Technical Analysis: Trends, Support and Resistance
Stocks are eternally rising and falling. Financial reports tell of stocks moving up and down. They are, of course, referring to prices. Stock prices change daily and fortunes rest on the ability to predict such changes. Your job as a stock or CFD trader is to learn to identify where the prices of actual or potential investments are going to go next.
Stock and CFD traders track historical prices using price charts. By keeping track of historical prices, traders are able to more accurately project where prices are likely to head in the future. The process of analyzing historical prices to intelligently predict future price movement is called technical analysis.
Technical analysis, or chart reading, is the natural progression after you have conducted your fundamental analysis. Fundamental analysis helps you determine whether you should buy or sell a particular stock or CFD. Technical analysis helps you determine when you should buy or sell that stock or CFD.
Despite the science and math behind it, technical analysis is considered by most traders to be almost an art form which takes time and practice to master. It may seem complex, but technical analysis is indispensable to good trading, and the fundamentals are reasonably simple:
Identifying trends and trading intelligently with them in mind is vital to your success as a stock or CFD trader. Traders are gregarious, and when one or two identify an opportunity or a threat, the others typically follow suit to push the price in the same direction. Once a stock has achieved some momentum, it is likely to be sustained for a while. Spotting such a trend will increase your likelihood of making money (or not losing it, which is equally important). Bucking a trend generally turns out to be a loss-making proposition.
Trends indicate where prices will probably head in the future. If traders push a price higher, then you ought to buy to make money. If traders push a price lower, then you ought to sell to prevent losses. If traders disagree over a price, then you could alternate between buying and selling, or you could wait until a clear trend emerges, then ride it.
Trends are not entirely linear. Prices rarely move straight up or straight down. Movements are always a little fuzzy because of the many individuals who are trading, and because they are largely trading in idiosyncratic ways. Yet there is a herd mentality. When a majority of traders believes the stock price is going to move in one direction, they can overpower the minority of traders who disagree with them. When this occurs, the price begins to trend and will usually move in one direction for a while until the majority loses confidence – which is reflected in reduced momentum. At that point, the minority can momentarily exert its influence and push the stock price in the opposite direction. And so on. It is a little like rugby.
Like in rugby, there are turning-points is price trends. There are moments when the application of huge amounts of force may achieve nothing, and therefore the effort is wasted, just as there are moments when a smaller and well-timed effort can achieve spectacular results. Trading is very much an activity in which timing is critical. Learning to identify the critical moments as a trader, the moments when a price will soar or plummet to create an opportunity, all hinges on the recognition of upward and downward trends.
Upward trends - stocks or CFDs that are upward trending form a series of higher highs and higher lows (see Figure 1).
Figure 1–Up Trend
Down trends - stocks or CFDs that are trending downward form a series of lower highs and lower lows (see Figure 2).
Figure 2–Down Trend
Sideways trends - stocks or CFDs that are trending sideways form a series of highs that are at approximately the same price level and a series of lows that are at approximately the same price level (see Figure 3).
Figure 3–Sideways Trend
Trends–whether they are upward trends, downward trends or sideways trends–can become immediately apparent or take a while to spot. Identifying the following trends over each time-frame and being able to utilise them will be crucial to your success as a stock or CFD trader:
Fundamental factors are the major drivers of long-term trends. If companies perform fundamentally well, their stock prices typically rise. If companies perform fundamentally poorly, their stock prices typically fall. Whilst the outlook for a company can literally change overnight, the trends established by a company's fundamental strength or weakness tend to last for a while.
Long-term trends, sometimes called major trends, are those trends that have dominated a stock or CFD for the longest period. Looking at this weekly chart of McDonalds (MCD:xnys), you will notice that the price has steadily risen in an upward trend, which runs from left to right. Notice the series of higher highs and higher lows as time progressed (see Figure 4 ).
Figure 4–Long-Term Trend
When you see a strong upward trend, like that on the McDonalds chart, you know that traders are keen to invest in its stock, and you should consider doing the same if you want to make money. If the trend on the McDonalds chart had been downward, you would then have been advised to consider selling to take advantage of the price movement.
Next, you ought to examine an intermediate trend to see if it is heading in the same direction as the long-term trend.
Intermediate trends, sometimes called minor trends, move more quickly than long-term trends because they do not last for so long. These trends are also affected by a company's fundamental factors. As the daily McDonalds chart shows, the price has not moved straight up but has followed a long-term upward trend. At times, the intermediate trend has seen the price move sideways, and at times it has fallen, but the overriding trend is clearly upwards (see Figure 5 ).
Figure 5–Intermediate Trend
Notice that, whilst there have been periods when the intermediate trend was moving both sideways and downward, the long-term trend was still upwards. Trends tend to move in a stepped fashion. Rarely do they move straight up or straight down.
Seeing this price trend should motivate you to buy McDonalds. You would then be bullish since you would anticipate that the price would continue to rise. But you might want to wait to buy when you saw the intermediate trend move upward-and in line with the long-term trend.
Next, you should look at the short-term trend to see if it is heading in the same direction as the long-term and intermediate trends.
