The subject of technical analysis is sometimes a controversial one in the world of trading. Some very successful traders swear by it, while others think that chart reading is nearly useless. The truth, however, likely lies somewhere in the middle. The reason why technical analysis is difficult to rely on in every situation is because stock prices display a high degree of randomness. The so called “random walk” theory explains this concept in detail. As traders, we can increase our odds in the markets by seeking out situations where prices are not moving randomly, but rather are being driven by some sort of catalyst. Corporate events, earnings, financial guidance, management changes and economic data are all examples of catalysts that can cause prices to move non-randomly. Furthermore, these catalysts almost always lead to a spike in volume, and it seems that technical analysis is most effective when a stock is in play and moving on heavier than normal volume.
For example, on Wednesday, October 3, Hewlett-Packard (NYSE:HPQ) provided guidance for fiscal 2013 which was well below analysts’ expectations. What was unique about this situation was that the news came out during market hours. At 11:15 EST, shares were trading at around $17.30 before the company issued the disappointing guidance. Once the news made its way into the marketplace, HPQ began falling on heavy volume as traders and investors began pricing in the updated financial estimates. The stock fell for the rest of the day, which amounted to nearly 5 hours of trading, and closed on the lows at $14.91.
This was an excellent opportunity for individual traders. The stock was certainly not moving randomly, volume was very heavy, and basic technical analysis worked well. Technical strategies that would have been very profitable included shorting the stock when it made new lows after shallow retracements and shorting it as it broke through key price levels like $17.00 and then $16.00. While events such as this are rare in individual stocks, fortunately there are thousands of symbols trading every day. While HPQ may not yield a similar opportunity again in the near future, on any given day, there are normally at least a dozen or more symbols that are. Therefore, traders that use technical analysis should focus on stocks that have a catalyst and are attracting heavy volume.
In today’s algorithmic driven market, short-term price movement has become very choppy and highly random. Unusually heavy volume, however, often as a result of news, is a telltale sign that big institutions are moving significant amounts of stock and that a lot of human eyes are watching price movement. In these situations, technical analysis frequently works well. In fact, the patterns almost become self-fulfilling. In other words, technical analysis may be effective for no other reason than the fact that most human traders are familiar with the patterns. When a stock has hammered out an obvious double top, for example, buyers may become reluctant to continue to accumulate the stock. If this pattern were not so well-known, it might not work as well.
Analyzing volume trends within a technical framework can also be a great way to identify key reversals and breakouts. Common examples would include selling capitulation, parabolic tops, and breakouts from consolidation areas. A reversal in a plunging stock price will often take place in the moments after a period of extremely high volume, panic-driven selling as longs capitulate and stop-losses are triggered. Traders can observe this phenomenon by looking at a simple candlestick chart with volume bars. Frequently the best time to enter a long position in a plummeting stock is when both volume and price are hitting extremes. This strategy can be risky, however, so it is always important to have a disciplined exit strategy.
Conversely, stocks that are surging will often put in a top on large volume spikes and parabolic price movement. A natural time of the day to look for these reversals is after the first hour or hour and a half of the trading day. Most of the volume in the stock market is traded during the first hour of the day and the last half hour. As volume subsides, stocks that have made extreme price movements will frequently be unable to sustain the momentum and price will retrace.
Another technical pattern that can be applied in tandem with volume trends is end of day breakouts from a high consolidation area. This pattern occurs when a stock rises sharply in the morning on heavier than usual volume and then consolidates during the middle of the day when there is less overall market activity. During the last hour or half hour of the trading day, these stocks are good candidates to break out of this consolidation area and run to new highs into the close. The same strategy can be applied on weak stocks as well. The key to this technical pattern is the tick up in volume towards the end of the day when institutions begin to trade heavily again. The ideal time to enter these trades is when price rises above (or below) its previous range and the volume bars begin to expand.
While many top traders are able to earn a great living relying solely on basic technical analysis and volume trends, it is crucial to know when to apply these skills. Technical analysis is not very useful in the absence of liquidity and volatility. In particular, with algorithmic and high-frequency trading dominating volume in the equity market, many stocks exhibit random and excessively choppy price action throughout the day. It is important for traders to find stocks that have a high degree of institutional activity and human involvement on a given day. When these opportunities are identified, they can be profitably executed on with a strong understanding of technical analysis and volume patterns.
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