|Using Technical Analysis to Trade Stocks|
When you discuss technical analysis, support and resistance are bound to arise. Technical analysis uses charts to predict the behavior of stocks while fundamental analysis uses news, market information and other sources.
Watching the ceiling, the floors, and the trends in between
Investors with experience can tell you that price levels may prevent traders from pushing the price either farther up or down. After watching stocks for a certain amount of time, they may be able to see a resistance level forming a ceiling or a support level establishing a floor for the price.
As the market goes up, you will see resistance levels when the price action starts to slow. This new price creates a plateau in the stock price, resulting in a top. You also should pay attention when the stock’s price falls towards the trend line. A trend line may support a stock for some time.
The opposite occurs when the market is trending down. Investors will watch the peaks, looking for a trend line. As the price gets closer, they can then watch for selling pressure since the stock has been pushed down by this point in the past.
The strength of a support or resistance level gets stronger each time that the price fails to move beyond it. Technical traders can use these levels to decide what the best entry and exit prices are, since these areas usually represent the prices that will affect the asset’s direction the most. Being able to recognize these can identify proper entry or exit points as well as the beginning of new trading levels once either is breached.
Another feature of support and resistance is that a price often will not move beyond a round price number like $50. Investors who do not have much experience like to buy and sell assets at whole numbers, since they have the impression that a stock is valued fairly at those points. Target prices and stop orders often will be set at round numbers by retail investors and investment banks, and the high volume helps to create the price barrier. Thus, if all of the clients of a bank put in orders to sell at $55, it would take a much larger number of purchases to avoid creating a resistance from it.
Moving with the average
Moving averages are used by many technical traders to assist them with determining the momentum of the short-term investments, but they often do not see the capacity that they have to identify support and resistance. A moving average is constantly changing, and it can allow the investor to see support and resistance, as well as smoothing out previous history. Traders will want to try different periods of time to find out what works best.
Another tool is the Fibonacci retracement, as it helps to find levels of support and resistance. Leonardo Fibonacci developed the Fibonacci numbers. It is a series of number patterns; when you add the two previous numbers, you get the third. For instance: 1, 2, 3, 5, 8, 13, and 21, through infinity. When you add 1 plus 2 you get 3, 2 plus 3 you get 5, and so forth. The way that these numbers relate gives you the Fibonacci retracements pattern.
Fibonacci reversal indicators
Before stocks reverse, they will often retrace a portion of their previous moves. You can usually see this at 38.2%, 50%, or 61.8%. The 50% point is not part of Fibonacci, but many traders use this level as a marker. After a stock climbs, it will drop minimally in value, retracing its own movement. Then it will climb back upwards. These small swings are what you need to watch for when choosing your positions.
After a stock has started to retrace its own movements, you can follow the levels on a chart to watch for an impending reversal. However, you should not buy a stock just because it is following a common trend. Look for candlestick patterns to develop, and if you do not see signs at the 38.2% area, wait for the 50%. You do not know when a stock will reverse, but instead have to watch the signals.
Visualizing the grid patterns
The way that you can recognize Fibonacci patterns is by drawing a Fibonacci grid with the swing points. Start the grid on a swing point high and go to the swing point low. If your charting package does not come with this feature, you can determine the information by first finding the range, multiplying the range by the Fibonacci ratio numbers (0.382, 0.5, 0.618), and then subtracting that number from the high swing point.
This can be useful to you in some cases. Often, you will see the support and resistance areas without drawing the lines, and thus, the grid is not always necessary. With experience, you will be able to simply look at the chart and estimate the levels. Even if you do not draw in the Fibonacci retracement lines, you can eyeball how far the stock retraced itself before moving back up. While you are still learning, drawing the lines in can help you understand the underpinnings of this strategy.
Easing the process with Fibonacci software
If this sounds too complicated or time-consuming to do on your own, there is Fibonacci software available for trading and many chart services and free websites allow you to build this and other analytical tools into your charts. You simply enter a high and low price, and the software will plot the different levels in price for you. The program may also give you time levels as well as price levels. That will make it even easier for you to watch for reversals with two indicators. However, you will still need to use your elements of common sense before initiating a trade, as you will want to make sure that you have a sign of reversal before proceeding.