INTRODUCTION TO TECHNICAL ANALYSIS
A person who puts money into the stock market can either practice investing long term or trading to capitalize on price movement. Investing is an activity that looks at the company behind the stock share. The investor essentially buys a piece of the company by buying a share. The common stock market strategy that investors use is called value investing. Value investing involves the analysis of the stock price based on the performance and prospects of the underlying company and looks for bargains or discounts. Value investors then buy the stock for the mid or long term expecting to profit from the stock price increase, profits that are known as capital gains.
In contrast to stock market investors are stock market traders. Traders, for the most part, are not concerned with the companies the stocks represent, they only look at the movements of the stock price. Traders use a basket of techniques under the label of technical analysis in order to trade in and out of a stock with the objective of making a profit. Technical analysis makes extensive use of stock price charts as a basis for anticipating price movement. One key topic under technical analysis concerns the concept of trendlines. A trendline on a chart can be depicted by connecting the high points or low points of a price pattern. The resulting trendline will show the stock price moving up, down, or horizontally. A trendline connecting the highs or peaks of a price line defines a resistance level, or the ceiling for the stock price. The trendline connecting the lows or troughs of a price line defines the support level or floor for the stock price. Therefore, a trendline informs the stock trader of the general direction of a stock price and the upper and lower price limits of the stock price for the period under consideration.
If a trendline moves sideways or horizontally this is known as a continuation or consolidation. During a consolidation the stock price defines a corridor in which it moves up and down continually, hitting the resistance and support levels. Consolidations do not last indefinitely — at some point the stock price may break the resistance or support level, resulting in an upward or downward trendline known as a breakout. It is important for technical analysts to understand if the stock price is in a consolidation phase or if, from a consolidation phase, it will launch into a breakout. Timing the buying and selling of the stock with these movements is the source of profits for the technical trader. For this reason traders have identified stock price chart patterns that can serve as signals for future stock movements.
Some of the most common patterns are pennants, flags, and cups and handles. Pennants form a triangular pattern on a stock chart. A pennant pattern is created by the convergence of the trendlines defining the resistance and support levels. The pennant pattern shows a steady narrowing of the trading range. This is usually accompanied by a decrease in the number of shares being traded. The pennant is a signal of a price breakout. Flags are formed by parallel sloping support and resistance trendlines. The downward sloping flag occurs as an upward trending stock price falters and goes in the opposite direction. Upward sloping flags occur after a period of sustained stock price drops. The flag pattern is also accompanied by declining volume and is taken as a signal to prepare for a breakout. A cup and handle pattern initially shows a drop in the stock price forming the start of a cup. Prices will gradually recover forming a “U” shape, which is the cup pattern. When the “U” shape has been formed a stock price pull back will happen, forming a handle. With the completed cup and handle pattern, technical analysts expect price to trend upward.