Technical Analysis - Tools and Tactics

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Technical Analysis:
Tools and Tactics
Just as with fundamental analysis, there are tools that technical analysts
use to determine when to buy or sell a stock. All of the tools explained
in this chapter can be found on a stock chart (since technicians study
stock prices using charts). By the time you finish this chapter, you
should have a better understanding of many of the tools and tactics used
by technical analysts. For some people, technical analysis can seem
confusing. With practice, however, it should make more sense.
Volume: An Underestimated but Powerful Indicator
Volume shows how many shares changed hands during a given period.
It is the fuel that drives stock prices higher or lower. By studying the
volume of shares being traded, you can obtain clues as to whether a
stock is moving because of true buying or selling interest or other fac-
tors that could influence the direction of the stock.
In today’s market, billions of shares of stock are traded every day
on all three stock exchanges. If less than a billion shares are traded dur-
ing the day, it is considered a light volume day. It isn’t hard to guess
CHAPTER
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why this is true. In 1929, only 8 percent of the people in the United
States were invested in the stock market. Now it is estimated that over
60 percent of the people are invested in the market, either through
mutual funds or directly in stocks.
Sometimes you will hear people on Wall Street talk about a liquid
market. This is another way of saying that there is a lot of volume in
the market or in an individual stock. The pros on Wall Street want to
see a lot of liquidity and do everything in their power to bring people

into the market, especially buyers. The more liquid a stock is, the eas-
ier it is to get into and out of it. That is why you want a lot of liquidity
in the market.
Advanced Technical Indicators and Oscillators
Now I’m going to show you a couple of neat little tools, called techni-
cal indicators and oscillators, that short-term traders use before they
enter or exit a trade. Although there are dozens of these technical indi-
cators, we’ll look at the most popular. Be aware that it takes a while to
thoroughly understand many of these tools.
Moving Averages: Simple but Powerful Tools
One of the simplest but most valuable technical indicators for both
investors and traders is the moving average (MA). A moving average is
the average price of a stock for a specified period—for example, a
specified number of hours, days, or weeks. When plotted on a chart, it
is displayed as a line that moves forward with each trading day. When
moving averages are put on a chart, they give technicians a lot of clues
about where a stock is headed.
Many technical analysts use moving averages as support and resis-
tance. If the stock price rises above the moving average, this is seen as
a bullish sign. Conversely, if the stock price drops below the moving
average, this is seen as bearish and is a signal to sell. In particular, many
institutional investors use the 200-day MA as support and resistance.
For example, if the stock price is trading below the 200-day MA, this is
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a signal to sell. If the stock price is trading above the 200-day MA, this

is a signal to buy.
Short-term traders tend to use the 40- or 50-day MA to determine
support and resistance levels. It’s sometimes uncanny how a stock can
nudge up to the 40- or 50-day MA and then immediately reverse direc-
tion. Keep in mind that you should not base your trading decisions
solely on moving averages (or any other technical indicator), but the
MA does give you an idea of the strength and direction of the stock
trend. Figure 12-1 shows a stock chart with two moving averages—the
50-day MA and the 200-day MA.
In Figure 12-1, for much of the period shown, Caterpillar remained
well below its 50-day and 200-day MA. Near the end of August, it
bumped up against the 50-day MA before reversing direction. At the
end of October, the stock broke through the 50-day MA on rising vol-
ume, a very positive sign. By the end of November, it also broke
through the 200-day MA. From a short-term technical perspective, this
stock should be held until there are signs that it has run out of steam.
TECHNICAL ANALYSIS
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TOOLS AND TACTICS
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CAT Daily
SMA (50) SMA (200)
Volume
Feb Apr May JunJul Aug Sep Oct Nov DecMar
56
58
60
54
50
52

36
38
40
42
44
46
48
32
34
10
8
6
4
0
2
12/06/02
Millions
©Big Charts.com
Figure 12-1 Moving averages
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On-Balance Volume (OBV): A Measure of Volume
On-balance volume (OBV) is one of the most underutilized but impor-
tant indicators. OBV measures volume, which, as you remember, is the
force that makes stocks go up or down. When you put OBV on a chart,
a volume line appears at the bottom of the chart on top of the volume
bars. OBV basically measures how much money is flowing into or out
of a security.
If the OBV line is dropping, it tells you that people are selling. If
the OBV line is rising, it tells you that people are buying. After all, no
matter what is happening in the market, if people are pulling money out

of a stock, its price will go down. Conversely, if people are buying a
stock, its price will go up. Figure 12-2 gives an example of OBV.
Because technical analysis is not an exact science, many traders
use OBV to confirm what is happening with a stock. For example, let’s
say that a stock is up by 3 points but the OBV is dropping. This tells you
that although the stock is temporarily going up, it’s not going to last.
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TOCKS
CAT Daily
On Balance Volume
811 1415181920212225
26 27
29 3Dec
4
5612 13
49
50
47
48
43
44
45
46
41
42
20
10

0
–20
–10
12/06/02
Millions
©Big Charts.com
Figure 12.2 On-balance volume
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For whatever reason, people, most likely institutional investors, are
selling. The dropping OBV is a signal that you should immediately sell
the stock. In Figure 12-2, the OBV initially rose along with the Cater-
pillar stock price. In early December, the OBV was slowly dropping
along with the Caterpillar stock price. This was a clear signal that, at
least for the short term, institutional investors were selling this stock.
One of the biggest problems with technical analysis is that you
sometimes get false signals. OBV helps you determine whether the
buying and selling pressure is real or whether a reversal is imminent.
For example, let’s say that the price of a stock is falling but OBV is ris-
ing. An alert trader will buy, not sell, because it’s possible that the stock
price will reverse as more buyers accumulate shares.
Relative Strength Indicator: A Measure of Whether Stocks
Are Overbought or Oversold
The relative strength indicator (RSI) measures the relative strength or
weakness of a stock when it is compared to itself over a specified
period. It is an oscillator with an upper and lower band that ranges
from 0 to 100 on a vertical scale. An example of the RSI is given in
Figure 12-3.
To understand the RSI, you need to know what is meant by relative
strength and relative weakness, two of the most important concepts in
technical analysis. Relative strength means that a stock is strong com-

pared to another stock or to an index. For example, if the Nasdaq is
falling but Bright Light is rising, then Bright Light is strong relative to
the Nasdaq. (From a technical viewpoint, stocks with relative strength
are good buys.) Conversely, if the Nasdaq is going up but Bright Light
is dropping in price, then Bright Light has relative weakness. (Gener-
ally, you avoid buying stocks with relative weakness.)
When used in conjunction with other technical indicators such as
moving averages and OBV, the RSI is a powerful tool that can help to
identify whether a stock is overbought or oversold. This allows you
to determine which stocks are going to run out of energy and succumb
to the bears (overbought). On the other hand, the RSI will also help
you to identify stocks that have fallen and are about to reverse and
move higher (oversold).
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