Technical analysis, as opposed to fundamental analysis, is the study of market action, primarily through the use of charts. The technician believes that anything affecting the price, such as fundamentally or psychologically, will be reflected on charts. Technicians believe that the market discounts everything and that any news about a company is already priced into the stock. Keep in mind that the charts do not cause market action, but rather, they reflect the actions of the marketplace and what has already happened. However, this does not mean you should not study fundamental analysis, since it is just as important.

Technical analysis is applied social psychology because when you analyze charts, you are analyzing the behavior of traders. Charts reflect trades by all market participants: buyers, sellers, and even insiders. Each price on the charts reflects the actions or lack of actions by all the traders in the market.

Technical indicators help make our analysis more objective as it seeks to recognize trends and changes in crowd behavior so that intelligent trading decisions can be made. Technical analysts study charts to find out whether the bulls or bears are in control. They look at past charts for repetitive price patterns and study to recognize the early stages of uptrends and downtrends.

There are 2 main types of technical analysis: classical and computerized.

1. Classical analysis – This is based only on the study of charts, without using anything more complex than a pencil and a ruler. This is mainly the focus on uptrends and downtrends, support and resistance zones, as well as repetitive patterns, such as triangles and rectangles. Its main drawback is its subjectivity: if you are bullish, your ruler will tend to inch up and likewise, if you are bearish, your ruler will tend to inch down.

2. Computerized analysis – This is more of a modern approach whose signals are much more objective. The 2 main types are trend-following indicators and oscillators. Trend-following indicators include moving averages, Directional System, and MACD (moving average convergence-divergence), which all help to identify trends. Oscillators, such as Stochastic and Relative Strength Index (RSI) help identify reversals.

As you can observe, technical analysis is partly a science and partly an art—partly objective and partly subjective.

But be careful because charts are full of false breakouts, false reversals, and flat trading ranges.

MACD Crossover

Let’s look at the following stock, KHD. MACD crossover occurs 4 times on the chart, and each time the stock went up quite a bit right after.

Stochastic Crossover

Stochastic crossover works pretty well for the following stock, AMED. There were 5 stochastic crossovers for this stock, and the stock went up after the crossovers. If you look at the chart carefully, the stock seems to be more bullish when the stochastic crossover is sharper.

Again, technical analysis is all about pattern recognition. You can get in when you find a pattern that you think is profitable and get out when that pattern breaks. That’s why you need to watch a lot of stocks.  Some stocks might work out, some don’t. In the past few years, I’ve seen people lose money because they tend to hold their stocks too long even after the pattern is broken. What they did is the following

1. They find a pattern on a stock and buys it.

2. The stock drops and the pattern is broken.

3. They keep holding the stock, hoping it will go up again.

4. Their losses are getting bigger and bigger, eventually destroying their whole portfolio.

5. They decide to move on by either giving up completely or looking for other stocks.

This is not going to work. There is no magic in technical analysis and it doesn’t work all the time. You need to learn to get out of the trade when the pattern is turned against you. You may argue, “what if the stock did go up when after you sell the stock?” This happens all the time, but what if the stock doesn’t go up and goes bankrupt instead? You will lose all your money on one single stock. To win the game, you need to be disciplined instead of hoping.

Bullish Triangle Pattern

There are 2 types of bullish triangle patterns – symmetrical and ascending as demonstrated in the following figures:

Type 1 – Bullish Symmetrical Triangle

1. A stock is in an uptrend

2. It forms a symmetrical triangle

3. It breaks out from the triangle and goes higher

Type 2 – Bullish Ascending Triangle

1. A stock is in an uptrend

2. It forms an ascending triangle

3. It breaks out from the triangle and goes higher

Let’s look at some examples:

The figure below shows ENTG formed a symmetrical triangle in May. Soon after that, the stock went from 2.0 and peaked at 3.4 with a percentage gain of over 70%.

Here’s another stock (FEED) that formed a symmetrical triangle in April.  The stock jumped from $2.5 a share to $8 in less than 3 months. That is a 220% gain in value.

Let’s look at a stock with an ascending triangle, TSL, which is a solar company I used to swing trade pretty often. The stock doubled in value from $14 a share to $28 in one month right after it formed an ascending triangle in May.

Bearish Triangle Pattern

There are 2 types of bearish triangle patterns- symmetrical and descending as demonstrated in the following figures:

Type 1 – Bearish Symmetrical Triangle

1. A stock is in an downtrend

2. It forms a symmetrical triangle

3. It breaks out from the triangle and goes lower

Type 2 – Bearish Descending Triangle

1. A stock is in an downtrend

2. It forms a descending triangle

3. It breaks out from the triangle and goes lower

Here’s an example of a descending triangle. The stock LGN formed a descending triangle pattern at the end of May. It was a declining stock and continued to drop when the pattern was forming. It declined another 20% in less than 2 weeks after the pattern was formed.

MORE ABOUT TRIANGLES

Bullish Stochastic Divergence

There are two types of bullish divergence patterns.

Type 1
1. When a stock is in a downtrend, the price is going down and at the same time frame,
2. Stochastic is going up.

Type 2
1. When a stock is in a consolidation area and at the same time frame,
2. Stochastic is going up.

The psychology behind this pattern is simple. The price is dropping, but the trend becomes weaker and weaker with a bullish reversal up ahead. The Type 1 divergence is more bullish than Type 2.

Bearish Stochastic Divergence

There are two types of bearish divergence patterns.

Type 1
1. When a stock is in an uptrend, the price is going up and at the same time frame,
2. Stochastic is going down.

Type 2
1. When a stock is in consolidation area and at the same time frame,
2. Stochastic is going down.

The psychology behind this bearish divergence pattern is the same as the bullish one. The price is going higher, but the trend becomes weaker and weaker with a bearish reversal up ahead. The Type 1 divergence is more bearish than Type 2.

Let’s look at some real examples.

The figure below shows DTV formed a Stochastic divergence on Mar 9 when the stock was still in a downtrend. Soon after the divergence pattern, the trend reversed, and the stock price went from 19 all the way up to 25.5.

The figure below shows two divergence patterns for the same stock. The first one was formed back in mid April as highlighted in blue, and the stock price went from around 9.25 to 15.5. The second one was from last week and that was one of the reasons why I bought this stock. Let’s see how it turns out.

Divergence is a leading technical indicator and is one of the most important indicators in technical analysis. However, one thing to always keep in mind is, no single technical indicator works all the time. When a pattern doesn’t work out, you must sell the stock and look elsewhere. There are thousands of stocks out there, so don’t fall in love with any one stock. You don’t have to be right every time to make money in the stock market. The important thing for you is to make lots of money when you were right and get out of trades with minimum losses as quickly as possible when you were wrong. After all, that’s what technical analysis is all about.