by John Lansing | July 23, 2013 9:18 am
There are lots of ways to pick stocks — fundamentals, technical analysis, giving a toy to a cat — and the one that works best to you will largely depend on your investment goals and time horizon.
Still, it’s helpful to have a grasp on the basics of all different investment strategies. You never know when they will come in handy.
With that in mind, let’s take a quick second to break down the basics of analyzing charts. Essentially, you are looking for patterns — i.e., objects or shapes that call to mind an image of a similar event in the past. Because patterns repeat, we can use them to determine the probability of a certain outcome. Technical analysis helps us distinguish between what is real and what we think is real. As I always say, “The charts never lie.”
Technical analysis is full of patterns, most aptly named for the type of shape they make. I’m going to describe a few of the more common bullish chart patterns that indicate that a stock is about to head up.
The following will give you a solid grasp of the basics you need to become a pro at reading these chart patterns.
In technical analysis, triangles appear to reflect a balance of forces, causing a sideways movement in the stock that is usually associated with decreasing volume and volatility. The ascending triangle (also called an ascending right triangle) is a bullish indicator.
An ascending triangle is characterized by a rally to a new high, followed by a pullback to an intermediate support level, then a second rally to test the first peak, followed by a second decline to a level higher than the intermediate-term support level and, finally, a rally to fresh new highs on strong volume.
A double-bottom occurs when prices form two distinct lows on a chart at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing. A double-bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double-bottom is a reversal pattern of a downward trend in a stock’s price. The formation marks a downtrend in the process of becoming an uptrend.
A head-and-shoulders bottom is a bullish signal that indicates a possible reversal of the current downtrend into a new uptrend in a security’s price.
A perfect example of the head-and-shoulders bottom has three sharp low points created by three successive reactions in the price of the financial instrument. It is essential that this pattern forms following a major downtrend in the financial instrument’s price.
Trading volume is absolutely crucial to a head-and-shoulders bottom. Traders should look for increasing volumes at the point of breakout. This increased volume definitively marks the end of the pattern and the reversal of a downward trend in the price of a stock.
A triple-bottom illustrates a downtrend in the process of becoming an uptrend. This reversal pattern displays three distinct minor lows at approximately the same price level. Prices fall to a support level, rise, fall to that support level again, rise, and finally fall, returning to the support level for a third time before beginning an upward climb. In the classic triple-bottom, the upward movement in the price marks the beginning of an uptrend.
The three lows tend to be sharp. When prices hit the first low, sellers become scarce, believing prices have fallen too low. If a seller does agree to sell, buyers are quick to buy at a good price. Prices then bounce back up. The support level is established and the next two lows also are sharp and quick.
Rounded bottoms are elongated and U-shaped, and are sometimes referred to as rounding turns, bowls or saucers. The price pattern forms a gradual bowl shape, and there should be an obvious bottom to that bowl. While price can fluctuate or be linear, the overall curve should be smooth and regular, without obvious spikes. The pattern is confirmed when the price breaks out above its moving average.
A rounded bottom forms as investor sentiment shifts gradually from bearishness to bullishness. As the sentiment turns down toward the bottom, there is a drop off in trading volume due to the indecisiveness in the market. There is a period of consolidation at the bottom (this must be present to consider it a true rounded bottom) as trading bounces within a certain range. Then, finally, there is a gradual upturn marking the shift to bullishness. As investors become more decisive about the bullishness, there is an increase in trading volume.
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