An Introduction to Technical Analysis
What is Technical Analysis and Does it Work?
Trading Volume
As well as price movement trading volume (ie the number of units bought and sold) also plays an important role in technical analysis. For example a rising price accompanied by rising volume is a healthy sign, the trend is likely to continue. A rising price but with a falling volume indicates a turning point is imminent. The same applies in a falling market.
Moving Averages
A moving average is the (mean) average (close) price of the past n periods. Moving averages help filter noise and highlight trends. They can be calculated over any number of trading periods and for trading periods of any length. A moving average based on the mean of all prices is known as a simple moving average. Variants include the weighted moving average, in which the latest price is given a weight of n, the previous one n-1 etc down to the oldest one with weight of 1. With an exponential moving average the weighting for a period increases by a percentage of the one before it, eg the first price has a weighting of 1, the next a weighting of 1 + 10%, the next a weighting of (1 + 10%) + 10 % etc.
If the price moves upwards above its moving average a buy signal is generated. If the price moves downwards below its moving average a sell signal is generated. It is common to use a combination of two (or more) moving averages with signals being generated as they cross one another.
Bollinger bands
Bollinger bands, devised by John Bollinger are drawn above and below the moving average at a distance of m standard deviations either side of it, with m often set to 2. Bollinger bands illustrate price volatility, widening when prices are more volatile and narrowing when they are less so. Generally a price moving above the upper band indicates "sell", whereas movement below the lower band indicates "buy".
Momentum
Momentum is the rate of change of prices.
Momentum = current price - price at n trading periods ago
A buy signal is generated when momentum becomes positive, and a sell signal when it becomes negative.
Relative Strength Indicator
The Relative Strength Indicator (RSI) is similar to momentum, but more sophisticated. It is an oscillator that varies between 0 and 100. At around 70 a stock is considered overbought (a signal to sell) and around 30 it is considered oversold (a buy signal), though these levels can vary according to market conditions.
It is calculated thus over n trading periods (with n typically between 9 and 25):
Relative Strength (RS) = average change on up days / average change on down days
RSI = 100 - (100 / (1 + RS) )
The smaller the value of n the more volatile the RSI and thus the more signals generated. A small n value carries the risk of more false signals, whereas a larger n carries the risk of missed buy/sell opportunities.
Recommended Reading
Technical Analysis of Stock Trends, 8th Edition Robert D. Edwards, John Magee. A critical reference for investors, especially in today's tumultuous markets, this seminal book (the first to produce a methodology for interpreting and profiting from the predictable behavior of investors and markets) revolutionized technical investment approaches and continues to show traders and investors how to make money regardless of what the market is doing.
Now, with the addition of noted technical analysis authority W. H. Charles Bassetti (editor), as well as charts and graphs that pertain to today's market environment and major stocks, this completely updated and revised edition confirms the wisdom of the original work for today's markets.
Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points Martin J. Pring. Recommended for professional certification by the Market Technician's Association The Original and Still Number One Technical Analysis Answer Book Technical Analysis Explained, 4th Edition, is today's best resource for making smarter, more informed investment decisions. This straight-talking guidebook details how individual investors can forecast price movements with the same accuracy as Wall Street's most highly paid professionals, and provides all the information you will need to both understand and implement the time-honored, profit-driven tools of technical analysis.