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Technical Analysis


The Benefits of Technical Analysis

Gain some insight into where the stock price might be heading

The Benefits of Technical Analysis - picture of a stock trader using both hands to conduct a technical analysis on a stock chart showing several different indicators on graph grid lines

Technical analysis involves visually displaying a stock's price history on a chart and analyzing the historical price movements. This analysis gives the stock trader some insight into the possible future stock price movements. The modern day concepts of technical analysis were developed during the late 1800s and early 1900s.

Some of the names behind its early development were the renowned Charles Dow, the famous investor Jesse Livermore and the market analyst and speculative trader Richard Wyckoff.

The concept behind trends within trends (such as a short-term within a medium-term trend) is accredited to Ralph Elliott developed the Elliott Wave Theory. The work done by Elliott paved the way to Understanding Trends.

Beginners wonder what is the difference between technical analysis and fundamental analysis and why are there two approaches to analyzing a stock. To put it simply, technical analysis is the process of analyzing a stock's price behavior while fundamental analysis is the process of evaluating the valuation and future prospects of the company. Thus there are two prices for a stock, fundamental analysis will determine what the company is worth and technical analysis tracks what the market is willing to pay for this stock.

While technical analysis is primarily directed towards short-term analysis and thus is extremely popular with stock traders, there are several concepts in technical analysis that are quite useful for a stock investor to understand. A lot of professional stock investors utilize some of these concepts to select a more opportunistic entry for their investments and indeed incorporate some stock trading in amongst their investments to further boost their returns.

The Benefits of Technical Analysis - picture of a newspaper with earnings chart shown on a tablet and a phone showing stock chart on screen with quote data

One of the most useful concepts in technical analysis is that the historical pricing displayed on a stock chart clearly shows how stock investors have perceived this company in the past, whether this behavior is rational or not. When combined with some fundamental valuation techniques, it allows the stock investor to rationally determine whether a proposed investment has any realistic short-term gains left in it or whether there is a high probably that the stocks price may have already reached its peak and thus primed for a significant price correction.

Ultimately all stock price movement is governed by the supply and demand for those stocks. When the demand exceeds supply, stock prices are driven higher irrespectively of whether they should and this is reflected on a price chart.

This leads to a commonly observed issue. Financial news events that rationally should drive the stock's price in a particular direction often move in the opposite direction to what the financial news event would indicate.

Contrary to popular belief amongst beginner stock traders and investors, technical analysis was never intended to predict the future but rather to analysis the past so as to provide a probability as to the possible future outcomes. Thus, technical analysis provides the likelihood that price will move in a particular direction, it is not a certainty. This leads to the fact that not all trades taken end up being profitable and as such there are trades that lose money. An important concept in short-term trading is that losing trades should be exited at predetermined price levels in order to stop a small loss from becoming a big loss. This is something that beginner stock traders and short-term investors need to accept.

The Benefits of Technical Analysis - picture of a stock traders hand pointing at the candle bars on a chart displayed on a tablet screen

Professional stock investors use the 'probability of the possible future outcomes' to determine whether buying a stock at that point in time would be a wise decision or not. Should a trade be taken which subsequently moves against them and results in a loss, they then exit that trade at a predetermined price level, known as a Stop-loss.

Technical analysis is often criticized by stock investors' which largely revolves around the misguided notion of predicting the future. To a certain extent this is justified, but to dismiss it totally is a mistake. Historical stock price analysis provides valuable insight into the rational or otherwise behavior of stock investors and may well determine whether a fundamentally sound company is worth investing in at the current stock price.

There are three main categories in technical analysis:

Main categories in technical analysis:

  1. Charting: Displaying a company's share price history on a chart provides a method of visually observing how stock investors perceive this company. The most commonly used chart styles by stock investors and traders are the Line Chart and the Bar Chart. Also some stock traders prefer to use candlestick charts. Although there are several other chart styles, they are not as widely used.
  2. Chart Patterns: There are several stock pricing characteristics known as chart patterns that tend to show up on stock price charts. These chart patterns provide some insight into how stock investors perceive this stock and are commonly used as entry points by short-term trades.
  3. Chart Indicators: These are numerical calculations performed on the stock's price data by the charting software. The graphs produced are plotted on the stock chart. The purpose of these chart indicators is to provide some insight as to where the stock's price may be heading.

