Charting a Course (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Assuming that the technical analyst has been studying his or her chart of choice for a period of time and patterns are beginning to reveal themselves, the question is what is being shown?  In his book, Stock Market Logic, A Sophisticated Approach to Profits on Wall Street, Norman G. Fosback discusses chart patterns as follows:

Because there is a potentially infinite number of price patterns that a stock can trace, chartists have identified (devised) a virtually infinite number of chart patterns to correspond to them.  These patterns are known by such esoteric names as head and shoulders, reverse head and shoulders, single, double, and triple tops and bottoms, flags, pennants, spikes, saucers, triangles, rectangles, lines, breakouts, consolidations, blowoffs; in short a name for everything and everything with a name.* 

This blog is not intended to provide an in-depth study of charting.  Given the large number of patterns studied by technical analysts, I will discuss only a few of the more well known patterns or indicators.  A chart covering a long period of price movement for an individual stock will begin to show trends, up, down or sideways.  If the time period shown on the chart is short term, the movements can be quite jagged.  As the time period lengthens, the chartist can trace a trend line along the price increases or declines shown on the chart.  The trend line (starting from the left) over time is either pointing northeast (going up); southeast (going down); due east (staying the same) or reversing itself (inflection point).  These are the most basic messages a chart can provide.

Over time, relatively consistent highs and lows begin to show a stock's "price range" which is defined by what is called the Support Level on the bottom, the lowest point beyond which the price has not dropped in the applicable time period, and the Resistance Level on the top, the highest point beyond which the price has not risen in the same period.  This is the band within which the stock is traded.  The chartist believes that a price break out above or below the "price range" is very predictive of where the price might go in future trading.  In effect, the market may be in the process of setting new Support or Resistance Levels.  One of the basic principles of technical analysis is that a price break out either above the Resistance Level or below the Support Level or the occurrence of a sustained inflection point when the trend line reverses itself are all very important indicators.  Depending on the volume accompanying such moves, the chart could be  providing a strong indicator for the technical analyst to consider.

We should remember that the prices being charted show purchases and sales by people in the market.  The Support Level reflects the price at which buyers have consistently come into the market to purchase shares of the stock.  This would appear to be the price level at which the market considers the stock so cheap that it is a buy no matter what.  Conversely, Resistance Levels reflect the price above which no one is buying the stock, the price level at which the market considers the stock too expensive to buy no matter what.  Any changes in these levels could be seen as changes in investor/trader sentiment about a stock.  Technical analysts see this as a foreshadowing of what people in the market may do in upcoming days, which could give the chartist a trading advantage.

We will study some additional common patterns or indicators in the next blog.

* Excerpt from Stock Market Logic, A Sophisticated Approach to Profits on Wall Street, Norman G. Fosback, copyright 1976, 1993, The Institute for Econometric Research, pages 212-213

Comments are always welcome.