INTRO TO TECHNICAL ANALYSIS: PART 2
Voleo analyst, Mike Nesselbeck, continues his introduction to technical analysis. In this part, Mike explains how to use charts to manage investment opportunities.
Technical analysis can be a very complex art/science, or it can be a basic tool to help you identify and manage investment opportunities to buy or sell. It is up to the individual regarding how complex you want your analysis to get. From part one we identified the uses, benefits and downfalls of using technical analysis. In this post, we are going to be talking about how one can actually use technical analysis to identify attractive stocks in the market. Identifying an attractive investment to buy begins with the stocks trend, and those depend on the time frame you are looking at. Things to consider include if it is in an uptrend or downtrend, and if that trend is broken or still intact. To properly address these trends, we need to use a certain type of chart called a log chart.
First, knowing what type of chart to use is essential for comparing time frames and chart trends properly. There are two types of charts people can use for viewing their stock market investments. The first type is an arithmetic chart, which spaces out the prices evenly along the graph. The second type is a log chart. A log chart is best for identifying trends because it measures price distances in terms of percentage change to make changes in price relative regardless if the stock is $50 or $0.50. For example, if a stock price moves from $100 to $110 this would be a 10% increase; if the stock moved from $110 to $120 this would be an 8.3% move. On an arithmetic chart, the 10$ price moves would have the same distance, but with a log chart the moves would not be the same distance because it is a different percentage increase. This makes charting trends easier, which I explain later.
To continue, we are going to look at chart timelines. A stock price trend is a continuous move of the price in a certain direction. Trends can be in an uptrend, with sustained higher price movements, and downtrends with sustained lower price movements. As well, there can be continuation trends where the stock price stays in a range that is neither moving continually higher or lower. Chart timelines are very important because short and long term charts may tell completely different stories. To illustrate, the chart below of Amazon shows a long term view of one year. As you can see, this chart tells a great story of a stock price that has continued to grow over the year.
However if you look at a short term chart below of 3 months, it tells a different story. Amazon looks like it reached a top back in December and the stock price has continued to fall lower into the start of February. For a short term trader, this three month chart does not look promising if you are looking to buy the stock. In contrast, a long term investor looking at the one year chart may want to buy the stock. They may want to buy because the stock has experienced a long term upward trend, and a drop in price but has held the upwards trend. Although the stock has declined since the New Year, this may make it more attractive to buy now. A long term view generally ranges from around six months to five years, while a short term view can range from one day to around half a year. It is always best practice to look at both a long-term chart and a short-term chart to identify the prevailing trends, and if it is a good opportunity to invest. The long term trend is significant because it shows the overall prevailing direction of the stock. Taking Amazon for example, the stock price has a prevailing uptrend, with a short term downtrend. The short term downtrend would have to be sustained for a while to change the overall direction and momentum of the long term uptrend.
Technical analysts who make investment decisions for longer periods tend to look for a couple things. First and foremost is the stocks ability to stay with its current trend, and how close it is to the top or bottom of that trend line identifies if it is a good time to buy. Secondly, the analyst may look for a continued up-trend, which I will show you how to identify. A trend line is defined as a straight line that touches or connects two or more low or high points of the stock price. We will use Starbucks as an example below. As you can see from the chart, there is both short term and long term trends. The long term trend has developed over the course of almost two years, while the short term trends can be seen over a period of two to three months. From the long term chart of Starbucks, you can see how short term trends develop in the overall long term trend. It is important that the short term trends do not break the long term trend, or this may signal an overall change in the long term trend.
To illustrate the effect short term trends have on long term trends, let’s take a look at a two and a half year chart of Disney. From the major long term trend, you can see how a trend line is drawn, connecting two or more low points. The uptrend line connecting the major low points acts as a support line for the stock. For the uptrend to continue, the stock price must stay above this line. A break in this line may signal a change in the stock’s momentum. As you can see from the start of 2016, Disney’s stock has broken its long term uptrend channel, and continued to move lower into February. Seeing a break in a long term trend can be an important point where you want to sell or buy. If I saw this long term trend break in Disney’s graph, I would consider not investing in this stock until an uptrend is prevalent again, as this break may signal that a downtrend could develop. This represents the significance of short-term price movements on the overall major trend of the investment. It only took about three to four months for the short term downtrend to break the long term uptrend line.
Lastly, I would like to show you an example of a down trending stock, and how its trend line acts as a line of resistance the stock sometimes has trouble breaking through. On multiple occasions, the stock tried to break its downward trend line, but as you can see it failed to do so and moved lower every time. Although this is not the case every time, it can give you a general idea of where the stock is headed if it does not break that resistance trend line.
To conclude, we have looked at time frames that technical traders and investors use to analyze a stock, given the time period they use. To identify time frames properly and the trends associated, we looked at log vs arithmetic charts and the benefits log charts have. It is important to look at both the long term and short term trends when looking at a potential investment. Just because a stock is in an uptrend on a four month chart, does not mean it will continue if the long term trend is downwards sloping. Additionally, we looked at how trend lines act as a support line for up trending stocks, and how trend lines can act as resistance for down trending stocks. Be sure to tune-in next week to learn more about personal investment management, as we will continue to discuss trend lines, how they create price channels and the incorporation of stock volume that helps confirm trend and price channel movements.
Written by Voleo Marketing Analyst, Mike Nesselbeck
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