The Line Chart

The original charting style that has stood the test of time

Technical Analysis - the line chart; picture of two stock traders analyzing a line chart for a stock using a magnifying glass to see the detail of the price dip before the price fully recovered

Short-term Line Charts

The Line Chart is plotted with the stock's price on the vertical axis and the dates on the horizontal axis, with the most recent date being at the right hand end of the chart. The stock price that's used to plot the Line chart is the closing stock price for each day. The closing price is the last price paid when the markets close which is 4:00 pm ET. It is common to also show the daily Volume on the chart, which is displayed below the Line Chart in a separate pane. The Volume pane gives a visually cue as to the liquidity of the stock, which is how many shares typically trade every day.

Shown below is a typical Line Chart which shows how the stock price for Caterpillar Inc. has moved each day over the last year.

Chart 1. Line Chart with daily prices over a 12 month period

the benefits of technical analysis - Line Chart for stock code ABT over a one year period in an uptrend with volume pane

Long-term Line Charts

When viewing a longer time period such as 5 years or 10 years, it is common to only plot the closing price for the week, which is the last price paid on Fri 4:00 pm ET. The exception is with the current week which uses the current trading day for the closing price. This means that the closing price for the current week will keep changing until the end of the week.

When viewing longer periods such as 20 years or more, it is common to only plot the closing price for the month, which is the last price paid on the last trading day of the month at 4:00 pm ET. The exception is with the current month which uses the current trading day for the closing price. This means that the closing price for the current month will keep changing until the end of the month.

The chart for Caterpillar Inc is shown again in Chart 2. with a monthly line chart which shows the stock price movement over the last 20 years.

Chart 2. Line Chart with monthly prices over a 20 year period

the benefits of technical analysis - Line Chart plotted over a 20 year period for the stock code CAT

Very Long-term Line Charts

Line charts are particularly useful when viewing very long time periods such as 100 years. They convey a significant amount of information regarding the markets movements. These long-term line charts are usually plotted with the monthly closing price, however they can also be plotted using the closing price for each quarter.

A very long-term line chart is shown below for the Dow Industrials index showing the markets movements over the last 100 years.

Chart 3. Line Chart with monthly prices over a 100 year period

the benefits of technical analysis - a long term Line Chart over 100 years plotted for the DOW industrials index

Line Charts - The Log Price Scale

Over the long-term, the fundamental characteristic of the compounding rate of returns from financial markets plot a curve rather than a straight line. This is due to the way market prices increases year after year.

Example: If the market price starts at $10 and increases by 10% every year for 10 years, the market price ends up at $25.94 and not $20. This is because 10% is added to each year rather than $1 added every year.

With time periods of 20 years or more, the price data can lose a lot of detail for the earlier periods when the market price appreciates significantly. To overcome this chart display issue, the price scale for the earlier periods can be expanded and this is achieved by using a non-linear price scale which is known as a logarithmic scale. The term Logarithmic is usually shortened to Log.

The Log scale still plots market prices on the vertical scale but the scale increments expand the lower prices so that the detail can be more readily observed. The effect is that as the prices increase then the higher prices become more compressed.

The above line chart for the Dow Industrials index is shown again in Chart 4. using a logarithmic scale.

Chart 4. Line Chart with logarithmic scale over a 100 year period

the benefits of technical analysis - a Logarithmic Line Chart over a 100 year period for the DOW index

From Chart 4. above, the logarithmic price scale tends to make the plotted data appear more linear. This provides more detail for the earlier periods when compared to Chart 3. and is especially noticeable for the data before 1980. Note that Chart 3. masks the market crash of 1929 and the broad consolidation period during the 1970s whereas these are more noticeable when plotted with a Log scale.

