EQUITY MARKETS Fundamental Analysis Technical Analysis

 EQUITY MARKETS

There are plenty of ways to analyze whether an investment is good or not, or when you should buy or sell it. The overall market, economic data, financial statements and fundamentals can all be beneficial factors to examine when looking at a new investment -- whether a stock or another kind of security.

But one of the major ways analysts and investors determine good investments is by using technical analysis. 

Unlike its counterpart fundamental analysis, technical analysis examines things like trends and price movement to analyze the viability of a potential investment. But what actually is technical analysis and what are some examples? 

What Is Technical Analysis? 

Technical analysis is a process used to examine and predict the future prices of securities by looking at things like price movement, charts, trends, trading volume and other factors. Unlike fundamental analysis, technical analysis focuses on trading signals to delineate good investments and trading opportunities by examining an investment's trends through its trading data and other statistical elements.

As a general rule, technical analysis prizes the current or past price of a security as the best indicator of the future price of that security. Technical analysis relies heavily on financial charts, data and statistics to uncover an investment's strengths or possible weaknesses and forecast trends in order to help analysts and investors decide if a security is viable or not, and for what action. 

Assumptions of Technical Analysis

"The future influences the present just as much as the past."

Friedrich Nietzsche (1844 - 1900)

Technical Analysis is built on some fundamental assumptions in regards to the fashion in which a market operates.

These assumptions are not only integral to you as an aspiring Technical Analyst, but are also central to Technical Analysis as a theory.

In summary, these assumptions include:

1. Price discounts everything.

2. Prices usually always move in trends and

3. History repeats itself over time!

A more detailed explanation of these assumptions will now be explored.

Price Discounts Everything

What exactly does this mean?

In a nut shell, this first assumption seeks to incorporate all the fundamental, political, macro and micro economic data as well as the risk component of a stock into the current market price at any one period.

This infers that the market price can be heavily influenced by an investor's perception of supply and demand, as well as the general broad economic overview at the time the price is captured.

Therefore, it can be assumed that Technical Analysts believe that the current market price of a stock reflects all the relatively important information that Fundamental Analysts are seeking to provide qualitative and quantitative explanations for.

This is one of the key reasons that Technical Analysts do not focus on the underlying data behind price variation, but rather focus on what the market is valuing the stock at.

Prices usually always Move in Trends

Prices usually occur in Trends, although some theorists argue that prices are completely random. Randomness of price is specifically related to the Efficient Market Hypothesis.

This theory is based on the fact that markets are "efficient" and information dissemination occurs instantaneously across the market.

In the real world however, this is never entirely achievable because of a varying number of factors and therefore complete randomness -- in its true form -- is never absolutely reflected.

Quite simply, the more efficient a market becomes, the faster information is dispersed to the market and as a consequence, the faster price changes to reflect this information.

From a charting perspective, this infers that prices follow a distinctly more "step-like-pattern" as opposed to a smooth trend for inefficient markets.

In consideration of this, prices can only adjust as fast as the news spreads across the market. It is important to realize that there is a subtle difference between information being available to the market, and investors actually processing this information to act rationally upon it.

Equally, since different investors have different risk preferences it infers that their reactions to this information will vary and increase the level of randomness in the market.

Those that have had several years experience in the market will be able to differentiate between these factors and as a consequence, will know which stocks will trend in patterns and which will not.

History Repeats Itself over Time

The psychology of trading and human nature in general is based on emotional factors.

Pride, greed, hope, anger, sadness and ego are all factors that affect the market place as much as they do our normal lives.

Even if some investors are completely risk adverse and others are risk tolerant -- these factors all have a substantial impact on the decision making process you adopt.

If you wrote down all the goals you seek to achieve in your trading strategy, you would find that the majority relate in some way to making a profit.

Fundamental vs. Technical Analysis: An Overview

Fundamental and technical analysis are two major schools of thought when it comes to approaching the markets, yet are at opposite ends of the spectrum. Investors and traders use both to research and forecast future stock prices. Like any investment strategy or philosophy, both have advocates and adversaries.

Fundamental Analysis

Fundamental analysis evaluates stocks by attempting to measure their intrinsic value. Fundamental analysts study everything from the overall economy and industry conditions to the financial strength and management of individual companies. Earnings, expenses, assets, and liabilities all come under scrutiny by fundamental analysts.

Technical Analysis

Technical analysis differs from fundamental analysis, in that traders attempt to identify opportunities by looking at statistical trends, such as movements in a stock's price and volume. The core assumption is that all known fundamentals are factored into price, thus there is no need to pay close attention to them. Technical analysts do not attempt to measure a security's intrinsic value. Instead, they use stock charts to identify patterns and trends that suggest what a stock will do in the future.

There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. In the following sections, we will focus on the S&P 500 Index during the period of January 2006 through May 2006. Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is different.

Line Chart

The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts.

