). The idea with the first set of dots (the dark coloured ones) is as follows: "if the share price falls to the price level of this dot in the next week, then this is an exit signal".
 

Step 2 - Invest wisely

If we want to invest wisely, there are a few key points to consider, all of which ought to be planned out in advance:
  1. Don't buy shares in a confirmed downtrend, because the downtrend is likely to continue until it is confirmed to have ended (this is one of the six tenets of Dow Theory).
  2. Use clever risk and money management, by not putting all eggs in the one basket. And consider the topic of position sizing. See more about risk management in the markets.
  3. Have an Exit Strategy already planned.

Step 3 - Protect your capital

This is perhaps the hardest and most challenging aspect. Once we have bought a parcel of shares, it is important to consider protecting the capital from any downside. A small drop in price might be okay, and it might be the normal part of the daily and weekly cyclical moves of the share price. However, a significant price drop is perhaps something that we don't want to tolerate.
 
If we subscribe to the idea that a stock which has turned and is now in a confirmed downtrend that is likely to continue, then we really want to close the position to limit any losses. [Note: If we have a good exit strategy, and we have small losses and larger profits, then we might still be able to be profitable with a win loss ratio of 4 to 6 - that is, 4 wins to every 6 losses can still be profitable.]
 
To achieve this means utilising a pre-determined exit strategy. Just one possible approach is a Stop Loss; but there are many ways to do that also.
 

Do we really want to sell the shares?

What's wrong with holding the shares for a long time? Why can't we simply buy and hold any more?
 
Why do we invest in the share market? Because we enjoy it? Or because we want either short term income from dividends, and/or capital growth? The reality here is that if we want to increase our chances of being profitable, then we have to accept that some shares will fall in value, and can fall a very long way, and that some of these might never recover. Don't forget, when we lend our money to a company by buying their shares, we are doing this on the basis that we can take our money back at some stage in the future, and see some appreciation. Otherwise we could be better off with our money in the bank earning interest.
 
A range of different circumstances can cause a company's shares to suddenly be over-valued, and to experience a mass of sellers wanting to sell the stock. An excess of supply with declining demand will result in a falling share price. Do we really want to be nice people and allow the company to devalue our shares? Or would we rather cash them in and protect our capital from further falls?
 
To achieve this, many investors need to adjust their investing mind-set. Many investors need to be comfortable that there might be a day when it is in their own interest to sell their shares.
 

Step 4 - Consider a Simple Stop Loss

A simple Stop Loss is a common tool used by many traders and investors to identify a weakening share price and to give a very clear signal that an exit might be prudent. It can be explained as follows. There are many ways to determine a Stop Loss value.
 
By way of example, the daily price chart below shows an uptrend for CBA from November 2012 into April 2013. This uptrend is distinguished by a series of peaks and troughs, but the alert observer will also see that between some of the peak/trough pairs there is actually a sequence of lower peaks and troughs (ie. a downtrend). This touchs on the topic of trends in multiple time frames (which we can't stop to discuss here, but the link provides more information for subscribing Toolbox Members). However, do take a look at the short horizontal lines on this chart. The green ones sitting under the price action are potential levels of support, and a good place to set a Stop Loss level (see more details about Stop Loss).
 

CBA and a series of Stop Loss levels  
 
These Stop Loss levels are placed on the chart once we can see that a clear trough has developed. If the price subsequently falls back to this price level, and continues below the level, then we would sell. For instance, near the start of this chart, the first horizontal line and label "1" indicate a trough in the price at about $58 in November. Going forward, if the price fell back to this level, we would sell. As the price continued higher into January, and then fell back to about $61 to form another trough, we would have scrapped our previous stop loss level of $58, and adopted the level of about $61 as the new stop loss level. And so we would continue as the price rose over time.
 
