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3.4.3 Technical analysis: some key features

While you can form your own views as to whether there is any substance to the predictive powers of technical analysis, this section looks at some of the key tenets of chartism.

The first involves moving averages and an example is provided in Figure 16. Here chartists impose on top of the graph of the share price movement a series of moving averages – typically 5-day, 30-day and 90-day averages. If the share price moves upwards through these moving average lines then this is taken as a ‘buy’ signal for the share – the more so if the longer term (for example, 90-day) moving average is breached. The reverse applies if the share price moves downwards through the moving average lines: such moves are taken as ‘sell’ signals.

Described image
Figure 16 Moving averages

The notions of ‘support’ and ‘resistance’ lines are central to technical analysis. A support line is a straight line that links the low points of the series of movements in the share price over a period of time. A resistance line is a straight line that links the high points of the share price movements. Here, the rule is that a downward breach of the support line presages a further downward movement in the share price. An upward breach of the resistance line points to a further upward move in the share price in the near term.

This image shows a share price fluctuating between a resistance and a support line.
Figure 17 Support and resistance lines

Two of the many special chart features which hint at the future share price movements are ‘head-and-shoulders’ and ‘islands’. These are identified in the image above. A ‘head-and-shoulders’ is where you have a series of three up and down movements in the share price over a reasonably short time frame. The first of these three forms the left shoulder, the second the head (which must be higher than the left shoulder) and the third forms the right shoulder (and it must be lower than the head). This patter, particularly if the right shoulder is lower than the left shoulder, presages a fall in the share price in the near term.

This graph shows the share price of a company moving over time.
Figure 18 The head and shoulders pattern

Islands (or island reversals) are where a high or low point of a share price cycle is detached from the rest of the chart movements. A clear gap exists between the previous day’s price range and the following day’s price range. In such circumstances, the island points to a reversal of the recent share price trend, for example, an island below the rest of the chart line presages a period of upswing in the share price. The reverse applies when the island is detached above the chart line.

Many technical analysts swear by the predictive powers of charts. But how can they be really predictive? A number of reasons can be postulated to support their predictive powers:

  • Those trading shares have predictable behaviour which leads to repeated, and hence, predictable, trading patterns and price movements (we look at behaviour and investment management in Week 6).
  • The traders themselves look at the charts, or are advised by those that do, with the result that the predictions made by the charts are fulfilled by subsequent trading decisions. In short, trading behaviour follows the predictions made by the charts!
  • The charts are just a summary of market sentiment as reflected in trades undertaken – and sentiment goes through cycles that are sustained for periods, sometimes long periods.

Sophisticated technical analysis uses very detailed charts that incorporate intra-day price movements (as opposed to just end of day prices) and the volumes of trading business done each day (since what happens on a high volume day is usually more telling about market sentiment than what happens on low volume days).

The debate about the predictive powers of charts will go on. There are clear examples where the charts have been ‘right’, but others where a major future price movement has failed to be predicted. Whatever the case, though, many analysts majoring on fundamental analysis to assess the likely future movements in share prices also use technical analysis to provide a ‘second opinion’.