On the Technical Analysis of Stocks

In an earlier post, I did a longer-term technical analysis of the chart of Stratabound Minerals Corp. Yesterday's market activity saw the stock break through a trading channel, though, so I think it deserves more commentary. (For a current view of the technical chart shown above, click here.)

Rising Resistance: In the chart, the blue line represents long-term rising resistance.

In technical analysis, resistance refers to the price at which a stock or market can trade, but which it cannot exceed, for a certain period of time. For recovering stocks like Stratabound, I prefer to create a line known as "rising resistance" - rising (in keeping with recovery), but still a line of resistance. In this case, I drew the line through two points: a significant low as the stock was collapsing and a significant high after shares began to recover.

That line lasted for four years - until last week's breakout, which essentially shattered this technical feature of the chart. It "shattered" resistance by going through it and staying there more than three days; breakouts are a function of both direction and duration.

A breakout is a price movement through an identified level of support or resistance. Usually (as in this case) it is associated with heavy volume and increased volatility. Traders often buy the underlying asset when the price breaks above a level of resistance (an upside breakout) and sell when it breaks below support (a downside breakout). Breakouts can influence stock performance by triggering higher-volume buying or selling.

Trading Channel: The red and green lines describe a medium-term trading channel.

A trading channel is the space in a chart between an asset's support and resistance levels. By definition, the price of the asset will stay between support and resistance levels until a breakout occurs. Range traders try to buy an asset when its price is near the bottom of the trading channel and sell it when the price gets close to the top. Buy low, sell high. They profit from the price spread.

Trading channels may be flat, ascending or descending. This one has been ascending for about two years. Like long-term rising resistance, it has now experienced a breakout.

In such a short period, to have breakouts in two areas - that is, in respect to both long-term rising resistance and medium-term trading channel - is extremely bullish for Stratabound.

Personally, I would expect to see the stock pull back and consolidate within the trading channel for a while. If it does not back off and consolidate, where will the stock price go? There is some overhead resistance at 50 cents, and stronger resistance at 60. Those points seem like logical stops along the way.

Voodoo or Philosophy? There is a lot of debate among economists and traders about whether technical analysis (also called "chartism") actually works - and if so, why. Technical analysis is the practice of trying to predict stock prices by examining trading patterns and comparing the shape of current charts to those from the past.

Some thinkers, like ultra-cynic Burton Malkiel, are even skeptical about fundamental analysis. Fundamentalists would study such business fundamentals as Stratabound's business environment and the company's business plan to forecast how its stock price is likely to perform.

On the matter of technical analysis, Malkiel is downright scathing. You cannot predict future stock prices on the basis of past stock prices, he thunders. Like Malkiel, the more extreme critics deride technical analysis as hocus-pocus, not far removed from tea leaf reading.

But technical analysts beg to differ. They insist that the stock market moves in broad patterns, and that those patterns can be recognized by careful charting and an understanding of stock market history. In the mainstream business media there is a constant stream of references to resistance and to its polar opposite, support. This suggests that technicians may be right, and it also suggests a credible theory why. TA is effective simply because its ideas have become so pervasive.

According to this notion, its value has little to do with any scientific merit it may or may not have. When a technical breakout is visible, investors pile into a stock (or, if the breakout is to the downside, get out). Practically speaking, in other words, technical analysis operates largely as a self-fulfilling prophecy.

The Collective Mind: For me, a more interesting explanation makes sense. Briefly, a stock's chart reflects a huge number of investment decisions. Those decisions reflect all known information about the stock in question, and the needs and desires of investors. The decisions those investors make constitute a kind of collective thinking about the company. That group mind shows itself in particular patterns on the chart.

According to this view, the collective mind can be understood by drawing simple patterns on a chart, and it can be calculated with the aid of such indicators as MACD and RSI. (Both of those indicators are shown on our sample chart - just below and above the chart itself.) These indicators are based on simple mathematical formulas, but they can be very powerful. For more information about these indicators - and about chartism in general - go to Investopedia. Another great site is Stockchart's Chart School.

Of course, if TA reflects a collective mind, then as a discipline it can become rather complex. For example, this study - current version available here - discusses key indicators as Stratabound's stock price moved up, and projects important price points it will encounter if it quickly moves higher. Generally speaking, the indicators in green are positive. Those in red are alerts; they suggest probable resistance points, based on recent share price performance.

As I revise this blog entry (October 5), the opinions generated by Barchart's internal indicators are all on the buy side. In time, of course, that will change; all stocks fluctuate between buy and sell signals. For more information on this kind of analysis, study the Barcharts site. As your understanding of these indicators grows, you may find this kind of analysis to be quite helpful.

In this commentary, I have offered a sketch of TA, illustrated with studies of Stratabound Minerals Corp. - a junior mining company based in Canada. I am not recommending that you buy this stock or sell it - I am a director and an officer of the company, so I cannot. I do think, however, that it offers a good case study of technical analysis in action.

Although the writer is a director and officer of Stratabound, the thoughts and views herein are mine only and not those of Stratabound. I am not registered in any jurisdiction as a broker or investment adviser, so nothing herein should be construed as advice on whether to buy, sell or hold shares of Stratabound or any other company mentioned herein.