Five Technical Analysis Tools for Investors

Special ReportWhen you're looking to make a trade, what factors do you take into account?

Do you look at the recent open and close prices? Do you incorporate economic news and company press releases? Do you know to take technical analyses, like the W pattern, into account?

I received a chart of this W pattern from Brian Hicks, owner of Angel Publishing, with a note that said: This 'W' pattern points to massive upside potential.

This chart of the Dow was from September 18th, the day the Fed was set to announce its decision to taper its stimulus program. But then the Fed said it wouldn't taper and the right side of the chart did indeed go up in classic fashion.

As an aside, a big W is a double bottom with tall sides. The price confirms the double bottom when it approaches the height of the left side, at which point it forms a small handle and continues to rise.

Brian was right. It launched. (Though I must add, as an aside to my aside, the middle hump should be more diminutive to be a clean W pattern.)

The trick is to buy after the second bottom in this case, using the dragonfly doji on September 6 as your signal.

A knowledge of technical patterns like these can be highly valuable to investors. Knowing how to play things like this W pattern could be the difference between a missed opportunity and a winning trade.

But the W pattern isn't the only important tool. There are five other technical analysis pattern tools every investor must have.

Five Technical Analysis Tools Every Investor Must Have

1. Double Top and Double Bottom

The double top is one of the simplest technical patterns to pick up. It happens when a stocks price bounces off the same resistance line twice.

You can see both double tops and double bottoms in the Dow Jones Industrial Average chart above. And it was right both times.

The double top is a sell signal. A double bottom is a buy; it means that theres a strong support level that the stocks price will have trouble falling below.

2. MACD

Many people don't know the MACD, but it is one of my favorite tools and you should never buy a stock without looking at it.

MACDstands for moving average convergence/divergence. It was created by Gerald Appel in the late 1970s. I find it a handy and simple guide for timing my buys and sells.

The MACD is an oscillator, or a collection of three signals calculated from historical price data: two moving averages, a long-term one and a short-term one, moving over a centerline.

I won't bore you with how these are calculated, but rather tell you how you can trade using MACD...

You see in the chart above where the red line crosses the blue line? This signals a turnaround in the share price. At the right side of the graph are numbers from -200 to 200. The farther the blue and red lines cross away from the centerline (0), the more powerful the turnaround.

In the case of the DJIA chart above, you would have sold in late May, bought in early July, sold the first of August, and bought again the second week in September.

Four trades, and each of them would have made you money how 'bout that?

3. Doji Master

Dojis are fantastic when they appear after a long trend. If you get seven up days in a row with a doji at the top sell, because she's gone.

"What's a doji?" you may ask. Well, I'll tell you.

Dojis are a candlestick chart pattern that was developed more than 1,000 years ago by traders on the Japanese rice markets. Dojis are powerful reversal signals, like stock ninjas.

A candlestick is a visual representation of a trading session. You have an open, a close, a high price, and a low price.

If the candlestick is white, it closed higher than it opened. If it is red, it closed lower than it opened. The vertical legs are the highs and lows. Doji candlesticks are black because they closed at or near where they opened.

In other words, dojis are formed when the candlestick opens and closes at the same level, implying the fight between the bulls and the bears is at loggerheads. Dojis signal turning points.

Dojis can be categorized into four subcategories:

Doji This candlestick looks like a cross, inverted cross, or plus sign. At the top of a trend, it can indicate a reversal is near.

Long-legged doji Long-legged doji formations occur when the stock opens at certain levels, trades in a wide trading range intra-day, and closes at the same level that it opened. These become better predictors when preceded by small candlesticks. Long-legged doji formations can imply a change in trend.

Dragonfly doji The bearish dragonfly doji can usually be found at the market top or during an uptrend. This candlestick tells us the bulls may be losing their way, and it casts doubt on the market's ability to continue north. Confirmation is essential. You can confirm with a gap down or a lower close on the following day.

Gravestone doji Gravestones are the opposite of dragonflies. These dojis look like gravestones and can signal the death of a stock.

4. Bollinger Bands

Bollinger Bands allow users to compare volatility and relative price levels over a period of time. They consist of three bands:

A simple moving average (SMA) in the middle

An upper band (SMA plus two standard deviations)

A lower band (SMA minus two standard deviations)

Standard deviation, a statistical term that provides a good indication of volatility, ensures that the bands will react to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases) will lead to a widening of the bands.

For our purposes, let's make this a bit simpler...

When we use the Bollinger Bands, the closer the market prices move to the upper Bollinger Band, the more the stock market is considered overbought. The closer the prices move to the lower Bollinger Band, the more the stock market is considered oversold.

Again, simple is good.

5. Volume

Volume is the number of shares traded in a session, and it represents the interest level in a stock. If a stock is trading on low volume, then there is not much interest in the stock. On the other hand, if a stock is trading on high volume, then there is a lot of interest in the stock. Volume gives you a good read on the hype in a stock.

I like low volume stocks because I know all of the sellers are out, and any good news will launch the stock higher.

Momentum traders like high-volume stocks. Another benefit of a high-volume stock is that it will be easy to buy or sell. The spread will be lower. You really don't want to trade stocks that are so small they only trade a few thousand shares a day.

A volume spike can signal a reversal of trend, such as a capitulation low or a blowoff top. If a volume spike comes before a known event, like an earnings announcement or a phase III trial announcement, it means there has been a leak and insiders are loading up.

In other words, volume precedes price.

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