Let’s continue our journey…

We have put together a framework of technical aspects here and we need to discover a few more to round out our knowledge of technical analysis.  Let’s do a quick review of what we have covered to this point so that we don’t miss anything in our discussion of all things technical.

First up is candlesticks and their function.  We talked about how we read candlesticks and that they are part of the chart type family.  We use candlesticks because they give us a complete picture of the day’s price action.  We talked about the information that we can get from a single candlestick.  We can get the open and closing prices as well as the high and low prices for that particular timeframe.  We can get candles that represent any time frame and they all give us the same information. When we group candlesticks together we get patterns and trends that form and that is where we are heading next.

We talked about how trends form and how important they are to our trading.  We discussed how the trend is our friend and that most of the time we want to trade with the trend.  We have 3 different trends that we look for.  That would be uptrends, downtrends, and consolidation or sideways trends.  An uptrend consists of a series of candlesticks that have higher high prices and higher low prices.  The downtrend is the opposite, a series of lower low prices and lower high prices.  The sideways trend is easy to identify and is how all trends typically start.  This brings up one more point about the markets.  All markets have three phases to their evolution.  Those three phases are consolidation, a breakout to the trend and then the blowoff or the end of the trend and the market will usually reverse at this point or go back into consolidation.  Next we need to look at what happens when a market or equity runs into a familiar price zone.  These price levels are known as support and resistance.

Support and resistance levels are price levels at which the market participants decide that an equity is either too expensive or too cheap to pass up the opportunity.  We see this at certain prices where an equity will try to break above or below a certain price level and pullback each time it hits that level.  This happens frequently at round numbers like $10 or $50 or $100.  It happens quite frequently at all $5 and 10$ levels typically.  Support and resistance levels usually fail at some point and then we can have breakouts which present us with great trading opportunities.  It is these levels of support and resistance in combination with other candlesticks that can start to form familiar patterns. That brings us to the next part of technical analysis which is the four major patterns.

The four main patterns that we look for in trading are the Bull Retracement, the Bullish Breakout, the Bearish Retracement and finally the Bearish Breakdown.  It is these patterns that give us something to look for that can be recognized and then we can set up higher probability trades from these setups and put ourselves in a position to make a profitable trade.  These four major patterns are not the only patterns you will recognize as there are many sub-patterns that can be found as well.  Some of these sub-patterns are the head and shoulders pattern or the ascending triangle pattern.  There are many more patterns and in the previous episodes of this blog, we go through a few of them.

So this recap of technical analysis brings us to the next part of the technicals that we need to learn about to round out our knowledge.  That is volume.  Volume is a graphical representation of the movement of entities in the marketplace.  Volume shows a picture of the buying and selling of indexes, securities and almost everything that is traded.  Volume can draw an accurate picture of what has taken place during any given time frame but more importantly, it can help us figure out what might be coming down the pike. Volume can help us define if the momentum of a trend may be slowing down or increasing.  This can be very important for the following reason.  Let’s say we are looking to trade a particular equity to the long or bullish side, essentially it means we expect it to go up or continue going up, and we see that as the price is moving upwards but that the volume, or participation rate as some have called it, is starting to drop off?  This could signal that the lust for buying this particular equity is falling off and a reversal could be in the cards, if this were the case then we might want to re-think our idea to buy into this security at least for the time being.  This works in reverse as well, if an equity was dropping in price and the volume was steadily declining then maybe a reversal is coming sooner rather than later.  Take a look at the chart of AAPL below and you can see this declining volume in action.

 

You can see the declining price between the yellow lines and then you can see the declining volume circled in red.  This declining volume is showing us that the selling is becoming less and less until that price turns around after that green doji looking candle.  This happens over and over again in the markets and this volume behavior is a big neon sign saying look at me!  If we pay attention to these things then it can give us a leg up in our trading.

Volume can do more than tells us if momentum is slowing.  It can also tell us a few more things about the psychology of the market participants.  If we see extraordinary volume then sometimes it can mean a little panic and it is typically short-lived as panics usually give way to normalcy at some point.  This panic can indicate that when the high volume starts to wane that a direction reversal is quite possible due to the exhaustive nature of the panicked buying or selling.  This is what is referred to as the blowoff.  It’s not just high volume that can give us clues but moderate or steady volume can mean that a trend in price can continue for quite a while.  From the same chart above, if you look at the volume after the reversal in red then the volume is pretty steady and the price just keeps climbing.  You can see that volume is very good at giving us clues as to what could be coming at us.  There are other leading technical indicators that can give us clues as to what the future might hold and we will discuss leading and lagging indicators and oscillators in the upcoming blogs!  So until we meet again make sure you are watching the volume on the charts as much as you are watching the trends and the candlesticks!