technical analysis -...

Technical Analysis Reference Guide

©2015 TD Ameritrade IP Company, Inc., All rights reserved. Terms of use apply. TECHNICAL ANALYSIS

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© 2015 TD Ameritrade IP Company, Inc. All rights reserved. 04/2015

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©2015 TD Ameritrade IP Company, Inc., All rights reserved. Terms of use apply TECHNICAL ANALYSIS

WelcomeWelcome to the world of technical analysis. Each topic taught here is designed to build your confidence in and strengthen your understanding of the tools available to you. The principles you will learn are transferable to almost any market in which there are sufficient buyers and sellers to create liquidity.

Please download the companion Online Course slides in PDF format from the Investools Education Center by clicking on the Adv Technicals Course icon > click I Agree on the Disclaimers page > in the left hand menu under Resources click on Download Slides.


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Technical analysis often involves many different indicators. The most influential indicator—and perhaps the most important—is price itself. Many indicators are derived from price.

Through price, you can recognize candle patterns, resistance levels, price patterns, support levels and other helpful insights.

There are three tenets, or principles, of technical analysis.

1. Market action discounts everything.

2. Prices move in trends.

3. History repeats itself.

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Defining the trend enables you to follow the prevailing direction of a stock’s price movement. It is said that “an object in motion stays in motion.” This principle of motion also applies to stock trends. Identifying and trading a particular trend is one way experienced investors put probabilities on their side. Remember, it is easier to swim with the current than against it.


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Trend is determined by analyzing a stock’s price on a chart. Stocks are like waves with regular ebbs and flows. A stock can rally higher and then pull back, creating peaks and troughs just like a wave.

Trends occur over various time cycles or time horizons. Short-term trends are typically days to weeks. Intermediate-term trends are months to one year. Long-term trends are more than one year.

When identifying short-term uptrends, compare recent and previous highs . When identifying short-term downtrends, compare recent and previous lows.

1-2-3 Reversal: When identifying trend reversals, locate a combination of three higher highs and lows.

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Technicians use relative strength to analyze and compare stocks to one another or to a benchmark such as an index or sector. The Relative Strength indicator default setting compares the chart to the SPX.

This comparison creates a relative strength line that can be analyzed as you would analyze any line on a chart. If the line is rising, the stock has the strongest relative strength. If the line is falling, the index has the strongest relative strength.


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It is important to realize that the trend of the relative strength line is not the same as the trend of the individual stock or sector. As shown, you can have rising sectors despite a falling relative strength line. This simply means the sector is not performing as well as the SPX that it is being compared to.

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Technicians use many different chart types.

The line chart only plots the closing price for each period and connects those prices with a single line. The line chart is used to see trend and support and resistance levels.

The bar chart tracks the opening, high, low and closing prices for each period and can be useful when determining entries and exits.

Candle charts have been used since the 1700s when they were used in Japanese rice markets. Like a bar chart, candles show three things: opening price, trading range and closing price.

As with any investing discipline, it is important to have a thorough understanding of the basics of charting and technical analysis to ensure you have a strong foundation upon which to build. All too often, investors believe they don’t need to spend as much time on these basic principles, only to have their lack of preparation come back to haunt them. Learn these concepts backward and forward. You’ll be glad you did.

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©2015 TD Ameritrade IP Company, Inc., All rights reserved. Terms of use apply. TECHNICAL ANALYSIS 8

BULLISH

Dragonfly Doji: Confirmation not required. May wait for higher close.

Hammer: Confirmation not required. May wait for higher close.

Inverted Hammer: Confirmation with higher close.

Bullish Harami: Confirmation with higher close.

Piercing Line: Close above the midpoint. Confirmation not required. May wait for a higher close.

Bullish Engulfing: Confirmation not required.

Morning Star (three candles): Confirmation not required.

BEARISH

Tombstone Doji: Confirmation not required. May wait for lower close.

Shooting Star: Confirmation not required. May wait for lower close.

Hanging Man: Confirmation with lower close.

Bearish Harami: Confirmation with lower close.

