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Technical Analysis

Share prices constantly change, as a trader your objective is to learn to identify where the prices may go next. 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 analysing 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 share or CFD. Technical analysis helps you determine when you should buy or sell that share or CFD.

While Technical Analysis may seem complex, it is indispensable to successful trading, and the basics are reasonably simple:

 

Trends – where prices may be going

Support and Resistance – where prices may stop and turn around

Technical Analysis - Trading with the Trend

Trading with the Trend

Identifying trends and trading intelligently with them in mind is vital to your success as a 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 share has achieved some momentum, it is likely to be sustained for a while. Spotting such a trend will increase your likelihood of making a profit.

Trends indicate where prices will probably head in the future. Trends are not entirely linear. Prices rarely move straight up or straight down. Movements are always a little unpredictable because of the many individuals who are trading, and because traders are largely trading in idiosyncratic ways. Yet there is a herd mentality. When a majority of traders believe the share 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 until the majority lose 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.

There are turning-points in price trends. 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, hinges on the recognition of upward and downward trends.

Upward trends

– shares or CFDs that are upward trending form a series of higher highs and higher lows (see Figure 1).

Technical Analysis - Up Trend

Figure 1–Up Trend

Down trends

– shares or CFDs that are trending downward form a series of lower highs and lower lows (seeFigure 2).

Technical Analysis - Down Trend

Figure 2–Down Trend

Sideways trends

– shares 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).

Technical Analysis - Sideways Trend

Figure 3–Sideways Trend

Technical Analysis - Trend time frame

Trend time frame

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 timeframe and being able to utilise them will be crucial to your success as a CFD trader:

  • Long-term trends
  • Intermediate trends
  • Short-term trends
  • Aligning trend time-frames
  • Long Term Trends

Fundamental factors are the major drivers of long-term trends. If companies perform fundamentally well, their share prices typically rise. If companies perform fundamentally poorly, their share 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 Trend

Long-term trends, sometimes called major trends, are those trends that have dominated for the longest period.
Looking at this weekly chart of CBA you will notice that during the period reflected in the chart the price continued steadily in an upward trend, which runs from left to right. (see Figure 4 ).

Next, you ought to examine an intermediate trend to see if it is heading in the same direction as the long-term trend.

Long Term Trend

Figure 4– Long – Term Trend

 

Intermediate 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 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 ).

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.

Mid Term Trend

Figure 5 – Intermediate Trend

 

Short-Term Trend

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 CBA 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 ).

If you look at the end of the hourly chart for CBA, 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.

Short Term Trend

Figure 6–Short-Term Trend

 

Aligning Trend Time-frames

Your most profitable trading opportunities will come when the long-term, intermediate and short-term trends all line up in the same direction. When long-term, intermediate and short-term trends all rise in unison, it is an ideal time to buy a share or CFD. When long-term, intermediate and short-term trends fall in unison, it is an excellent time to sell.

The CBA chart shows that the trend for each time-frame has risen over the period show in the chart (see Figure 7 ).

Understanding trends is critical to technical analysis but you should also understand the concepts of support and resistance.

Short Term Trend

Figure 7–Aligning Various Trend Timeframes

Technical Analysis - Support and Resistance

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 to which prices repeatedly fall, and bounce off, as if hitting a floor. It is thought of as the level at which a lot of buyers tend to enter the stock.

Support usually occurs because of the following:

  • Traders who missed an earlier buying opportunity decide it is a good price to invest
  • Traders who bought the share or CFD decide it is a good price to add to their positions
  • Traders who sold the share or CFD decide it is a good price to take profits

Resistance is a price level to which prices repeatedly rally, and then pull back, as if they were hitting a ceiling. Resistance usually occurs because of the following:

  • Traders who missed an earlier selling opportunity decide it is a good price to trade
  • Traders who sold the share or CFD decide it is a good price to add to their positions
  • Traders who bought the share or CFD decide it is a good price 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 and you would only frustrate yourself trying to pinpoint a specific price level as the ideal price to support. Instead you would be much better off identifying a price range 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
  • Diagonal support and resistance

Horizontal Support and Resistance
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 CFDs that you are interested in trading.
On the BHP chart, for instance, you can see that certain price levels (indicated by bold yellow lines) acted as strong levels of support and resistance. (see Figure 8).

Once you can confidently identify horizontal levels of support and resistance, you can move on to diagonal levels of the same.

Horizontal Support and Resistance

Figure 8–Horizontal Support and Resistance

Diagonal Support and Resistance

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.

As you look at the chart of a CFD you will notice that they often form higher highs and higher lows (or lower highs and lower lows). The lines connecting these highs and lows are diagonal support and resistance levels.

Examine the BHP chart again. You can see that the price hit a series of lower highs and lower lows toward the end of the chart period. If you connect all of the highs with one diagonal line and all of the lows with another diagonal line (indicated by bold yellow lines) you will be able to see the diagonal levels of support and resistance that drove BHP’s price (see Figure 9).

Diagonal Support and Resistance

Figure 9–Horizontal Support and Resistance

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 BHP’s price chart, such levels co-exist and interact. In conclusion, your 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.