The Trader's Toolbox: Technical Analysis

Key Points

  • There is a wide range of stock technical analysis tools available to traders, each designed for a particular purpose.
  • The two types of market data are price and volume, from which traders may analyze the trend in price for a given timeframe.
  • We discuss the principal types of technical indicators and oscillators. 

Imagine a frustrated professional golfer throwing his entire bag of clubs into a water hazard over a bad shot. Likewise, a trader shouldn't fault the tools of stock technical analysis—the chart-based examination of market data—for a bad trade.

In fact, in many ways the tools of stock technical analysis compare to those of a golfer or master craftsman. Each tool has a specific purpose for which it is designed, along with specific capabilities and limitations. The master craftsman has learned through experience which tool to use in a given situation.

Of course, some technical tools can be applied to multiple situations, just like an adjustable wrench can perform many of the tasks of fixed wrenches, sockets and pliers. Unfortunately, some technicians will use their favorite tools or indicators in nearly all situations. Through experience—and often "injury," which in trading is called "losses"—a technical trader learns the same lessons as a master craftsman. For example, using a single tool such as stochastics in all market situations is no different than using an adjustable wrench rather than a hammer to drive a nail.

In this first in a series on technical analysis, we'll introduce the major types of technical tools and provide a short overview as to their function. In future installments, we'll examine each general type of technical tool in greater depth.

Types of technical tools

We can categorize technical tools by their primary uses:

Price action

The basic premise of technical analysis is: All that is known, suspected, hoped or feared about a given stock or index is reflected in the price at which informed buyers and sellers agree to trade.

Simply put, when a stock trades at a new high price or new low price, we may infer that someone knows (or thinks he knows) something new and he is willing to risk his money on that knowledge.

Therefore, I believe price action is the single most important technical tool. The current price is the unquestionable market value of that stock or index at that moment in time—period.

The trend in price

The trend in price for a given timeframe is perhaps the second most important bit of information behind the current price of an asset. There are only three types of trends: up, down or sideways.

A trend in price simply measures which side is more urgent in implementing their trades. Are the buyers becoming more aggressive at higher prices or are the sellers becoming more aggressive at lower prices?

When determining the trend in price, a trader must examine the correct timeframe: in other words, a period of time similar to his desired holding period. Is that desired period of time longer term, say three to five years? Or is it a shorter period of time, perhaps weeks or months?

Different timeframes can and often do show different trends in price. What may be perceived to be a minor correction in a longer-term uptrend could show as a strong downtrend in a shorter timeframe.

Volume traded

Volume—or how many units are traded in a given unit of time (such as a day, week or hour)—is a confirming indicator. A simple analogy might be a water hose: If price is the speed at which water comes out of the hose, volume is how big the hose is. The stream of water from a six-inch fire hose can knock a person head over heels. Yet, water coming out of a garden hose at the same speed will at worst make someone wet and upset.

Volume could be considered as the third most important technical tool. As price rises, ideally a trader would like to see higher volume, and as price falls, correspondingly lower volume. In the chart below, we can observe the relationship between price, trend and volume.

Monitoring Volume

Monitoring Volume

Source: StreetSmart Edge®. 

This chart shows five short trends higher and five short trends lower. Notice that as price declines, volume rises and as price rises, volume declines. This is exactly the opposite of what a trader would want to see in a rising or "bull" market and typical of a falling or "bear" market.

At point A, price has risen in the short term to $131.42. The fact that price has risen to $131.42 is the most important, as it helps to define the short-term trend (second most important) which at that moment in time has turned higher, within a longer-term downtrend. The fact that the short-term trend has turned higher is more important than the fact that the move up has been on lower and decreasing volume.

With that said, because the move higher is on lower and declining volume, this short-term uptrend is rather suspect. In this type of situation, consider using tighter-than-normal stop-loss orders to protect capital and/or profits against the possible resumption of the longer-term downtrend, which in this case is exactly what transpired.