Dark Cloud Cover: Close below the midpoint. Confirmation not required. May wait for a lower close.

Bearish Engulfing: Confirmation not required.

Evening Star (three candles): Confirmation not required.

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Support and resistance is one of the most important technical concepts. Support and resistance levels are price levels that are created by the buying and selling pressure of investors. Prices tend to bounce up off support levels and bounce down off resistance levels. As with all technical principles, support and resistance levels are not absolute, but using these levels can help as you try to increase your probability of a successful trade.


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The concept of support and resistance is relatively simple. However, identifying appropriate support and resistance levels is much more involved.

Support is where buying pressure becomes stronger than selling pressure and is a price level that is difficult for a stock to penetrate on the downside. It may be a horizontal or diagonal price level.

In most instances, support levels are important trading areas. In a downtrend, old support can become new resistance. Analysts examine past support levels and, assuming the psychological and financial conditions that existed in the past still exist, project where future support levels will be. Investors then use these projected levels in their future trading decisions. The more often a stock price bounces off a support level, the stronger it becomes.

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Resistance is the opposite of support. It is where selling pressure becomes stronger than buying pressure and is a price level that is difficult for a stock to penetrate to the upside.

In an uptrend, old resistance often becomes new support. It may be either a horizontal or diagonal price level. Just like support levels, resistance levels are created by market participants. The more often a stock price bounces off a resistance level, the stronger it becomes.


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When support or resistance is established with two or more touches, high volume should confirm the breakout. Price typically closes 1% - 3% past the level.

Price Targets: When price breaks out of a support and resistance channel, the price difference between support and resistance can be added to the resistance price for a bullish price target and can be subtracted from the support price for a bearish price target.

Example: A stock trading between support at 45 and resistance at 51 would have a $6 difference. If the stock breaks out of resistance the bullish price target is 57. If the stock breaks below support the bearish price target is 39.

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Another form of support is found in gaps.

BREAKAWAY GAPS

These usually occur after a short-term consolidation or correction. They generally take place with above-average volume. These gaps create a significant level of support or resistance.

RUNAWAY GAPS

These gaps occur while a stock is trending. They gap in the direction of the trend on average to above average volume. They signal a very strong trend. The gap creates a significant level of support. It is held that these gaps will occur near the middle of a trend and can be used as a measuring point for a future target. This is why they are also referred to as measuring gaps.

EXHAUSTION GAPS

Exhaustion gaps appear at the end of a trend. They often occur after a runaway gap. Unfortunately, there is no way to distinguish this gap until the price closes under it.


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Use gaps as potential areas of support or resistance. You may find them useful for managing your risk as areas to adjust stops.

At times it may be beneficial to ignore gaps. Some potential gaps to ignore are buyouts, ADRs, commodity gaps and common gaps.

After-hours price action may also create a gap on the open. A gap may be anticipated if there are tighter bid/ask spreads in after-hours trading. Gaps created at the open that are less than 10¢ to 20¢ are often ignored. Always look for confirmation of the gap with volume to identify significance.

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Market analysts and technicians have devoted entire books to Fibonacci retracements and how they can help identify, and even predict, support and resistance levels.


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Charles Dow, the first editor of the Wall Street Journal, made several observations when developing his theory. One important observation was that of retracements. He noticed that price action was likely to retrace to either one-third, one-half or two-thirds of the previous move.

Today technicians combine Dow’s retracement observations with Fibonacci’s number sequence.

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Historians credit Italian mathematician Leonardo Fibonacci with discovering a sequence of numbers in which each subsequent number in the series is equal to the sum of the two previous numbers. The Fibonacci sequence has an interesting relationship with nature. Sunflower seeds, nautilus shells and tree branches, for example, all exhibit growth formations related to the sequence.


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Three important ratios occur between numbers in the Fibonacci sequence. The first ratio is 38 percent—the ratio between alternating integers in the sequence. For example, if you divide 21 by 55—the next alternating number in the sequence—you get 38 percent (21 / 55 = 38 percent). The second ratio is 62 percent—the ratio between two sequential integers in the sequence. For example, if you divide 34 by 55—the next sequential number in the sequence—you get 62 percent (34 / 55 = 62 percent). The final ratio is 50 percent—a common retracement level halfway between 38 percent and 62 percent.