Time Frame

Common time frames used to display stock price data on a line chart are;

Common time frames:

  • Daily price chart: 3 months to 3 years
  • Weekly price chart: 3 years to 10 years
  • Monthly price chart: 10 years plus

The decision as to which time frame to display a stock's or index price history is dependant on the amount of data available and the intended time frame for the investment or trade.

As a general guide, long-term investments require a long-term view, thus long-term charts showing a history of 10 years or more are appropriate. Charts showing 3 to 5 years of history are suitable for longer-term stock trading. Short-term stock trading where the trades only last several weeks, are more appropriately conducted using short-term charts showing 3 to 12 months of history.

The shorter time frames show more detail for the most recent price history, which is beneficial to short-term stock trading such as swing trading or position trading. As the time frame increases, the recent price history becomes compressed and as such the detail is lost.

Medium and long time frames are particularly good at providing a more complete view of the historical trending nature of a stock, which is beneficial to stock investors.

The Bar Chart

This popular charting style provides additional information

Technical Analysis - the bar chart; picture of several bar charts drawn on paper sheets for the stocks to conduct a technical analysis by using a calculator and pen for stock traders

Daily Bars

Similar to the Line Chart, the Bar Chart is plotted with the stocks price on the vertical axis and the dates on the horizontal axis, with the most recent date being at the right hand end of the chart. The Volume pane is also generally shown on the Bar Chart. Unlike the Line Chart which only plots the closing stock price for each day, the Bar Chart also shows the opening price and the daily price range that the stock traded within for the day. These prices are visually displayed on the chart with a vertical line for each day as illustrated in Figure 1.

Figure 1. Components of a Bar chart

the benefits of technical analysis - Components of a Bar chart with high, low, open and close

Historically, all the bars on a bar chart are shown as black bars. Modern charting software generally allows the up and down days to be displayed in different colors. If colors are used, the down day bars are usually displayed in red and the up days are displayed in black or green. The choice of colors is a personal preference and a lot of stock investors and traders still prefer to display the bars in black. An alternative form of chart display is the candlestick chart which highlights the up and down days.

Figure 2. shows several bar examples using black for the up day and red for the down day.

Figure 2. Common Bars found on bar charts

the benefits of technical analysis - Common Bars found on bar charts

The bar chart shows the range that the stock price traded each day as well as how bullish or bearish the stock has been. A bullish stock chart shows a larger portion of up days. Conversely, a bearish stock shows a larger portion of down days.

A daily typical Bar Chart is shown below in chart 1. which shows the daily range that the stock traded each day over the last 5 months.

Chart 1. Bar Chart with daily prices over a 5 month period

the benefits of technical analysis - four month daily bar chart for the stock code ABT shown with an uptrend

Weekly Bars

When viewing time periods longer than a couple of years, it is common to only plot the Bar Chart using the high to low range for the entire week rather than for each single day, otherwise the chart becomes cluttered with bars making it unclear to read. The Open is now the opening price on Monday. The High and Low are the highest and lowest prices for the entire week. The Close is the closing price on Friday. The exception is with the current week which uses the current trading day for the closing price and the current days traded for the week for the high low range. This means that the closing price and range for the current week will keep changing until the end of the week.

A typical weekly Bar Chart is shown below in Chart 2. which shows the weekly range that the stock traded each week over the last 3 years.

Chart 2. Bar Chart with weekly prices over a 3 year period

the benefits of technical analysis - three year weekly bar chart shown with an up trending stock code ABT

Monthly Bars

When viewing long time periods such as 10 years or more, it is common to only plot the Bar Chart using the high to low range for the entire month rather than for each single day or week. This makes the long-term charts less cluttered with bars so it is clearer to read. The Open is now the opening price on the first trading day of the month. The High and Low are the highest and lowest prices for the entire month. The Close is closing price on the last trading day of the month. The exception is with the current month which uses the current trading day for the closing price and the current days traded for the month for the high low range. This means that the closing price and range for the current month will keep changing until the end of the month.