In this text we keep saying "a stop loss level of about...". It is important to set your actual stop loss level a little under the last trough in the price, because many less experienced investors will also have a stop at a similar level. And when the price falls they will all close their positions. But the short term trading desk professionals all know this, and they know they will be able to pick some stock at these levels, before the price continues to rise. Remember that once all of the available supply is gone, the price will have to rise. So be careful not to get caught out, and do have your stop loss a little lower so as to be utilised with a genuine falling share price. 

Initial Stop versus Trailing Stop

Just to clarify some terminology, the first Stop Loss line on the simple example above would be consider the initial stop loss value, and all the other stop loss levels at higher values in this price trend are referred to as trailing stop loss values.
 

Trailing Stop using a chart indicator

Without trying to explain too much about it here, the charts at right are some more examples of a Stop Loss (actually a Trailing Stop Loss).
 
In these examples, the sequence of heavy dots that rises across the chart under the share price is the stop loss value. The way to read it is that if the share price in the next period falls to the level of the dot, then we should sell. We can see in the second example that the price has fallen below the dots towards the end of the chart so that a sell signal was given.
 
In both charts here, the row of dots running across and up the price chart is the Wilson ATR Trailing Stop chart indicator (available in BullCharts software and others). It is based on the Average True Range (ATR) calculation, and does not fall on the chart. It is just one of many chart indicators that are available for this purpose.



 


Step 5 - Consider other exit strategies

There are many ways to determine how to decide to exit a position. One of these is shown in the sample chart at right.
 
Sample at right - The example chart at right shows CBA's weekly share price in October to December 2007. On this chart a dotted horizontal red line above the price action indicates a likely resistance level - a price above which no one is prepared to buy the stock at this point in time. The rising blue line across the chart is a Moving Average (MA). The observations we can make are as follows:
  1. The share price made a "peak" in the week of 29 October.
  2. Over the following weeks it failed to move higher than that peak, indicating a possible resistance level. The price peaked in the two weeks commencing 3rd and 10th December , then fell in the following weeks. This confirmed the Lower Peak (indicated on this chart as "Lower high"), which confirmed the end of the uptrend that had been in place.
  3. By early January the MA curve had flattened, and the share price had fallen below the MA. According to Stan Weinstein*, this is a classic sell signal
* - "Secrets for Profiting in Bull and Bear Markets", 1988, Stan Weinstein.
 
See more information about Exit Strategies



Step 6 - Implement and action your exit strategy

Okay, so you have an exit strategy written down so that it is clear in your mind. That is, when the specific condition that you have described occurs, you can action your exit without a second thought. This is most important. The first loss is always the smallest. Remember that we can be profitable with a win to loss ratio of 4 to 6 (ie. 40 percent of trades are winners), provided the losses are small and the wins are large.
 
But, how do we know when the share price has triggered our exit condition? If we are using a simple stop loss, and we have determined that if the share price falls below a particular value, how do we know when the share price actually falls to this level? We don't want to spend all day watching the share price. Here are a couple of methods:
  • For an End of Day (EOD) investor, the charting software can be used to implement an alert, and then after you download the latest EOD data the software can flag the stocks where a particular price level has been triggered (eg. BullCharts software can do this).
  • If you would like a simple way to know as soon as a share price has hit a particular level, then utilise the alert tools that your online broker offers. For example, if CommSec is your online broker, they have an alert service where you can easily set up an alert so that if a share price hits a specific level, their system can send you either an informational SMS message and/or an email.
There are many ways to make the final decision as to whether to exit now, or wait for a second signal of some form. It is important to have thought through the process and have it clear in your mind.
 

Summary

In the information above we have looked at some of the simpler ideas regarding technical analysis, and some of the straight forward ways in which we can utilise technical analysis. However, this is only the beginning, and there is a lot more to technical analysis than what is shown here. There is so much to this subject that a successful technical analyst only needs to use a small amount of it. There is no need to understand everything about the subject. The secret is to learn just enough.
 
Good luck with your investing / trading, and watch out for the sharks in the ocean.
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