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As an investor, you are looking to see where potential support is. It could be at any of the Fibonacci levels illustrated on the chart. Watch for confirmation of a bounce at each level. If the stock price breaks the 38 percent level, expect to set a new target at the 50 percent level. If the stock price breaks the 50 percent level, set a new price target at the 62 percent level. A support bounce at any of these levels gives you another chance to decide if you want to go long.

To see potential support, draw the Fibonacci level from low to high. To see potential resistance levels, draw the Fibonacci level from high to low.


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Price patterns are tools for displaying areas of support and resistance. Price patterns can be used to project future price direction. Investors tend to react in predictable ways to various situations, and price patterns illustrate these reactions. These formations have been a favorite tool of technicians for years because they capture market sentiments and can give specific entry and exit points.

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To recognize patterns, it is essential to identify support and resistance levels. Price patterns are the result of connecting these levels of consolidation. Once you identify these levels, the price pattern suggests a specific entry point and a minimum price target.

When a stock moves above resistance or below support, it is known as a breakout. It is important to always trade in the direction of the breakout, even if it occurs in the direction you didn’t expect. You will see variations of each pattern as you learn about trend continuation and trend reversal signals for each pattern.

As shown, we have organized price patterns into three groups: flags, triangles and rectangles.


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A flag is a short-term pattern that forms over a few days or weeks. It can be either bullish or bearish. Flags often trend in the opposite direction of the previous trend, which means that bull flags tend to trend down and bear flags tend to trend up.

Bull flag is a pullback in an uptrend followed by a support bounce and a trend continuation move.

Bull Flagpole is the price difference from the previous support low to the recent resistance high before the flag pullback and is added to the entry price for the flagpole price target. In this example the flagpole is about $6.

Bear flag is a bounce in a downtrend that rallies to a lower high followed by a trend continuation move.

Bear flagpole is the price difference from the previous resistance high to recent support low before the flag rally and is subtracted from the entry price for the bear flagpole price target.

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A pennant is a short-term continuation pattern that forms over a few days or weeks and can be either bullish or bearish. Pennants appear when a stock channels between symmetrical support and resistance levels that are sloping toward one another.

The flagpole is the price difference from the previous support low to the recent resistance high before the pennant consolidation and is added to the entry price for the price target. In this example the flagpole is about $3.50.


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An ascending triangle is a pattern that appears during an uptrend when a stock begins to consolidate between a horizontal resistance level and a rising support level. To be a valid ascending triangle, the price must bounce twice off both the support and resistance levels. The pattern forms over weeks to months and is usually complete when the price is about three-quarters of the way to the apex of the triangle.

The price target is the widest point of the triangle added to the resistance breakout price. In this example the difference between support and resistance is about $3.50.

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A descending triangle is a pattern that appears during a downtrend in which the stock begins to consolidate between a horizontal support level and a falling resistance level. To be a valid descending triangle, the price must bounce twice off the support and resistance levels. The pattern will usually complete when price is about three-quarters of the way to the apex of the triangle.

The price target is the widest point of the triangle subtracted from support. In this example the difference between resistance and support is about $6.


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A symmetrical triangle is a consolidation of an intermediate-term trend, which usually spans a couple of weeks to months and can appear in either an up- or downtrend. The lower highs show weakness in the trend, and the higher lows show strength.

The price target is the widest point of the triangle added to a breakout of resistance for a bullish trade or subtracted from a breakout of support for a bearish trade. In this example the distance between support and resistance is about $17.

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A wedge is a multi-week trend that moves in the opposite direction of the intermediate-term trend. This trend lasts weeks to months. It can appear in either an intermediate-term uptrend or downtrend. The trendlines sloping toward each other indicate weakness in the short-term trend.


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When price reaches similar highs and lows multiple times, the pattern forms a rectangle. These patterns are consolidations of intermediate-term trends and last several weeks to months. The parallel support and resistance levels can be horizontal or have a slight slope.