Short-term trends, sometimes called micro trends, are more volatile than both long-term and intermediate trends because they cover the shortest period of time and are driven by the news of the day. Often, these short-term trends rapidly reverse. Looking at the McDonalds hourly chart you can see that the price was initially on a short-term downward trend. Notice the series of lower highs and lower lows as time progressed (see Figure 6 ).
Figure 6–Short-Term Trend
Notice that, whilst the short-term trend was downward, the intermediate and long-term trends were upward. So it is possible to have trend time-frames simultaneously moving in different directions.
Seeing this downward trend on the hourly chart would probably have prevented you from bullishly investing in McDonalds at that time, even though the intermediate and long-term trends were bullish. However, since it is the only the short-term trend that might undermine confidence, you should still be bullish about McDonalds.
In fact, if you look at the end of the hourly chart for McDonalds, you can see that the short-term trend is changing direction and that this change could soon align the short-term, intermediate and long-term trends in a way which should encourage you to buy.
Your most profitable trading opportunities will come when the long-term, intermediate and short-term trends all line up in the same direction. Just as it is easier to swim downstream instead of upstream against the current, it is easier to trade with a trend than against it. When long-term, intermediate and short-term trends all rise in unison, it is an ideal time to buy a stock or CFD. When long-term, intermediate and short-term trends all fall in unison, it is an excellent time to sell.
The McDonalds chart shows that the trend for each time-frame has risen for the past few months, during which the price has soared. Had you invested in the company throughout this time, it would have been very profitable for you (see Figure 7 ).
Figure 7–Aligning Various Trend Timeframes
Understanding trends is critical to technical analysis. Yet, you also have to understand the concepts of support and resistance.
Support and resistance levels are like the ends of an Olympic swimming pool. Just as the ends of the pool force swimmers to turn and swim in the opposite direction, support and resistance levels tell traders that the price of a stock or CFD is likely to stop moving, to turn around and to start moving in the opposite direction. Knowing when such a reversal should occur helps traders to buy and sell at the most profitable times.
Support is a price level at which a currency pair tends to stop falling, turns around and starts climbing again. Support usually occurs because of the following:
- Traders who missed an earlier buying opportunity decide it is a good time to invest
- Traders who bought the stock or CFD decide it is a good time to add to their positions
- Traders who sold the stock or CFD decide it is a good time to take profits
Resistance is a price level at which a currency pair tends to stop rising, turns around and starts falling again. Resistance usually occurs because of the following:
- Traders who missed an earlier selling opportunity decide it is a good time to trade
- Traders who sold the stock or CFD decide it is a good time to add to their positions
- Traders who bought the stock or CFD decide it is a good time to take profits
Support and resistance levels are not precise. You could compare them with soft buffers or crash barriers. They are the vague limits at which traders say 'they cannot be worth so much; I'm selling' or 'they cannot be worth so little; I'm buying.' You would only frustrate yourself trying to pinpoint a price level of 1410 on the S&P 500 as the ideal time to support. Instead you would be much better off identifying a price range of 1400 to 1420, or 1390 to 1430, as support. So support and resistance levels should be flexible.
There are different types of support and resistance levels, and you will need to learn to recognize the following:
Horizontal support and resistance levels form as prices rise or fall. You can see these support and resistance levels take shape on charts which track the stocks and CFDs that you are interested in trading.
On the Caterpillar (CAT:xnys) chart, for instance, you can see that certain price levels (indicated by bold black lines) acted as strong levels of support and resistance. From June 2007 until the early part of August 2007, the $77.50 price level served as support for the stock (see Figure 8). This same price level, once the stock tumbled down through it in mid-August, served as resistance to the price rising through the rest of August and into September.
Figure 8–Horizontal Support and Resistance
If you had bought into Caterpillar in early September at $72.50 as it was bouncing off the support level, and it was now nearing $82.50, you might well think of selling. Previously, this price had marked a significant resistance level. Consequently the price might now turn around and move lower.
Once you can confidently identify horizontal levels of support and resistance, you can move on to diagonal levels of the same.
Diagonal support and resistance levels can be invaluable to a trader. Whilst these levels can be more difficult to identify for novices, they are invaluable for analyzing a trend. Remember it is much easier to make profitable trades when a stock or CFD is in a trend.
As you look at the charts of the stocks and CFDs you will notice that they often form higher highs and higher lows (or lower highs and lower lows) as their fortunes wax and wane. The lines connecting these highs and lows are diagonal support and resistance levels.
Examine the Caterpillar (CAT:xnys) chart again. You can see that the price hit a series of lower highs and lower lows toward the end of 2007. If you connect all of the highs with one diagonal line and all of the lows with another diagonal line (indicated by bold black lines) you will be able to see the diagonal levels of support and resistance that drove Caterpillar's price (see Figure 9).
You can also see that a downward trend level between the support and resistance levels served as both support and resistance during this same time period.
Figure 9–Diagonal Support and Resistance
If you were to invest in Caterpillar, you would most likely wait until you saw the price rise to the downward trending resistance level before you would sell and take your profits.
The knack of effectively investing using support and resistance levels is to combine both horizontal and diagonal levels in your analysis. As is apparent from these illustrations of Caterpillar's price chart, such levels co-exist and interact. In conclusion, your stock and CFD charts have a wealth of information locked within them, and they are waiting for you to unlock that information with simple-but-effective technical analysis techniques.
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