Pattern recognition

Humans are creatures of habit and emotion and we tend to react to similar situations in the same way. Pattern recognition attempts to predict the future behavior of market participants by identifying patterns of price, trend and volume.

Are buyers or sellers becoming more anxious and impatient to get in or out? Pattern recognition tools include reversal patterns such as double tops and bottoms, head-and-shoulders tops or bottoms, and continuation patterns such as flags, pennants and wedges.

The chart below provides an example of one such trend-reversal pattern, a head-and-shoulders bottom. In this example, this stock trends sharply lower, then changes direction, "reversing" its trend from down to up and then advances sharply higher, which is considered to be a bullish signal.

A head-and-shoulders bottom

A head-and-shoulders bottom

Source: StreetSmart Edge. 

Trend-following tools

There are two primary trend-following tools:

  • A trendline is a sloped line drawn through two or more low points in an uptrend (or high points in a downtrend). 
  • Moving averages are simply the average closing price of a stock or index for a certain period of time. The more commonly used moving averages are 20-day for the short-term trend, 50-day for the intermediate-term trend and 200-day for the longer term trend. For example, the 20-day moving average is simply the average closing price for the last 20 days. It "moves" through time because at today's close, today's price is added to the average and the price that is now 21 days old is dropped from the average. The slope of a moving average follows behind the trend of price action, confirming the trend and identifying when a trend changes by changing its slope, following the trend in price.

These tools can help you to identify and confirm trends in price. However, remember that these are lagging indicators. See the chart after the next section for an example.

Trading-range tools

Range-bound markets by definition oscillate, or trade up and down between fairly well-defined lows and highs, known as support and resistance levels. Oscillators are the primary tools for these range-bound markets.  Examples of oscillators include stochastics (shown below), the Relative Strength Index and Moving Average Convergence/Divergence (MACD).

Once a range-bound market has been identified, oscillators can help identify possible turning points as the price "bounces off of" the lower end of the range, called a "support" level, or as the price "bounces off of" the higher end of the range, called a "resistance" level.

Trend following in action

Trend following in action

Source: StreetSmart Edge.

In the above example, we see examples of trendlines, 50-day (red) and 200-day (blue) moving averages and the stochastic oscillator:

  • Notice that the trendlines are somewhat of a "connect the dots" indicator, drawn by literally connecting the lower highs in a downtrend and the higher lows in an uptrend. 
  • Also see that the moving averages, especially the 200-day, lag behind the trend in price and do not change slope until well after price has changed its trend. 
  • Finally, notice that in a strong downtrend or uptrend, the stochastic oscillator doesn't oscillate very much.

This illustrates that oscillators generally only add value in a sideways trend, or trading range type of market.

Momentum

How rapidly is the market changing? This is the question that momentum tools seek to answer. Price momentum, or rate of change (ROC), and the oscillators mentioned above, are the primary tools for determining market momentum. The Average Directional Movement Index (ADX) developed by Welles Wilder is another tool that seeks to measure how strongly a market is trending and whether its momentum is increasing or falling.

By recognizing when market momentum has been strong and is beginning to weaken, traders may gain an early warning that the trend may be weakening. I emphasize "may" because the trend does not actually change until it actually does.

Specialty

I consider specialty tools to be those that do not fit into any other category and may provide a different type of insight into the overall technical picture. One notable specialty tool would be "Bollinger Bands®," which may help users identify extreme short-term price moves. Other specialty tools might include Fibonacci percent retracements and Elliott Wave Theory.

Stay tuned

In future installments, we'll cover these tools one or two at a time with specific examples of how to use each tool along with its capabilities and limitations. We'll focus on using these tools to help identify potential trades with smaller defined risk and higher probability of profit.

Good luck and good trading!

Next Steps

  • Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Learning Center.
  • Not yet a client? Learn more about Schwab's Trading Services.

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