Other rectangle patterns include: ▪ Double top ▪ Double bottom ▪ Triple top ▪ Triple bottom ▪ Head and shoulders top ▪ Inverse head and shoulders

The price target is the price difference between support and resistance added to a resistance breakout for a bullish trade and subtracted from a support breakout for a bearish. This example is a bearish breakout of support and the measuring distance is about $6.

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You are already familiar with Fibonacci lines as potential support and resistance levels. However, in this section we will discuss how Fibonacci retracements can also be used to determine a target price.


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The key to this analysis lies in how the Fibonacci is drawn. Instead of drawing from support to resistance, start at resistance and draw down to support for uptrends. For downtrends start at support and draw up to resistance. This will put the extensions above the price action.

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In the case of a bear flag pattern, you could easily use the common measuring technique that assumes the flag occurs at the halfway point and price should move down again an equal or greater distance than the initial drop.


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For the same bear flag pattern, try drawing a Fibonacci line backwards, from support up to resistance, to provide a target. In this case, the target is similar to the bear flag measurement, and a little easier perhaps.

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With intermediate trend targets, when price pulls back to a retracement level and then breaks through the 100 percent level, it may reach 162 percent. If the trend continues, it could also reach the 262 percent level or ultimately the 423 percent level over the following weeks or months.


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When finding short-term price targets using price patterns, use the width of the pattern to project your target by either adding or subtracting from the breakout point.

When finding short-term price targets using Fibonacci levels, draw the lines backwards to project the 161.8 levels.

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It is important to identify trends and support and resistance levels. Draw current trendlines, price patterns and Fibonacci lines. You can also use the text notes within ProphetCharts® to annotate your findings. In addition to drawing your findings onto your charts, it is also important to monitor your charts often to watch for potential breakout points and entry signals.


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The adage “The trend is your friend” is mentally tattooed on every successful trader’s mind—trading with the trend can help increase your trading success ratio. Trending indicators help you take advantage of market periods when a prevailing trend is the driving force.

Moving averages are the most commonly used trend-identifying tool. Moving averages smooth price action to avoid the static of erratic price movements.

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There are several ways to calculate a moving average. A simple moving average is calculated by averaging closing prices over a specific time period. For example, to apply a 20-day simple moving average to a stock, take the closing prices for the past 20 days, including the current day, add them together and divide the sum by 20 (the number of days you are analyzing). This produces the arithmetic mean for the past 20 days’ closing prices.


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An exponential moving average (EMA) is calculated by averaging the closing prices during a specific time period also. However, the calculation gives more weight to the most recent days when determining the average. A 20-day EMA for a stock takes the closing prices for the past 20 days, including the current day, and multiplies each number by a corresponding weighted percentage.

Investors use EMAs when they need faster signals. The drawback to an EMA is that it can be much more volatile. This volatility may increase the number of bad signals as the moving average jumps around.

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One of the simplest methods involving moving averages is using them as a support line in an uptrend and as a resistance line in a downtrend. With this method, you would enter the stock as the price bounces up off support and short the stock as the price bounces down from resistance.

Moving averages generally are more responsive than a manual trendline and can help identify various entry and exit signals. As with many technical analysis methods, choosing the indicator’s length is a subjective process. Short-term investors usually like a short-term moving average.


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Often, you will find that one indicator will complement the signals displayed in another indicator. Some investors will use two or more indicators as added confirmation or a filter for entry and exit signals.

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When a stock is trending up, it will spend a greater amount of time above its moving average. For this reason, investors look to enter into stocks that have crossed above their moving average. Exit strategies are also often planned around the price dropping back below the moving average.


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The one green arrow method is an example of a system that pays close attention to where the price is in relation to its moving average.

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Be sure to check the posture of the overall market before determining your own posture. Remember, it is easier to swim with the current.

Market Forecast™ for Market Posture:

When the SPX Market Forecast Intermediate Term Green Line is rising or in the upper zone the market posture is bullish. A bullish market posture gives permission to look in the Portfolio Technical page for a One Green Arrow entry signal on a stock.

