Technical analysis examines market trends, price patterns and the flow of funds in an attempt to exploit potential patterns. Technical analysts utilize a variety of market indicators to assess whether an asset is trending, and if it is, the probability of its direction and potential for continuation.
Technicians look for relationships between price and market indicators, such as the relative strength indicator (RSI) and Chaikin Oscillator (ChiOsc). Other avenues of study include price chart patterns to identify potential future movement, such as the widely known head and shoulders or double top/bottom reversal patterns. Technicians also follow lines of support, resistance, channels and more obscure formations such as flags, pennants, wedges and cup and handle patterns.
For more information on particular technical indicators, the stockcharts.com ChartSchool is a great resource.
RELATIVE STRENGTH INDICATOR. The Relative Strength Indicator (RSI) measures the momentum and speed of price movements. RSI oscillates between zero and 100. Traditionally, the indicator is considered over bought when above 70 and oversold when below 30. RSI is an extremely popular momentum indicator.
Overbought / Oversold Indication. The chart below shows SPY with a 14-day (the default look-back) RSI. Working from right to left, the SPY got over bought in late January due to the effects ofQE2. Despite this over bought reading, the index did not decline. Instead, it stalled for a couple of weeks then continued higher. Four more over bought readings occurred before the stock finally peaked in late March. Momentum oscillators can become over bought (or oversold) and remain so in a strong up (or down) trend. The first four overbought readings foreshadowed consolidations or small pullbacks. The fifth coincided with a significant peak.
RSI then moved from overbought to oversold in May. The final bottom did not coincide with the initial oversold reading as the index ultimately bottomed a couple of weeks later. Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.
Divergence. Divergence signals a potential reversal point because directional momentum does not confirm price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.
The SPY chart above shows a bearish divergence from February-March. The index moved to new highs in March, but RSI formed lower highs for the bearish divergence. The subsequent breakdown in April confirmed weakening momentum.
A bullish divergence formed in the middle of May. The bullish divergence formed with SPY moving to new lows and RSI holding above its prior low. RSI reflected less downside momentum during the decline. The early June breakout confirmed improving momentum. Divergences tend to be more significant when they form after an overbought or oversold reading.
CHAIKIN OSCILLATOR. The Chaikin Oscillator measures the momentum of the Accumulation/Distribution Line. More specifically, it measures the different between the 3-day and 10-day moving averages of the Accumulation/Distribution Line, and is designed to anticipate directional changes by measuring the momentum behind the movements. A momentum change is the first step to a trend change.
It is important to note that the Chaikin Oscillator is an indicator of an indicator, making it three steps removed from the underlying price of the security. First, price and volume are reshaped into the Accumulation/Distribution Line. Second, moving averages (3- and 10-day) are applied to that Line. Third, the difference between the moving averages is used to form the Chaikin Oscillator.
The indicator is designed to measure the momentum behind buying and selling pressure (Accumulation Distribution Line). A move into positive territory indicates that the Accumulation Distribution Line is rising and buying pressure prevails. A move into negative territory indicates that the Accumulation Distribution Line is falling and selling pressure prevails.
Technicians typically use the Chaikin Oscillator to visualize how the price action has reacted to similar levels of buying/selling pressure in the past. If the Chaikin Oscillator is very high, it may be a signal that the security is overbought and more likely to sell-off. Conversely, a low indication may historically precede significant rallies.
As an example, I added lines of potential support (blue) and resistance (red) to the SPY daily chart below. Four of the five previous instances of the Chaikin Oscillator reaching – or dropping under – the blue line, led directly into substantial rallies in the SPY. One instance in mid-May was followed by a continuation in selling pressure. On the flip side, the red line of resistance was far weaker in indicating a potential change in trend. Nearly half of the instances failed. It’s important to analyze the success of the indicator for each individual security before deriving at a conclusion. In this specific case, we’re much more comfortable calling a bottom than we are calling a top in the SPY based on the Chaikin Oscillator.
Divergence. A bullish divergence forms when price moves to new lows and the Chaikin Oscillator forms a higher low. This higher low shows less selling pressure. It is important to wait for some sort of confirmation, such as an upturn in the indicator or a cross into positive territory. A move into positive territory shows upside momentum in the Accumulation Distribution Line.
A bearish divergence forms when price moves to a new high and the Chaikin Oscillator fails to confirm this higher highs. This failure reflects less buying pressure that can sometimes foreshadow a bearish reversal.
The green lines in the chart above show the Chaikin Oscillator forming divergences (both bullish and bearish).
