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Filtering the Market using Technical Analysis

Identify & evaluate potential trade opportunities using technical analysis tools, including trend lines, moving averages, volume, and more.

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Every trader faces the challenge of identifying potential trading opportunities. With thousands of candidates to choose from, researching each one can be overwhelming. To narrow the universe of choices into a manageable number, consider using technical analysis tools as filters.

Technical Analysis Tools

Many traders use these four primary technical analysis tools to evaluate market indexes and individual stocks and to help identify trend lines.

  • Support and Resistance—If an index or stock is moving up and down between a consistent low and a consistent high, it is said to be "range-bound." Drawing horizontal lines at these price levels can help you develop a sense of where the selling pressure overcomes buying pressure, at support, and buying pressure overcomes selling pressure at resistance. You can use these price levels to identify a trend as well as possible entry and exit points.
  • Trend Lines—A simple trend line can help you assess whether an index or stock has been bullish or bearish. To determine a bullish trend, draw a line connecting price lows over the period in question. If a stock price is experiencing higher lows, that can indicate a bullish trend. To identify a possible bearish trend, connect price highs with a drawn line. A stock price that is experiencing lower highs points to a bearish trend. Drawing one or both of these lines to create a trend channel can help you evaluate both the strength and duration of a market trend. How has the index or stock moved—or not—over the last week or month or quarter, depending on your time frame?
  • Moving Averages—Moving averages reflect the recent price history of an index or stock. A simple moving average is the sum of the prices over a period of time divided by that time period. For example, a "20 day Moving Average" is the sum of the prices over 20 days divided by 20. Moving averages show you how the current price compares to an average price over an index or stock's history. An index or stock with a current price above its moving average is performing better than it has during the period used to calculate the moving average. Typical moving average time frames are 20, 50, and 200 days, which approximate one month, 10 weeks and 40 weeks, respectively. Some traders look at "crossovers" (when one moving average "crosses" over another). When a moving average with a shorter time frame crosses over and above a moving average with a longer time frame, that's a bullish indicator. It reflects that the stock is doing better in the shorter term than its average performance during the longer time period.
  • Volume—Looking at volume in combination with price activity can indicate how strongly investors feel about a stock's current pricing. Larger volume indicates greater conviction from the market. Lower volume may indicate less conviction. When volume exceeds the current moving averages, support for the price action may be growing.

Filtering the Market

When you're assessing the market, a top-down approach can be helpful. Begin by using major indexes like the S&P 500®, the Dow Jones Industrial Average, or the NASDAQ Composite Index and observe what the market is currently doing. Technical analysts believe that what the market is actually doing is more important than why it might be doing it. Is the overall market trending up or down? How aligned are the major indexes? Where are the indexes in relation to support and resistance? Is volume supporting the current price trend?

Filtering Sectors

Once you've taken a look at the big picture, it's time to figure out which sectors within the market are driving any trends. If the overall market is bullish, some sectors are likely to be very bullish. Likewise, if the overall market is bearish, some sectors will be particularly bearish. Identify the two or three sectors leading the trends.

In choosing these two or three sectors, you've already focused your search on a small percentage of the market, and you haven't had to think about particular companies or indicators. Remember that the objective of filtering is to find the opportunities that fit your specific criteria as efficiently as possible, without looking at every chart in the market or even the sector.

Filtering Stocks

Now the search gets more specific. Just as you looked for sectors that were leading the market trend, now you look for the stocks that are leading those sectors. This process will help you identify the "strongest of the strong" or the "weakest of the weak."

Next, build a of stocks within your chosen sectors. Once you create a sector list, you can filter it a few different ways. Be sure to base your filtering criteria on your trading strategy. One straightforward approach is a technical filter that looks for stocks with prices above their moving averages. Other technical screens include uptrend breakout or downtrend breakout with increasing volume. There are also tools that can filter a list to look for clear support and resistance levels.

Once you have reduced your candidates to a manageable number, scan each chart and begin to choose the stocks that present opportunities that best fit your trading style and goals.

What's Next

With a few steps and basic filters, you can effectively reduce thousands of choices to a qualified short list of stocks that meet specific criteria and line up with broader market trends. Use technical analysis to scan the whole market and make more objective decisions about what and when to trade.

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