Technical Analysis

In a post earlier this week I talked about Fundamental Analysis and some of its basic tools. The counter to Fundamental Analysis is Technical Analysis.

Technical Analysis involves finding patterns and trends in market data, and using those trends to build an investment strategy. Technical Analysts believe that all relevant information regarding a security is contained within the current price of that security, so their focus is primarily on the internals of the price, rather than external factors such as company announcements or activity in the greater market. This is the primary reason why Fundamental Analysis and Technical Analysis are so different; from a Technical Analysis point of view, Fundamental Analysis is pointless because the effect of those fundamental indicators that I described in my Fundamental Analysis post has already been taken into account with the current price of the stock. Believing this, a Technical Analyst can then focus solely on the price of the security, and study how it has trended over time.

To illustrate the application of Technical Analysis, I’m going to look at Google’s (GOOG) chart over the past year, using Yahoo! Finance’s tools.

As you can see from the chart, I have the original price data, with a number of overlays and indicators. I will explain each of them and why I chose to use them, but it should be noted that they represent just a subset of the indicators and chart overlays that can be used, and the parameters can and should be adjusted. The analysis is for example purposes only.

My dataset is the two year price chart for Google (GOOG). With that price chart I have included two overlays:

• Moving Average – Moving Averages are a commonly used tool in statistical analysis, particularly in the analysis of time-series data (i.e. a dataset that contains data at a sequence of time intervals, which are often uniform), so it is a perfect fit for stock price analysis. Moving Averages are used to smooth out the data, meaning short-term fluctuations are minimized so that the long-term trends can be more easily identified.

• Exponential Moving Average – EMAs are a modification of the standard Moving Average. It introduces the idea of “weights”, in this case, meaning that older data points have a smaller impact on the average value than more recent data points. EMAs have the same purpose as standard Moving Averages, except that by weighting the data points based on time, they hopefully do a better job of illuminating trends and eliminating noise.

In addition to the two overlays, I have included the following four indicators:

• MACD – MACD stands for “Moving Average Convergence/Divergence”; it is used to identify trend changes by generating three types of signals: when the MACD line crosses the signal (i.e. price) line, when MACD crosses zero and the divergence between the MACD line and the stock price line. MACD is a lagging indicator, and many Technical Analysts use more modern, computer-based, computational analysis tools. However, it still has use as a price movement monitoring tool.

• ROC – ROC stands for Rate of Change, and all it does is show the percentage difference between the current price of a security and the price of the same security a certain number of periods ago. ROC is most commonly used as a way of indicating momentum.

• RSI – RSI stands for Relative Strength Indicator, and it compares up and down close to close movements in an attempt to measure how fast a security’s price is moving either up and down and at what magnitude it is doing so, in other words, the momentum of the stock’s price.

• Fast Stoch – Fast Stoch refers to the Fast Stochastics indicator, which is used to find the relation between a stock’s current price and its highest and lowest point over a period of time. Fast Stoch’s tend to be very sensitive to price changes, an as such, the Slow Stochastic indicator has been introduced, and it uses Moving Averages to smooth out the Fast Stochastic values.

As I mentioned, those are just a number of the different analysis tools that you can use (others include MFI, Slow Stoch, and a variety of Volume analysis tools). I am not much of a Technical Analyst; I see value in it but right now I only use it to give me a little more information and some perspective on stocks that I’m interested in (although I’d certainly like to learn more). So if any readers have any books they’d like to suggest, I’d love to hear about them. The book I’ve used is entitled “Select Winning Stocks Using Technical Analysis” by Clifford Pistolese. From a technical standpoint, it doesn’t have a lot of the details that some might be interested in, but it has an excellent overview of a variety of topics and I’ve found it very useful. Let me know what you use and what you think of Technical Analysis in general!

-Michael
Twitter: @Michael_Dink