A monthly Bar Chart is shown below for the S&P 500 index which shows the monthly range that the market traded over the last 20 years.

Chart 3. 20 year Bar Chart with monthly bars (Log scale)

the benefits of technical analysis - 20 year period stock chart shown with logarithmic scale monthly bar chart for the index SP500

Quarterly Bars

When viewing very long time periods such as 50 years or more, it is convenient to only plot the Bar Chart using the high to low range quarterly rather than monthly. This is because the monthly bars really start to get compressed which makes the bars ranges difficult to see clearly. With quarterly bars, the Open is the opening price on the first trading day of the quarter. The High and Low are the highest and lowest prices for the entire quarter. The Close is closing price on the last trading day of the quarter. The exception is with the current quarter which uses the current trading day for the closing price and the current days traded for the quarter for the high low range. This means that the closing price and range for the current quarter will keep changing until the end of the quarter.

A quarterly Bar Chart is shown below for the S&P 500 index which shows the quarterly range that the market traded over the last 50 years.

Chart 4. 50 year Bar Chart with quarterly bars (Log scale)

the benefits of technical analysis - a 50 year monthly bar chart with logarithmic scale bars plotted for the SP500 stock index

Time Frame

Common time frames used to display a stock's price data on a bar chart are;

Common time frames:

  • Daily price chart: 3 months to 3 years
  • Weekly price chart: 3 years to 10 years
  • Monthly price chart: 10 years plus
  • Quarterly price chart: 50 years plus

Larger chart sizes allow more bars to be shown without becoming cluttered. As a general rule, if the bars become too cluttered for the selected time period, then reduce the time period or alternatively select weekly, monthly or even quarterly bars.

The decision as to which time frame to display a stocks price history is dependant on the amount of data available and the intended time frame for the investment or trade.

As a general guide, long-term investments require a long-term view, thus long-term charts showing a history of 10 years or more are appropriate. Charts showing 3 to 5 years of history are suitable for longer-term stock trading. Short-term stock trading where the trades only last several weeks, are more appropriately conducted using short-term charts showing 3 to 12 months of history.

The shorter time frames show more detail for the most recent price history, which is beneficial to short-term stock trading such as swing trading or position trading. As the time frame increases, using weekly or monthly bars increases the amount of pricing information.

Medium and long time frames are particularly good at providing a more complete view of the historical trending nature of a stock, which is beneficial to stock investors.

Stock Price Behavior

Understanding the trending nature of stocks

Technical Analysis - picture of a stock trader using a tablet to analyze the stock price movement with a large screen behind showing a line chart with data with a light blue background panel

For beginner Stock traders and investors who are not familiar with viewing a stock price chart, the stock prices may appear to rise and fall quite randomly, however on closer examination there is a considerable amount of organization to this apparently random price behavior.

The main purpose of looking at a stock chart is that they provide valuable insight into the supply and demand behavior of market participants and thus allows the astute stock investor to make an informed decision about a proposed investment, such as whether a buy and hold tactic is appropriate or whether a shorter term trade would be more suitable. Stock traders find charts a valuable tool in selecting their proposed trades. The stock chart allows them to located a short-term opportunity and subsequently determine the best time to exit their trade.

The stock chart shows where the stock's price has been in the past and where it is currently heading. This broad direction that the stock's price is taking is known as a Trend and they give the stock investor and trader a sense of where the stocks price may be heading in the future.

Short-Term Trends

A short-term trend occurs when the stocks price moves continuously in a particular direction and generally lasts several weeks before reversing. Short-term trends can be as short as a couple of days and can last up to a month or more. These trends can be readily seen on charts using short time frames such as 6 months. A short-term trend with increasing stock prices is referred to as a Rally and a short-term trend with declining stock prices is referred to as a Pullback. A typical stock chart will show several Rallies and Pullbacks in a 6 month period as illustrated in below in Chart 1.

