Technical Analysis: the Basics

As previously mentioned in this article comparing fundamental and technical analysis, technical analysis uses a security’s price and volume data to determine a trend. But in its most basic form, what is a trend?  Understanding this concept is the most important aspect of technical analysis.

A trend is the general direction something (in this case the price of a security) changes or develops.  The price can either be moving in an upward motion, a downward motion, or it could have no apparent motion at all, which would be an uptrend, a downtrend, or sideways trend, respectively.

But what causes the trend?  Simple, the price of the security.  Security prices are set by the balance of its supply in the market and investor demand.  When one is greater than the other the price will change and either increase or decrease.  If the supply and demand relatively match, then the market will be in equilibrium and trade sideways.

The trend will then be used to forecast where the price of the stock will go.  However, before trying to apply trend analysis to a chart know that in some instances no apparent trend could exist.  Avoid the temptation of forcing a conclusion about a trend which could lead you to false interpretations.

Uptrend and Downtrend

An uptrend occurs when the price of a stock reaches higher highs and higher lows.  As the price of the security increases, each new subsequent price high is higher than a previous high.  Each time there is a reversal in the movement of the security’s price, it must stop at a higher low as well.  Because prices are set based on the supply and demand of the security, an uptrend occurs when demand is greater than supply.  If the amount of supply is overwhelming the current levels of demand, then a downtrend will form. This type of trend occurs when a security’s price makes lower lows and lower highs.  As the price decreases, each new high must be lower than the previous one, and each new low must be lower than the prior low.  As discussed prior, if the forces of supply and demand are relatively equal then the security will not be in an up or downtrend. Instead, the price will be moving sideways.

Support and Resistance Levels

Besides understanding the difference between trends, it is important to know the two concepts of support and resistance, which are used heavily in technical analysis.  A support level is the level a security’s price reaches but does not go under. The reason the price does not go under this level is because the demand for the shares is sufficient enough to stop the decline in the price. A resistance level is the level a security’s price reaches but does not exceed, and they form at a price point where selling is sufficient to stop the increase.  A support level forms because buyers of the security think the price is at a good level to buy the asset – a large increase in demand then raises the price of this security.  A resistance level forms at a price point where investors holding the stock think it is at a good price to sell.  An increase in sell trades increases the supply of the stock on the market, driving the price downwards.

An important aspect of support and resistance levels is the change in polarity principle which states that once a support level is breached, it because a new resistance level.  According to this principle, the same can be said for resistance levels: once a resistance level is breached, that price point will become a new support level.  For example, say that the stock of a company never rises about $250 over a time period of 1 year.  Every time the price creeps up to this level it drops down – this price point can be seen as a resistance level.  However, one day the price breaks through this resistance level by a significant amount, reaching a new high.  The price point that this stock reaches will now become a new support level.  Because technical analysis relies heavily on investor behavior and psychology, support and resistance levels are commonly round numbers.

Summary

If you want to try your hand at analyzing securities based on technical analysis techniques, or are studying for any of the CFA exams, definitely familiarize yourself with the different types of trends as well as why they are formed: prices are determined on the relationship between supply and demand within the market. Also, be sure to understand what support and resistance levels are, why they are formed, and what will happen to the price of the underlying security if it breaks through a resistance level or drops below a support level.