What is Technical Analysis?
Stockscores.com Perspectives for the week ending February 27, 2005
In this week's issue:
There are two main disciplines of security analysis; fundamental and technical. The fundamental approach considers all aspects of a company's business as it relates to the overall economic environment in an attempt to extrapolate the future value of the stock. Where this analysis reveals that the expected value of the company is greater than its stock price, an investment opportunity is found.
Technical analysis considers market activity to reveal significant new information and understand the psychological factors affecting stock price in an effort to predict future prices and trends. The remainder of this essay will seek to better explain what this means.
How is Stock Price Determined?
Simply put, the value of a company is the present value of all the money that the market expects the company to make in the future. The company's value is based upon the earnings value of its assets, which will fluctuate as the economy rises and falls and as the company makes changes to it business. Of course, this calculation presents a good deal of uncertainty, so there is an added component of risk.
What is important in evaluating the earnings potential of any company is information. For each publicly traded company there exists an immense amount of information on that firm's future earnings potential. As new information is made public, the market seeks to 'price in' that information. For example, if a small oil company finds a new source of oil, their earnings potential and value will rise. The increase will occur when the market learns of the new find. On a macro-economic level, another example affecting an oil company will be the price of oil. If oil prices go up, the value of the oil company will also improve as they will be able to enjoy greater profits from the price increase of their commodity.
What is important to understand is that prices change because new information affecting the value of the company, and therefore its stock, comes to the market. The stock market is a forum for debate on what that new information is worth and, every day, market participants argue about stock value by buying and selling stock. Those who sell feel that the company is not worth more than the price they are selling at, and those who buy believe that the information known about the company is worth more than the current market price.
Information, Fear and Greed
It should now be clear that information is key to determining share price. However, it is not the only factor that has an effect. Since the stock market is the product of human decision, our characteristics must also be factors. While many financial theorists argue that all market participants are rational, the reality is that we are not computers and therefore are subject to that thing which sets us apart: emotion.
Emotion causes market participants to make what, with hindsight, are determined to be emotional decisions. Fear causes us to sell stocks because we are afraid they are going lower, and greed causes us to buy stocks because we hope they are going higher. Being afraid and hoping are not rational thought processes, but rather emotional outlets in the pursuit of pleasure and pain. It hurts to lose money, and it feels great to make money.
The results are stocks that go up higher or down lower than the presently available information warrants. Eventually, rational valuation of information takes over and these stocks move toward their fair value, but the process takes time.
The Opportunity
Technical analysts use the trading activity of stocks to understand where new information is being revealed on stocks, and where fear and greed have made the market on that stock get overextended. Just as a doctor uses a cardiogram to reveal what is going on in a patient's heart, technical analysts use the stock chart to understand what is happening in the market.
By understanding how to read a stock chart, anyone can understand any business. Those people who have the highest level of understanding of an individual company's business will have the greatest effect on predicting where a stock is going because they cast their vote in the market by buying or selling the stock. When they do, they leave a trail that the technical analyst follows by looking at the stock chart. They reveal new information by buying or selling enough stock to be noticeable. Then, other market participants cause the stock to overextend because of fear or greed.
The Application of Technical Analysis
Stock charts tell us a lot about what companies are doing, what they will be doing and what the market thinks of it all. However, we have to learn how to read stock charts. At the most basic level, there are some important concepts that should be kept in mind:
Uptrends are characterized by rising bottoms on the stock chart and can be described as periods of optimism
Downtrends are characterized by falling tops on the stock chart, and can be described as periods of pessimism
Abnormal trading activity often signal significant fundamental change in the company's business
Support is a floor price that the market has shown an unwillingness to trade under in the past
Resistance is a ceiling price that the market has shown an unwillingness to above in the past
We invite you to learn the tools available on this web site to become better at understanding why stocks move and how to predict when they will make significant moves. In doing so, you can become an expert on any business simply by reading market activity. Technical analysis is a powerful tool that really just interprets fundamental analysis and the efficiency of the stock market.
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A common theme among Head and Shoulder Bottom, Ascending Triangles, Pennants and Rectangle Consolidation patterns is a break through resistance from low price volatility, usually with volume supporting the breakout. Rising price bottom formations in to the breakout point are common, but what market dynamic do these patterns really represent?
Rising bottoms are a sign of growing optimism among investors. As time passes, they demonstrate a weakening of selling force and increase power among buyers. As a stock moves up toward a resistance price point, the market is faced with the upper limit on what investors believe the company to be worth. We often see that stocks will go in to narrow trading ranges under resistance as investors come to a consensus on the value of the company. When stocks break out from this condition, they may be signaling significant new fundamental information at work in the market since resistance has been broken from strong consensus out of a period of optimism.
The Sentiment Stockscore is useful for finding optimism in the market, and the Signal Stockscore is heavily weighted on the abnormal market activity that comes with breakouts. By looking for stocks that have a Sentiment Stockscore of 60 or higher, and a Signal Stockscore of 80 or higher, we can consider charts that may have a good chart pattern set up. The Stockscores Simple Market Scan adds in some other technical filters to shorten the list of potential candidates further.
This strategy is not solely about finding stocks with good Stockscores. The most important step is visually inspecting the charts to ensure that the chart patterns are what we are looking for. A good chart pattern will have the following characteristics:
a break through resistance
abnormal activity, in terms of price and volume activity
The break through resistance should be from a period of low price volatility. Low price volatility is characterized by the price range of trading on each day (how tall the trading range is on the chart) and by the range of trading over a number of days (are the trading days side by side on the chart, or is there a price trend?)
low of optimism leading in to the break through resistance from low price volatility.
It is necessary to have all of these criteria, many traders forget to check whether the stock was trading with low price volatility before the breakout, or to make sure that the stock is truly breaking through resistance and will not encounter more selling pressure soon.
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1. NTST
NTST is breaking out through resistance at $10 from a period of rising bottoms and therefore optimism. This break from a pennant pattern looks very good, my only concern is the lack of volume supporting the breakout. The stock has potential so long as it can hold above support at $9.40.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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