Chart 1. Short-term trends - Rallies and Pullbacks

Stock Price Behavior - stock chart showing the various short-term trends for stock code ABT with uptrends and downtrends

Relative Highs and Lows

The top of a Rally is referred to as a Relative High, which is the highest price reached before the short-term uptrend ended. The bottom of a Pullback is referred to as a Relative Low, which is the lowest price reached before the short-term downtrend ended. The previous example is shown again below in Chart 2. with the Relative Highs and Lows illustrated.

Chart 2. Short-term trends - Relative Highs and Lows

Stock Price Behavior - stock chart showing the short-term Highs and Lows for code ABT with relative high and low

Thus it is becoming obvious that a stock chart is a never ending sequence of alternating Rallies and Pullbacks. This is the essence of the stock market.

The Relative High is sometimes referred to as a Minor High and the Relative Low as a Minor Low.

Intermediate-Term Trends

Intermediate-term (also referred to as Medium-term) trends are formed from a sequence of Rallies and Pullbacks. When these work their way higher on a stock chart this is referred to as an uptrend. This is characterized by the Relative Highs of each successive Rally being higher than its preceding Rally and the Relative Lows of each successive Pullback being higher than its preceding Pullback. In other words, an Up Trend occurs when both the Relative Highs and Relative Lows tend to work their way higher on the stock chart.

A downtrend occurs when both the Relative Highs and Lows tend to work their way lower on the stock chart.

Intermediate-term trends generally last from a couple of months up to about 6 months long and are readily observed on stock charts with time frames of one to two years.

This is illustrated in Chart 3. The Relative Highs are noted as RH and the Relative Lows are noted as RL.

Chart 3. Medium-term trends - Relative Highs and Lows

Stock Price Behavior - chart showing the intermediate term trends for the stock symbol GGG with downtrend and uptrend

In an uptrend not every single consecutive Relative High is necessarily higher, but that the Relative Highs tend to generally increase in an uptrend. Also the Relative Lows in a downtrend are generally lower than its preceding Relative Low.

At times the short-term trends do not lead to an intermediate-term uptrend or an intermediate-term downtrend. When this occurs, the stock is referred to as consolidating or as the stock price is merely trading sideways. This consolidating can take the form of a consolidation chart pattern or the stock may be trading in a trading range.

Some intermediate-term uptrends will have the Relative Lows all line up and a straight trend-line can be drawn directly under these Relative Lows connecting them together. This can also occur with an intermediate-term downtrend when the Relative Highs line up in a straight line.

Long-Term Trends

A long-term uptrend is merely a sequence of intermediate-term uptrends and intermediate-term downtrends that tend to work their way higher on a stock chart. Relative Highs and Lows are also applied to intermediate-term trends, thus a long-term uptrend occurs when the Relative Highs and the Relative Lows tend to work their way higher on the stock chart. Similarly, a long-term downtrend occurs when the Relative Highs and the Relative Lows tend to work their way lower on the stock chart. These can be readily observed on charts with time frames of 3 years or more. A long-term trend can last for years before ending as illustrated below in Chart 4. using a weekly bar chart.

Chart 4. Long-term trends - Relative Highs and Lows

Stock Price Behavior - stock chart showing the long-term trends symbol GGG and how the medium term trends relate to the long-term trend

Summary

When a trend ends, it does not necessarily lead to a new trend in the opposite direction. Stock prices will quite often pause and trend sideways rather than reversing direction. This is known as consolidating and is frequently observed in all the time frames from short-term trends to long-term trends.

The stock price behavior on a chart is quite organized with a sequence of uptrends, downtrends and sideways consolidation periods, which allow the stock investor or trader to readily determine how other stock investors perceive this company.

Many stock investors only feel comfortable buying a stock when its stock price has been increasing for some time. They include growth investors and the price chart provides them with a quick and easy way of determining whether the stock is in a long-term uptrend.

Other stock investors such as value investors seek to buy stocks that have fallen significantly in price, but do not feel comfortable unless the stock's price is regaining strength. Again the price chart clearly shows whether the stock price has bottomed and that a new uptrend has started, thus providing confidence for the stock investor that the worst is over and that the stock may well continue its new uptrend.

