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Introduction to Technical Analysis

Introduction to Technical Analysis

Technicians develop their trading strategies by analyzing statistics generated by market activity, such as past prices and volume.  Technical analysts do not attempt to measure a security's value, but instead use charts to identify patterns that can suggest future activity.  These traders typically have a shorter time frame than investors, seeking to make money from the shorter term movements of securities.

They look for peaks, bottoms, trends, patterns and other factors that provide insight on the potential movement in a stock.  There are hundreds of indicators and chart patterns that these "chartists" use today.  Many claim to have phenomenal success, though these results are hard to independently verify.  However, Thomas N. Bulkowski, a hardware and software design engineer with Raytheon and Tandy, conducted a statistical study of stock chart patterns from 1991 to 1996.  His study, Encyclopedia of Chart Patterns (Wiley Trading), statistically analyzes the performance of over 50 chart patterns identifying best performing bullish and bearish patterns.  These patterns along with changes in daily volume help indicate entry, target and exit points for trading stocks.

To help everyone gain some understanding of how technical analysis works let's look at an example.  T. J., our industrious trader, has read and studied Bulkowski's book.  Late November 2004, he was searching for potential stocks to trade when he looked at the chart for Carrizo Oil & Gas, Inc. (CRZO).  The chart below is what he saw.

He noted that there was resistance (the high reached the week of 6/21/04) at 10.87, then in October the price hit a high of 10.50, and there was an underlying up trend that began April 2003 with average volume increasing.  He knew that this pattern is called an ascending triangle.  Ascending triangles represent market supply and demand forces of a stock that is building support through the uptrend and encountering resistance at the horizontal line.  Looking at CRZO T.J. noted that retreats toward the uptrend encountered buyers who think this is a good buy causing the price to go up.  As it approaches the resistance line sellers who have been in the stock from earlier positions close out some of their positions causing the stock to stop rising.  He knows that a break out (the stock moves above 10.87 with strength) will only occur if there is sufficient buying volume to move the stock up.  So he created an alert in his stock trading system that would warn him when this stock price reached 10.57 (.30 below break out).  T.J. also entered an alert for CRZO on the down side after noting that in addition to the uptrend, the 200 daily Exponential Moving Average seemed to act as support as well.  He chose 9.50 as that alert price.

In November and then again in early December the price approached support near 9.  Since this is looks to be a good intermediate term support level, T. J. could enter an order between 9 and 9.5.  This might be a good entry price if the fundamentals for the company were strong.  Also, a stop loss could be placed below the support level of 9, at 8.75, to help minimize any loss.  Many technical traders also use these support levels to make their buys.

On 12/20/04 CRZO broke above 10.87 with volume slightly above average.  T.J.'s discipline calls for him to enter breakout trades when there is strong continuous volume and he felt he should wait to see what happens in the next several days.  T.J. likes to swing trade, often holding a stock for several months before selling.  His sister C.J. is a day trader and traded CRZO, entering a limit order at 10.91 (4 cents above breakout to help insure she gets the shares) when CRZO trades through 10.87 with above average volume.  C.J. sold 1/2 of her shares later that day for $.30 profit per share (3%) before commissions.  She also entered a trailing stop loss at $.30 below the bid price.  This way she was assured of at least breaking even on her remaining shares.  On 12/21/04, C.J.'s remaining shares were sold at 11.27, leaving her a $.36 profit on her remaining shares (3.3%) before commissions.  A nice quick trade.

CRZO moved sideways for the next several weeks eventually moving down to 10.  On 1/11/05 volume jumped dramatically and continued the next day.  T.J. decided to enter his limit order at 10.91 on the second day, since volume was so strong.  He chose 10.91 since it was $.04 above the earlier resistance level.  Before entering his trade T.J. selected his initial stop loss to be 9.1, $.20 below 200 Day Exponential Moving Average (EMA).  T.J. will move this stop up with the upward movement of the 200 EMA.  T.J. had observed that the overall market was in a secular bull market and that the price of oil seemed to be trending up.  The chart above shows what how CRZO performed over the next year and a half.

As CRZO moved up, T.J. decided to set up two stops.  One that followed the 200 EMA for half of his position and one that was set at key support levels as displayed by the chart for the other half of his position.  Late in March 2005 T.J. observed that there seemed to be support at 14.7 area.  So he reset his key support stop to 14.71 for half of his position.  On May 19, 2005 this stop was hit and T.J. closed out half of his position for a $3.80 profit per share or 35%.  Not bad for 5 months.  Note that his stop that is following the 200 EMA is just above 12.5 in May 2005.

T.J. is using a proven money management technique that captures profit in stages as his stock's price rises.  By selling half of his position, T.J. not only captures a very nice profit, but he now has more capital to invest again.  And he still has the other half of his original CRZO position still invested with a trailing stop following the 200 EMA.

Staying true to his discipline T.J. continues to move his trailing stop up throughout 2005.  Finally on 2/28/06 CRZO price hits his stop at 22.91 leaving T.J. with a $12.00 per share profit or 110% over 14 months.  Another nice trade.

Now not every trade using ascending triangle technical analysis and this stop loss discipline will produce these kind of profits.  Hey, it is a good example of what is possible.  Trader's Insights will include more on technical analysis and trading techniques over the next several weeks and months, so please check back often.


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