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How to Incorporate Technical Analysis Into Your Trading Strategy

Discover how understanding trends, support and resistance, and a few basic concepts may be used in conjunction with fundamental analysis.

Technical analysts believe that everything known about a company is already reflected in the supply and demand balance that determines the price. This being said, at an exclusive focus on price might then seem tempting to a technical analyst. However, in practice, many traders regard technical analysis as a valuable supplement to fundamental analysis, rather than a substitute for it. They may use fundamental research to generate potential trade ideas, and then incorporate technical analysis to help narrow the choice between similar trading candidates, or to try to identify potential entry or exit points.

For example, imagine that you believe a stock is undervalued based on increasing earnings per share. While you may believe that the stock price will rise to reflect the company’s growing profitability, you prefer to wait for the price to actually begin a strong positive movement before investing. Technical analysis can help you identify a potential entry point.

The core beliefs of technical analysis

The charts, technical studies, and specialized terminology used in technical analysis can intimidate many investors trying to incorporate them into their strategy. And, yes, it can be an incredibly complex discipline that requires study and practice before being successfully applied.
However, much of technical analysis flows from a few simple core beliefs:

  1. Prices tend to move in trends
  2. Trends tend to continue
  3. Patterns tend to repeat themselves

Let’s examine each of these concepts in turn.

Prices tend to move in trends:

At first glance, prices seem to move randomly - a couple days up, followed by a day down, and so on. Trends often are not neat and clean, but they can be recognizble once you understand what to look for. Consider the following example:

Source: StreetSmart Edge®, Chart tool

Note how, despite minor fluctuations, the stock price has made a series of peaks. If you drew a line connecting these peaks you would see that they create a series of higher highs. That means each peak is higher than the one before it. Equally important, imagine drawing a line connecting the dips and you will see that they form a series of higher lows. (That is, each dip is higher than the preceding low.) A series of higher highs and higher lows is an uptrend. Now why is that important?

Trends tend to continue

According to technical analysts, once trends have been established, they tend to continue. Why should that be the case? According to technical analysis, a trend represents an imbalance between supply and demand. In the case of an uptrend, there are more buyers than sellers; therefore the price rises in response. The trend will continue until a new balance between buyers and sellers is reached.

This is recognized whether prices are trending up, trending down, or even drifting sideways. Those changes in supply and demand that end one trend and begin another, known as reversals, are significant events and comprise a prime focus of technical analysis.

Patterns tend to repeat themselves

This may be the most surprising concept for traders new to the study of price charts, but certain patterns do tend to repeat themselves. This is especially useful in trying to identify the end of a trend and the beginning of a new trend. The chart below illustrates one of the most well known patterns:

Source: StreetSmart Edge®, Chart tool

This pattern, known as head and shoulders, is used by technical analysts to help recognize when an uptrend has probably peaked. The first shoulder and the head are a continuation of the pattern of higher highs mentioned earlier. However, the second shoulder does not establish a new high. In fact, it usually only reaches about as high as the first shoulder. Once the price dips below the line drawn between the two lows (as shown above), known by technicians as the “neckline,” the uptrend is considered broken.

Does the head and shoulders pattern always indicate a trend reversal? No, of course it doesn’t. But it has been used successfully enough in the past to produce potential (not guaranteed) signals. There are dozens of patterns with multiple interpretations; discovering which patterns may be useful in your strategy will come through research and experience.

Applying technical analysis

If you believe the assumptions that prices move in trends and that certain patterns tend to repeat themselves, how do you begin to apply this understanding to trading decisions? In other words, how do you begin to do technical analysis?

Let’s consider three increasingly complex areas of technical analysis: support and resistance, moving averages, and technical indicators. This discussion will not make you fluent in technical analysis, but it will give you a basic foundation of knowledge which you can use to then explore further.

1. Support and resistance

Trend lines can be drawn by connecting the series of lows, forming a line of “support,” or by connecting a series of highs, forming a line of “resistance.” It is easier to illustrate support and resistance in a chart for a price trending sideways, as shown here:

Source: StreetSmart Edge®, Chart tool

Support is indicated by the line beneath the trend. Once the price declines to support level, buyers may come back in, creating demand, and start to send the price higher. Once the price reaches resistance, the trend line above the price range, sellers may add pressure through additional supply, sending prices lower.

Identifying support and resistance offers a great example of how technical and fundamental analysis can be used together. Imagine that fundamental research on the stock shown in the illustration above suggests that the stock is undervalued. Yet, you are reluctant to invest until you see signs that the positive trend is starting. Charting the stock and waiting for signs that it has traded through its resistance level may be one way to identify a potential entry point. Likewise, passing through support may be a sell signal for a stock whose fundamentals are beginning to show signs of stress.