Understanding Trends

Technical Analysis - Understanding Trends; picture of a stock trader pointing at a line chart with a pen with the chart drawn on a glass panel mounted on the wall to analyze the trends

"The trend is your friend" is a saying that most seasoned investors are familiar with. This popular phrase has been around for a long time and those investors involved with trading have learnt that it's easier to work with the trend than against it.

While we have established that trends are an investor's best friend, just exactly how does an investor go about determining the trend? What one investor considers to be a medium-term trend another investor considers to be a short-term trend.

A certain amount of trend analysis is subjective but there are some tactics that can be used to help clarify what trend is in place. While trend-lines have their use they are still subjective regarding which points to connect the trend-line.

Moving averages do quite a good job of highlighting the trends when the stock is essentially trending - moving averages do not work so well with congested markets.

The following serves as a good guide when using moving averages to highlight trends:

Moving averages:

  1. The 10-day or 20-day moving average tends to highlight the short-term trends on a daily chart.
  2. The 50-day moving average tends to highlight the medium-term trends on a daily chart. With a weekly chart this is a 10-week moving average.
  3. The 260-day moving average tends to highlight the long-term trends on a daily chart. With a weekly chart this is a 52-week moving average and with a monthly chart this is a 12-month moving average.
  4. The 10-year or 20-year moving average tends to highlight the very-long-term trend. On a monthly chart this is a 120-month or 240-month moving average.

StockInvestingToday.blog uses the 20-day moving average for short-term trends to help locate the relative highs and lows used with Dow Theory. Also the 20-year moving average is used to highlight the very-long-term trends with the market indices.

The investor can use either the simple moving average (MA) or the exponential moving average (EMA). The difference is that the simple moving average MA is slightly less responsive and tends to produce straighter lines than the EMA.

The short-term trends tend to oscillate within the medium-term trend and the medium-term trends tend to oscillate within the long-term trends. Also the long-term trends tend to alternate within the very long-term trend.

There are usually several short-term trends within a medium-term trend and there are usually several medium-term trends within a long-term trend. If there is sufficient data, there are typically several long-terms alternating within the very-long-term trend.

Chart 1. below illustrates the use of moving averages to highlight the short-term trends.

Chart 1. Short-term Trends within the Medium-term Trend

understanding trends - stock chart showing the short-term trends within the medium-term trends for uptrend and downtrend for stock code ACC

The short-term trends become much clearer when a 10-day MA is plotted on the chart (Red line). The Gold line shows the 50-day MA which is basically the medium-term trend. Essentially the medium-term downtrend is from A to F and the medium-term uptrend is from F to K on Chart 1. Generally if the moving average line slopes upwards then it's an uptrend and if the moving average line slopes downwards then it's a downtrend.

Chart 2. below shows a weekly chart illustrating the same concept but with the medium-term trends oscillating within a long-term uptrend

Chart 2. Medium-term Trends within the Long-term Trend

understanding trends - stock chart showing the medium-term trends in a long-term uptrend with medium downtrend and uptrend over a three year period

The medium-term trends are highlighted with the 10-week MA (Gold line which is also a 50-day MA). The long-term trend is highlighted by the 52-week MA (Purple line).

Chart 3. below shows a monthly line chart which shows how the long-term trends alternate within the very-long-term trend (illustrated with the DOW Industrial index).

Chart 3. Long-term Trends within the very-long-term Trend

understanding trends - stock chart for the dow industrial index showing the long-term trend over a thirty year period with a moving average plotted underneath

The long-term trends are highlighted with the 12-month MA (purple line which is also a one-year MA). The very-long-term trend is highlighted by the 240-month MA (Purple line which is also a 20-year MA and is used in the monthly market update reports). A 10-year MA can also be used for the very-long-term trend.

