Technical Analysis

The Smart Profits Report: Issue #214
Tuesday, June 7, 2005

Technical Analysis - Two Simple Tools for Spotting a Technical Trend
By Mt. Vernon Research Team
Former Options Specialist for Mt. Vernon Research

Traders are supposed to be good market readers and work with, not against, the market direction at all times.

This does not mean calling tops and bottoms! That’s an interesting but not critical exercise. And, as Karim has noted, two of the most common indicators - the put-call ratio and the VIX - are difficult to read and often give false signals.

Besides that, market turnarounds only happen occasionally, but the market is there every day. Better to learn a skill that’s always useful rather than one that’s sometimes useful, like the basics of technical analysis.

Using the Force to Reach Your Goal

Don’t worry too much about predicting bottoms and tops, especially not as you start out. At first, focus on learning where your stock is going right now and using the force of its trend to reach your goal.

This, by the way, is one of the subtle differences between thinking as an investor and thinking as a speculator. Sometimes, going with the market as a trader will mean going against your judgment as an investor.

Let me give you a concrete example…

As an investor, for instance, I'm keeping my eye on Avid Technologies because its earnings and profitability are growing. (Don't take this as a recommendation, just a good example.)

Eventually, this company is going to be a winner if it continues the progress it's made in the last couple of years. But as a trader, I wouldn't buy any calls on Avid right now simply because it "should go up."

The fact is, it's not going up.

The market trend is against Avid. The sector trend is against it. The stock's own trend is very much against it. Yet not so long ago, in April ‘04, I made 136% in three weeks with an Avid call. The company's the same. The trend changed.

Today, though, I still like the company enough to think about going long as an investor - as a trader I'd go short.

"A Simple Approach to Technical Analysis"

How do you know whether you have a good trend? This is where technical analysis comes in.

On the rough level, you can look at a chart and see whether the price is tracking up or down. But learning to draw trend lines is a simple task that takes it a step farther.

Though trend lines can get complex, as can all technical analysis, I’ll explain the simplest approach. It will be more than adequate to get you started, and may be all you ever need.

For a Rising Stock:

Here are some simple steps for tracking a rising stock (pull up any good one-year stock price chart from Yahoo! Finance and print it out for this revealing little exercise)…

Find the lowest point on the chart and put your ruler under it.
Now connect it to the next-lowest point (there may be some lows between these that don’t touch the ruler).
Draw a line all the way out to the end of the chart. What you have is a line under the stock prices. Support.

If the stock is really bullish, you will be connecting a series of higher lows. A stock that is staying above that line is "respecting" the bull support trend. It remains bullish as long as prices are above that line. Every time the stock drops toward that line, bullish buyers tend to snatch it up and the price tends to rise again.

By the way, in the rare cases where you can’t get a very good fit - for instance, if two extreme lows create a line that is far away from the rest of the prices, choose a shorter, more recent section of the chart and connect the lows in that segment.

For a Falling Stock:

For a bearish stock, one whose price line is going down, do almost the same. This time you are interested in finding the line that is keeping prices down, overhead resistance.

Find the highest peak on the chart and put your ruler on top of it.
Connect that peak to the next-highest peak and draw your line.

You should have a line that is slanting down, with successive tops getting lower. As long as the stock price stays below this "bearish resistance" line you’ve just drawn, it’s still on its bear trend. Every time the price rises toward the bearish resistance line, investors tend to sell off to take profits and the stock resumes falling.

Trend lines tend to stay in place for months at a time, even years, which is why they are so worth your time.

Better than a Trend Line: the ADX Indicator

A more sophisticated tool that I rely on is the ADX line, also known as Wilder’s DMI. It’s not as well known as relative strength, momentum and some other indicators, but it is ALWAYS the first indicator I look at. Always.

That’s because the most important thing to know about a stock you want to trade is whether it is trending and how strong the trend is.

The ADX line will tell you that and also whether the trend is getting stronger or weaker. I do trade stocks that aren’t trending, but that takes special skills and more complicated analysis. As a new trader, you should stay with stocks that are trending. The ADX is your friend.

The way you read the ADX is simple. First, you want to know if there is a valid trend or not. The number will tell you. ADX goes from 0 to 60, or higher, although you never see a zero and rarely a 70.

The Key Number Is 20

When the ADX is below 20, there is no trend in the stock. It is ranging. It may go up and down, but not enough to make trading it easy. When the ADX goes over 20, you have a trend in place. (For Nasdaq stocks, I like to see it over 22 because they are more volatile and more likely to suffer a trend reversal.)

Once you know that you have a trend, look at the direction the ADX line is traveling. If it is rising, the trend is getting stronger. If it’s falling, the trend is getting weaker. This applies to bullish and bearish trends alike.

If the number was very high, say over 40, I don’t worry too much if the ADX is dipping a bit. The reason is logical: Even if the trend is tapering off, it’s still in the "strong" range.

But when the ADX drops from a good number to under 20, look out! Your trend is drying up and you should probably shut down your trade the minute it stops working for you.

Today's Smart Profits Crib Sheet

The essential tool for technical analysis is both powerful and easy-to-understand. So where do you get access to the ADX? Expensive charting software always has this choice, but you can find it for free at www.stockcharts.com.
Also, check out the Smart Profits Glossary for more definitions of options terms used above like "technical analysis", "indicators" and "resistance."

Good trading,

Mt. Vernon Research

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