BOLLINGER BANDS. Bollinger Bands are volatility bands placed above and below a moving average. Volatility is based on the standard deviation, which changes as volatility increases and decreases. The bands widen when volatility increases and narrow when volatility decreases.
Bollinger Bands consist of a middle band and two outer bands. The middle band is a simple moving average and is usually set at 20 periods. The outer bands are typically set 2 standard deviations above and below the middle band. That’s why the label on the chart reads “BB(20,2,0)”.
Bollinger Bands reflect (a) direction with the 20-period simple moving average and (b) volatility with the upper/lower bands. Statistically, the bands should contain roughly 90% of price action, which makes a move outside the bands significant. Technically, prices are relatively high when above the upper band and relatively low when below the lower band. However, these bands should not be used as a stand-alone tool, since prices can be relatively high or low for a reason. Bollinger Bands should be combined with other indicators to confirm bullish or bearish signals.
Walking the Bands. Moves above or below the bands are not necessarily buy or sell signals. At face value, a move to the upper band shows strength, while a drop below the lower band shows weakness. Prices can “walk the band” with a number of touches during a strong uptrend. Consider this: the upper band is 2 standard deviations above the 20-period simple moving average. So it takes a strong price movement to exceed this upper band, which is likely preceded by a strong fundamental driver. So it is imprudent to take the indicator as a stand-alone tool to buy or sell a security.
FLAGS AND PENNANTS. Both flags and pennants are short-term continuation patterns, marking a consolidation period before the previous move continues. They are usually preceded by a sharp advance (bullish flag/pennant) or decline (bearish flag/pennant) and mark the mid-point of the broader move. Volume should confirm the initial move, consolidation and resumption. Heavy volume tends to accompany the initial move and breakout, while volume subsides considerably during consolidation phases.
Flag: A flag is a rectangular pattern that forms at the end of a sharp advance or decline. It slopes against the previous trend – if preceded by an advance, the flag slopes down; if preceded by a decline, the flag slopes up. The price should be contained between two parallel trend lines, which forms the flag pattern.
Pennant: A pennant is a symmetrical triangle that converges as the pattern matures. There is no specific slope of the triangle necessary to identify the pattern; however, the price action should be contained between the two converging trend lines forming the pennant.
Price Targets: The price target for a flag/pennant break out is determined by the size of the flagpole (the distance of the sharp advance or decline that precedes the pattern). This distance is applied to the breakout point to determine the target.
WEDGES. Just like flags and pennants, wedges have a bullish or bearish tilt. The patterns begin wide and contract as the trading range narrows, typically on lighter than average volume. There are no price targets based on wedges.
A Rising Wedge is a bearish pattern that contracts as prices move higher, narrowing the trading range as it matures. The loss of upside momentum on each successive high gives the pattern its bearish bias. It acts like a spring that is tightening. Once it’s clear that the bulls momentum is waning and the shares have little room to run on the upside, the shares spring to the downside.
A Falling Wedge is a bullish pattern that contracts as prices move lower. The loss of downside momentum on each successive low gives the pattern its bullish bias.
DOUBLE BOTTOM REVERSAL. A double bottom reversal is a bullish reversal pattern. The pattern consists of two consecutive troughs that are roughly equal, separated by a moderate peak. An intermediate- or longer-term reversal is only confirmed once the key breakout point resistance is broken. In the chart of Morgan Stanley below, we show both a double bottom (w-bottom) and double top (m-top) reversal. Once the line of resistance is broken decisively, the shares continue almost uninterrupted toward the target price.
With any reversal pattern, there must be an existing trend to reverse. In the case of a double bottom reversal, a significant downtrend should be in place. The first trough should mark the lowest point of the current trend, which is followed by an advance. The high of the peak is often rounded, which signifies that demand is increasing, but there is too much hesitation for a strong break out to ensue. The subsequent decline tends to occur on lower volume and meets support from the previous low. Support is considered a band, not necessarily an exact price.
Volume is an important aspect of an advance following the second trough. There should be evidence that buying pressure is accelerating (and potential change in sentiment). A decisive break of the key resistance is necessary to confirm a double bottom reversal, which should also see a rise in volume. If a breakout occurs, the previous line of resistance becomes support.
The price target is measured as the distance from the trough lows to the intermediate peak. This distance should be added to the breakout point. Before a position is taken, however, an investor should wait for support to be broken in a convincing manner, and usually with an expansion of volume.
DOUBLE TOP REVERSAL. A double top reversal is simply a bearish alternative to the double bottom reversal. It consists of a prior uptrend, halting at a peak price. A trough is later formed, followed by a re-test of the peak. For the pattern to be fully formed, the previous trough needs to be taken out decisively on heavy selling pressure.