The Market Forecast indicator can also be added as a study in ProphetCharts®.


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In any strategy that requires you to own shares of stock, it is wise to have a solid fundamental foundation.

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Determine your entry signal ahead of time. When the time comes to enter your position, there should be no more decision making because the decision has already been made long in advance by your rules.


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Before entering any position, you should already know what your exit strategies are.

What will you do if the trade goes poorly?

What will you do if the trade goes well?

To see where a stop would be 3% below the 30-day MA, use the Moving Average Envelope study on ProphetCharts ®.

To add a Moving Average Envelope study go to Studies > Apply Studies > scroll down to and click on Moving Average Envelope (Simple) > click on Apply Study button > click on Edit Study icon > in the Study Editor box type 30 in the Period field > type 3.0 in the Percent Shift field > uncheck the check mark in the upper box > click on the OK button > in the Apply Studies box click on the Save Study Set button > in the Save Study Set box click the circle Save a new Study Set named: and type in a name in the field > click OK > in the Apply Studies box click OK.

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As you have seen, moving averages can provide potential support and resistance levels. Using more than one moving average, however, adds greater credibility to support and resistance levels created by a single moving average.

This technique provides context for your trades. If the moving averages prescribe bullish strategies, then your odds for success may be increased when you go long. If the moving averages prescribe bearish trades, then your odds for success may be increased when you go short. Using multiple moving averages makes your decision-making process more efficient.

Crossovers for Posture

Chart setup:

Five-year chart with weekly candles

10-period exponential moving average

40-period exponential moving average

10 crosses above 40 = Bullish posture

10 crosses below 40 = Bearish posture

Each is confirmed on third candle (third week) after the cross

This establishes the intermediate-term trend.


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Bands are effective tools not only for identifying support and resistance, but also for helping establish limits and stops.

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You create a moving average envelope by plotting a simple moving average, then plotting two additional lines parallel to the moving average—one line above the moving average line and one line below it. The two parallel lines are separated from the moving average line by a set percentage that is determined by you. These two parallel lines create the envelope.


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When choosing a percentage for your moving average envelope, select a time frame that not only fits your investing style but also goes well with the price action of the stock under consideration.

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Bollinger Bands® are similar to moving average envelopes with one key distinction—they reflect volatility. You construct Bollinger Bands by applying a simple moving average (usually 20 days) to a stock and then applying an envelope to the moving average. Each side of the envelope is placed two standard deviations—a statistical term used for telling you how tightly all various examples are clustered around the mean in a set of data—of historical volatility away from the moving average. This means the range between the two Bollinger Bands at any given time represents 95 percent of the price movement, or trading range, for the past 20 days.


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Oscillators and other indicators are invaluable for technicians hoping to identify accurate entry and exit signals. Using oscillators increases your ability to identify extremes in market sentiment and take advantage of the principle of contrary opinion.

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There are multiple uses for oscillators. You will use them to identify confirmation of price movement, lack of confirmation—divergence—and for potential entry and exit signals.


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The MACD indicator is calculated using two exponential moving averages (EMAs). The first moving average is a short-term average— usually eight periods in duration. The second moving average is a longer moving average—usually 17 periods in duration. Both averages are calculated on a daily basis. Surprisingly, neither is directly reflected on the MACD indicator. The first line of the MACD indicator is actually the difference between these two moving averages. The second line is usually a nine-period EMA of the difference between the other two moving averages.

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Often, when the MACD is hitting a low point and beginning to rise, price is doing the same thing. This is especially true during an upward trend.


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Divergences suggest that the current trend is getting weak. They are also predictive signals for determining potential market tops and bottoms and are created by most oscillators.

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The stochastic indicator is an oscillator that moves between zero and 100, with an overbought range above 80 and an oversold range below 20. It is created using a calculation that measures how close the stock is closing to its extreme high or low during a specific period. As the stock closes closer to its high, the stochastic indicator line moves upward. As the stock closes closer to its extreme lows, the stochastic indicator line moves downward.