Summary

The advantage of using moving averages is that they tend to highlight the appropriate trends. About the only time the moving average method fails to work properly is when the stock is in a congested trading range. This is because moving averages are trend following which means that they do require a trending direction. Certainly when stocks are trending, it is pretty hard to beat moving averages for their simplicity and ease of use.

Locating Trend Reversals

Technical Analysis - Locating Trend Reversals; picture of a stock line chart on a large screen with a dark green background and a down trend bottoming and turning up into an uptrend with a rebound

Investors love the idea of buying just as a downtrend reverses - there's nothing like buying at the bottom and riding the stock all the way to the top.

While to a certain extent this is fantasy, there are some techniques investors can use to help determine whether a new uptrend has begun.

A simple technique an investor can use is based on the rally pullback principle. Typically a medium-term downtrend consists of a sell down followed by a rally and this process usually repeats numerous times. The medium-term downtrend can be highlighted with a 50-day moving average. The sell downs and rallies can be highlighted with a 10-day moving average. This process is illustrated in Chart 1.

Chart 1. Downtrend reversal

Locating Trend Reversals - picture of stock bar chart highlighting the trend reversal after the stock traded down and bottomed and turned into a new uptrend

The chart above shows three moving averages:

  1. The 260-day MA (Purple line). This is sloping downwards which indicates that the stock is in a long-term downtrend.
  2. The 50-day MA (Gold line). This highlights the medium-term trends which from Oct 2013 until Feb 2014 showed a medium-term downtrend.
  3. The 10-day MA (Red line). This highlights the short-term trends. These are the sell downs and rallies when the medium-term trend is downwards and the rallies and pullbacks with a medium-term uptrend.

The basic principle behind a trend reversal is illustrated in Chart 1. above.

The investor will note that there are three points on the chart which are labeled "A", "B" and "C". The short-term trend from A to B is a rally which is still part of the medium-term downtrend. This rally is usually quite pronounced. Sooner or later this rally pulls back - this is the short-term trend from B to C. The possibility that a new medium-term uptrend has begun is given when the stock starts to trade up from label C.

The location of label C is quite important. If label C is below label A then this indicates that the medium-term downtrend will likely continue. If label C is at the same basic level as label A then this suggests that this is either a possible double bottom or that the stock might be entering into a trading range. Ideally label C is around the mid-point from A to C.

The rally from A to B is referred to as the "first rally" or the "first thrust" and is usually quite a dominate rally. The pullback from B to C is referred to as the "first pullback" and is usually quite minor. In fact some first rallies are so strong that they do not even pullback - the first rally becomes the entire medium-term uptrend.

Another important fact that investors need to be aware of is that this method locates the likelihood of a medium-term uptrend and not a long-term uptrend. Remember that a long-term uptrend (measured with the 260-day MA) will typically have several medium-term uptrends and medium-term downtrends (measured with the 50-day MA).

The setup shown in Chart 1. is basically known as "bottom fishing" which is quite a popular investing strategy. Speculative investors often buy stock when it starts to trade above label C indicating that there is a chance that a new medium-term uptrend has begun. One popular tactic with these investors is to use a stop-loss placed under label C. Some investors will place their stop under label A.

Some speculative investors prefer that the stock has formed a bottoming pattern such as the rounding bottom. This is in contrast to the stock in Chart 1. which is in a long-term downtrend. An example is shown below in Chart 2.

Chart 2. New Uptrend

Locating Trend Reversals - stock chart for aa using bars in an uptrend to highlight the trend reversal with moving averages plotted underneath

The difference with the stock in Chart 2. is that the 260-day MA has flattened out and started to turn up by label C in Nov 2013. This is in contrast to Chart 1. where the 260-day MA was locked in a strong down slope. The first rally has already carried above the 260-day MA at label B. The low of the first pullback at label C has also held above the 260-day MA.

The possibility that this is a new medium-term uptrend is given when the stock starts to trade up from label C. Since the 260-day MA is starting to slope upwards, this stock has a higher probability that the long-term downtrend has reversed and formed a new long-term uptrend.

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