2. Moving averages

Moving averages are a great example of how the data captured in a stock chart can be used to provide insight. For simplicity’s sake, this discussion will consider only simple moving averages (SMA) and the time intervals will be based on daily prices. (Other moving averages weight recent prices more heavily.) Here’s what an SMA line looks like on a price chart:

Source: StreetSmart Edge®, Chart tool

In this example, SMA captures the average of the last ten days’ prices and plots them on the chart. The next day, the oldest price is dropped off, the most recent price is added in, and the new average is calculated and plotted. (Any time interval can be used, from months down to minutes.) The moving average smoothes out minor price fluctuations and can make the trend easier to see. For a stock in an uptrend, the moving average appears below the price line. If the stock is in a downtrend, the moving average will move above the price line.

Moving averages can also be used in combination. For example, a 10-day moving can be used with a 50-day average. If the shorter moving average (10 days) moves above the longer average (50 days), it is considered a bullish sign. These crossovers are potential entry and exit signals that can help confirm your fundamental research.

3. Technical indicators

As you grow more comfortable reading stock charts, you can add technical indicators to measure the rate of price change, volatility, and other factors. In a sense, technical indicators amplify a signal that might otherwise be drowned out by market noise. Take for example, the stochastic oscillator, which is used to measure price momentum or to provide “overbought” and “oversold” signals.
The stochastic oscillator measures a stock’s closing price against its trading range. Stocks with upward momentum should be in the higher portion of the range, while stocks with downward momentum should be in the lower range.

Source: StreetSmart Edge®, Chart tool

The stochastic oscillator is also used for identifying potential entry and exit signals. As shown in the chart above, the stochastic is plotted on a range between zero and 100. A reading above 80 is generally considered overbought (a potential sell signal) while a reading below 20 is generally considered oversold (a potential buy signal).

Bringing it all together: Using StreetSmart Edge®

The charting in StreetSmart Edge®, Schwab’s newest trading platform available to Schwab Active Trader clients, is designed to be both sophisticated and intuitive, supporting the needs of both charting experts as well as beginning chartists who are gradually building up a comfort level. By simplifying the process in how trend lines are drawn and moved, StreetSmart strives to make basic technical techniques less intimidating for those just beginning. Later, you can incorporate moving averages into your charts, experimenting with the lengths of averages to find combinations that are meaningful for your personal strategy. Once you have a good understanding of these simple charts, you can experiment with more sophisticated studies. The annotation tool lets you add notes directly to the chart so that you can mark your own observations, such as labeling potential crosses or breakouts you’ve identified.

Source: StreetSmart Edge®, Chart tool

If you find that technical analysis is helping you sharpen your trading decisions, StreetSmart Edge provides access to additional powerful tools, such as Recognia®, a third party service that provides chart pattern recognition and technical event screeners. Recognia’s technology searches for bullish and bearish technical signals for the stock you are exploring which, in turn, can help you identify potential entry and exit points, as well as profit and loss targets. Recognia also scans the market and produces lists of securities providing specific technical signals.

Conclusion

A few simple concepts and tools can help you gradually incorporate technical analysis into your trading strategy. Over time, you may discover a particular combination of fundamental research and technical signals that produce potential trades that work with your specific trading strategy. StreetSmart Edge’s integrated tools can help to streamline the workflow between trading and research, allowing more time to be spent on strategy, planning, and risk management.

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Important Disclosures

This information does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. The investment strategies illustrated may not be suitable for you. Any opinions expressed herein are subject to change without notice.

Schwab's StreetSmart Edge® is available for Schwab Active Trading clients. Access to NASDAQ TotalView® is provided for free to non-professional clients who have made 120 or more equity and/or options trades in the last 12 months, 30 or more equity and/or options trades in either the current or previous quarters, or maintain $1 million or more in household balances at Schwab. Schwab Active Trading clients who do not meet these requirements can subscribe to NASDAQ TotalView for a quarterly fee. Professional clients may be required to meet additional criteria before obtaining a subscription to NASDAQ TotalView. This offer may be subject to additional restrictions or fees, and may be changed at any time.

Access to Electronic Services may be limited or unavailable during periods of peak demand, market volatility, systems upgrade, maintenance, or for other reasons.

Recognia, Inc. is not affiliated with Charles Schwab. Schwab does not endorse any of the content or features made available to you in Recognia’s “Technical Insight” and “Strategy Builder” tools. Schwab does not recommend the use of technical analysis as a sole means of investment research.

Past Performance is no indication of future results.

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