10.7 Predicting the stock
For forming such decisions, a technical analyst usually examines two factors: the outlook for the general market and the price movement of the stock. We have already discussed how the first factor (i.e. market outlook) is analyzed. Now for the second factor one should use:
- Charts pattern of individual stocks
- Use of moving average
- Use of price volume chart (for specified securities only) as described earlier
Basic Premises in Reading A Chart:
There are three basic premises in chart reading:
Like a Dow theorist, a chartist also believes that individual stock prices tend to move in a certain direction for a considerable time. This tendency to move in a definite pattern along an imaginary straight line is called a trend and is one of the most extraordinary characteristics of chart movements. Time is of no importance, for a trend may persist for a matter of minutes or years, but what is important is that the trend is assumed to be intact until it actually reverses. In order to spot a trend, a minimum of three points is needed to confirm. An uptrend is a series of ascending highs and lows that can be connected with a line which points upward. The opposite is implied and true for a downtrend. In practice, an uptrend line is drawn by connecting the lower points (bottoms), and a downtrend is drawn by connecting higher points. (See a bearish trend line: the green lines indicate volume).
Trend Vs Volume:
Chartists believe that if a scrip turns bullish, its volume increases with price rise and declines as the price falls. Similarly, for bearish scrip, the volume will increase as the price declines and volume will fall as the price increases.
Support Level and Resistance Level:
Any chart of stock price or market index will show that the rise or fall is not uniform, and is rather characterized by a wave-like pattern with successive peaks and troughs. When a stock price (or market index) touches a certain level (i.e. peak) and then drops, the peak is called a ‘resistance level’ by analysts. Conversely, when the price (or market index) after sliding to a trough bounces back once again, the bottom level of the trough is called a support level (refer graph below). An analyst expects the price of scrip to change between consecutive support and resistance levels. Security prices are the result of a head-to-head battle between a bull (the buyer) and a bear (the seller). The bulls push prices higher and the bears push prices lower. This is because as soon as the price approaches the resistance level, investors who failed to sell their shares at the previous peak (which is the resistance level), would be keen to sell their holdings. The resulting selling pressure will keep the price from falling below this level. Conversely, as the price slides once again to the support level, there will be a buying pressure from those investors who failed to buy at the lowest price.
The penetration of support/resistance levels can be triggered by fundamental changes that are above or below investor expectations. The effect is significant - new expectations lead to new price levels. A breakout can occur when a company releases a higher than expected earnings’ report. However, support/resistance levels can be emotional. If the price rises above its previous peak, it is said to have broken through the resistance level. This is called a ‘breakout’. Such breakout of resistance level is considered a signal to buy stock which is expected to continue further to a new level due to the momentum of the bullish expectation of investors. Similarly, analysts believe that when a price declines below the previous low i.e. the support point, it should continue to fall because its price has fallen to such low levels that based on historical stock price comparisons, people might think that the share has become worthless. So, when a stock price makes a penetration of its support level, this is a signal to sell. In short, technical analysis recommends buying when a security’s price goes higher than its last peak and selling when its price sinks below its previous low.