Bar Charts

The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. A bar that is colored red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Candlestick Charts

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period’s trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colours to explain what has happened during the trading period. A major problem with the candlestick colour configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two colour constructs for days up and one for days that the price falls. When the price of the stock is up and closes above the opening trade, the candlestick will usually be white or clear. If the stock has traded down for the period, then the candlestick will usually be red or black, depending on the site. If the stock’s price has closed above the previous day’s close but below the day’s open, the candlestick will be black or filled with the colour that is used to indicate an up day.

Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the stock, which can distort traders’ views of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis.

CONCEPTS OF TREND, SUPPORT AND RESISTENCE

Trend is the direction that prices are moving in, based on where they have been in the past. Trends are made up of peaks and troughs. It is the direction of those peaks and troughs that constitute a market’s trend. Whether those peaks and troughs are moving up, down, or sideways indicates the direction of the trend.

3 directions of trend

1. An uptrend is made up of ascending peaks and troughs. Higher highs and higher lows.

2. A downtrend is made up of descending peaks and troughs. Lower highs and lower lows.

Source: Active Trader Pro®

3. A sideways trend (consolidation) is when prices move sideways in a horizontal range.

Support

Support is the level at which demand is strong enough to stop the stock from falling any further. In the image above you can see that each time the price reaches the support level, it has difficulty penetrating that level. The rationale is that as the price drops and approaches support, buyers (demand) become more inclined to buy and sellers (supply) become less willing to sell.

Resistance

Resistance is the level at which supply is strong enough to stop the stock from moving higher. In the image above you can see that each time the price reaches the resistance level, it has a hard time moving higher. The rationale is that as the price rises and approaches resistance, sellers (supply) become more inclined to sell and buyers (demand) become less willing to buy.

Types of patterns - Head and shoulder, Cup and Handle, double tops and bottoms, Triangles, Rounding Bottom and wedges

Head and Shoulders

The Head and Shoulders pattern is an accurate reversal pattern that can be used to enter a bearish position after a bullish trend. It consists of 3 tops with a higher high in the middle, called the head. The line connecting the 2 valleys is the neckline. The height of the last top can be higher than the first, but not higher than the head. In other words, the price tried to make a higher high, but failed. The closer the 2 outer tops are to the same price, the more accurate the pattern.

If the price breaks the neckline and closes below it, the pattern has completed. Conservative traders may look for additional confirmation. The target can be estimated by measuring the height of the pattern (from the neckline to the head) and projecting this downwards. Common stop levels are above the neckline or above the right shoulder.

 Cup and Handle

A cup and handle is a technical indicator where the price movement of a security resembles a “cup” followed by a downward trending price pattern. This drop, or “handle” is meant to signal a buying opportunity to go long on a security. When this part of the price formation is over, the security may reverse course and reach new highs. Typically, cup and handle patterns fall between seven weeks to over a year.

Double Top Pattern

A double top pattern is formed from two consecutive rounding tops. The first rounding top forms an upside-down U pattern. Rounding tops can often be an indicator for a bearish reversal as they often occur after an extended bullish rally. Double tops will have similar inferences. If a double top occurs, the second rounded top will usually be slightly below the first rounded tops peak indicating resistance and exhaustion. Double tops can be rare occurrences with their formation often indicating that investors are seeking to obtain final profits from a bullish trend. Double tops often lead to a bearish reversal in which traders can profit from selling the stock on a downtrend.

Triangle Patterns

Triangle patterns are a commonly-used technical analysis tool. It is important for every trader to recognize patterns as they form in the market. Patterns are vital in a trader’s quest to spot trends and predict future outcomes so that they can trade more successfully and profitably. Triangle patterns are important because they help indicate the continuation of a bullish or bearish market. They can also assist a trader in spotting a market reversal.

There are three types of triangle patterns: ascending, descending, and symmetrical. The picture below depicts all three. As you read the breakdown for each pattern, you can use this picture as a point of reference, a helpful visualization tool you can use to get a mental picture of what each pattern might look like. And here is the short version of triangle patterns:

Ascending triangles are a bullish formation that anticipates an upside breakout.

Descending triangles are a bearish formation that anticipates a downside breakout.

Symmetrical triangles, where price action grows increasingly narrow, may be followed by a breakout to either side—up or down.

What is Rounding bottom ?

A Rounding bottom is a chart pattern used in technical analysis and it is identified when a series of price movements forms a ‘U’ shape. Rounding bottom pattern is a bullish reversal pattern.

Rounding bottom appears in all time frames daily, weekly and even intraday time frames. The pattern represents a long consolidation which turns into bullish bias from bearish bias.

Wedge patterns are chart patterns similar to symmetrical triangle patterns in that they feature trading that initially takes place over a wide price range and then narrows in range as trading continues. However, unlike symmetrical triangles, wedge patterns are reversal signals and have a strong bias towards being either bullish – for falling wedges – or bearish – for rising wedges. Wedge patterns can be difficult to recognize and trade effectively since they often look much like background trading activity on charts