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The stochastic indicator has two lines. The faster-moving line is called %K and the slower-moving line, which is actually just a smoother version of %K, is called %D. These lines trigger buy and sell signals when %K crosses above or below %D.

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Like the MACD, the stochastic indicator will often give an early warning of possible future trend reversals by way of divergences.


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The RSI is calculated by comparing the average prices of positive closes with the average prices of negative closes. The RSI line will fall as the negative closes begin to outweigh the positive closes. The RSI line will rise as the momentum shifts and the positive closes begin to outweigh the negative closes. The RSI is specifically used as an overbought and oversold indicator. You should not confuse the RSI with relative strength (RS), which refers to a comparison between the stock’s performance and the performance of another benchmark or index.

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Remember, you may treat oscillators like the price. Draw lines to identify trend and support and resistance levels.


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Be alert when the trendlines drawn on your oscillators do not match the trendlines drawn on the price chart. Again, this is a sign of weakness in the current trend.

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This oscillator can be used in channeling and trending markets. The CCI is an interesting indicator because, although it is used as an oscillator, its calculation is similar to Bollinger Bands®. It measures the distance from the market price to the moving average and turns that distance into a ratio.

The CCI can identify excess buying pressure when it is above 100 and excess selling pressure when it is below −100. It can also be used as a traditional oscillator by showing overbought and oversold divergences.


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Like the MACD, stochastic and RSI indicators, CCI divergences will appear to warn of weakness in the current trend.

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As discussed earlier, investors will often combine indicators for confirmation of entry and exit signals. It is important not to add too many indicators to your rules as it can result in too much or too little trading. Some indicators will tell you essentially the same thing that other indicators do. Pay attention to how closely correlated your indicators are.


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The indicators and techniques discussed so far can help you begin trading more proficiently. However, there is a great tendency for investors to bounce from one set of indicators and strategies to another without a real strategy.

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Creating profitable trading rules is the most important step in your trading career. Though this may require some time and effort at first, remember that the most successful strategies are often the simplest ones. The real challenge is writing specific entry, exit and position sizing rules and applying them consistently.

What to Buy = Watch List Criteria

Fundamental criteria

Trend

Volume

Set up

When to Buy = Entry Rules

Price action

Volume requirements

Oscillator confirmation

When to place orders

Order types

How Much to Buy = Money Management

Amount of total capital at risk

_____% of net liquid value -or-

$____ per trade

Portfolio draw down or heat

When to Sell = Exit Rules

Target price

Stop loss

Time stop

Stop adjustment

Routine = Daily, Weekly, Monthly


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Backtesting is an important first step toward developing a profitable trading strategy. Backtesting is the process of testing your entry and exit rules on a chart.

To backtest, pick a stock chart and identify the entry and exit points according to your written rules. List the entry price, exit price and net gain or loss in a trade journal or spreadsheet. For your backtesting to be of any value, you should establish and follow specific rules.

After backtesting one stock, select another. You should backtest your rules on several stocks in multiple markets—up, down and sideways.

It is easy to cheat in backtesting and look forward a few days before deciding if you would have placed a trade. If possible, do your backtesting with another person. Your backtesting buddy will be helpful in not only keeping you honest, but also in analyzing the chart and applying your rules.

Backtesting doesn’t give a good sense of the passage of time while trading, nor does it give you a feel for the emotional aspects of trading. However, it will give you an idea of whether your rules are specific and repeatable.

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Before trading a plan, you need to know what results to expect. This means you should know approximately how much you expect to profit, on average, per trade. If you don’t know what to expect, you don’t really know what you are risking.

Expectancy is an approximation of what you expect to make or lose on average per trade from a specific set of rules.

Expectancy Example:

50 total trades

20 winners = 40% of total trades

30 losers = 60% of total trades

Average winner = $550

$11,000/20 = $550

Average Loser = $150

$4,500/30 = $150


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The guiding principle behind technical trading is to manage your losses and put the odds of a successful trade in your favor. By concentrating on the real numbers behind a system or indicator, you can move beyond guesswork. This will ultimately lead to the defeat of an investor’s worst enemy—lack of discipline. Good luck, have fun and prepare for the best.


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