Introduction
CHARTS AND TECHNICAL analysis can be used to better understand what the current price trends are for the markets and companies you are interested in. They also provide a feel for overall sentiment, which can help decide whether to favour growth or value companies.
Such insight will help you to avoid investing in companies during periods of bearish sentiment, where companies’ share prices tend to fall together. Moreover, when sentiment is bearish, waiting until downward price pressure abates may give you a better purchase price for the company’s shares as well as afford some time to check your analysis and underlying assumptions.
Conversely, bullish company sentiment and no obvious areas of price resistance shows that investors have noticed the disparity to underlying value and that any investment in the company will be supported by positive price momentum. This is a good time to invest or add to positions in the company.
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Colour versions of charts are available at www.theequityedge.com and links to the original colour charts are included under the relevant figures. |
Weekly chart set-up
To identify the medium-term price trend weekly price charts are used. Weekly charts tend to smooth out the day-to-day volatility, cutting out much of the noise that is found in the daily chart. This makes it easier to identify underlying trends and key areas of support and resistance.
Candlestick charts
Weekly candlestick charts are used to help identify the underlying trend. Each candlestick in the chart represents the range of prices the shares traded at over the week. The body of each candlestick shows the area between the open and close of the week, while the area between the high and low of the candlestick shows the overall price range. The shadows of a candlestick show where price traded outside of the open and close price range.
Figure 13.1 Structure of candlesticks
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The structure of candlesticks is summarised in figure 13.1. An increasing candlestick is green (shown as light grey in black and white versions of the book) to demonstrate that the weekly price closed above the opening price and moved higher across the week. Conversely, a decreasing candlestick is red, (shown as dark grey in black and white versions of the book) indicating that the weekly price closed below the opening price of the week.
Figure 13.2 shows a weekly chart of the FTSE 100 from the Trading View website (tradingview.com). The lines on the chart represent different (exponential) moving averages of the closing prices.
Figure 13.2 Weekly chart of FTSE 100
Source: Trading View (tradingview.com)
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Moving averages
Weekly moving averages are used to help identify price trends. Each moving average calculates the (exponentially) weighted average price over a specified moving period. For example, a 21-week moving average will calculate the average price over each period consisting of 21 consecutive weeks’ closing prices.
Each weekly chart has two groups of moving averages: a short-term group representing the traders in the market and a long-term group representing the more conservative, longer term investors. The trader group consists of the three-, five-, seven-, nine-, 11- and 13-week moving averages, while the investor group consists of the 21-, 24-, 27-, 30-, 33- and 36-week moving averages.
The ribbons of moving averages for these two groups are used to filter out the short-term price movements while highlighting the underlying price trend.
Defining a weekly price trend
Weekly price trends and their strength are determined by the direction and relative position of two groups of moving averages. This technique was created by Daryl Guppy, a renowned share trader and bestselling author, who came up with the idea of using two distinct groups of moving averages to glean information about market fluctuations.
A group of moving averages is defined as being in an uptrend when the shorter moving averages in the group are above the longer. The primary price trend is determined by the investor group; if the investor group is in an uptrend, the moving averages are coloured green to denote that the primary trend is upward. The secondary trend is determined by the trader group; if the trader group is in an uptrend, the moving average lines are coloured light blue (provided the primary trend is also upward). These two trends are used to determine the direction and strength of the weekly price trend.
The weekly price trend is upward when the following criteria are met:
1. the primary trend is upward (i.e., investor moving averages are green),
2. the trader group is above the investor group of moving averages,
3. the latest weekly candlestick is above the long-term (investor) group of moving averages.
The weekly price trend is strongly upward when, in addition to the above criteria:
4. the investor moving averages are rising at an upward angle and are not close to horizontal, and
5. the price width of the investor group of moving averages is widening or remains wide, signalling trend strength.
Conversely, a group of moving averages is defined as being in a downtrend when the shorter moving averages in the group are below the longer. If the investor group is in a downtrend, the moving averages are coloured red and the primary trend is downward. If the trader group is in a downtrend, the moving average lines are coloured orange (provided the primary trend is also downward).
The weekly price trend is downward when the following criteria are met:
1. the primary trend is downward (i.e., investor moving averages are red),
2. the trader group is below the investor group of moving averages,
3. the latest weekly candlestick is below the long-term (investor) group of moving averages.
The weekly price trend is strongly downward when, in addition to the above criteria:
4. the investor moving averages are falling at a downward angle and are not close to being horizontal, and
5. the price width of the investor group of moving averages is widening or remains wide, signalling trend strength.
The weekly price trend is classified as a sideways (directionless) trend when the weekly price trend is not upward or downward.
Example
Figure 13.2 shows the FTSE 100 during May 2018. The primary trend is upward (as the long-term group has turned green) and the trader group of moving averages is above the investor group. The last weekly candlestick closed above the long-term group of moving averages. The investor group of moving averages are rising on an upward trajectory and have started to widen, suggesting a strong upward trend. That said, prices have reached an area of price resistance, so some caution is needed.
Market direction and stages of the price cycle
The transition in the primary trend for a market index can be used to define stages in the market price cycle.
When the primary trend changes from downward to sideways a bottoming stage (stage 1) is formed. When this stage has lasted for several weeks you can start to allow light buying of shares, while waiting for price recovery. The longer the bottoming stage occurs for, the more pronounced the recovery part of the cycle is likely to be. Buying value or income shares is preferred at this stage of the cycle, as they tend to afford more downside protection than growth shares.
Stage 2 of the price cycle is the recovery stage, where the primary trend transitions from sideways to upwards. Most of your share buying should occur in this stage.
In the first few weeks of stage 2 the preference is to buy value and income shares. You should transition to buying growth shares, once the trend has been established for several weeks and has cleared any nearby horizontal price resistance. This is usually accompanied by improving earnings growth.
The topping out stage (stage 3) occurs when the primary trend transitions from upwards to sideways. The trend may be consolidating before it continues an upward trend (back to stage 2) or the sideways trend may be followed by a downward trend, initiating a downward stage (stage 4).
During the downward stage (stage 4) you may start to see some sell signals in your portfolio as share prices start to fall and hit their sell stops (see chapter 14 for selling rules). This is useful as it moves some of your portfolio into cash ready to take advantage of new opportunities when the price cycle changes, while helping to limit portfolio losses.
When the overall market is in the downward stage (stage 4) no buying of shares is allowed until a bottoming stage has formed, as share prices tend to get dragged down together regardless of the fundamentals. Use this time to research companies that you might want to invest in and prepare for when you can start to buy again.
Example
Figure 13.3 shows over five years of price history for the FTSE 100 and the transitions between the different stages of the price cycle. The FTSE 100 is currently in a stage 2 uptrend, indicating that company share prices in this market are broadly rising and that additional positions can be added. However, caution is needed as the FTSE 100 is approaching a major price resistance level.
Figure 13.3 Trend transitions – FTSE 100
Source: Trading View (tradingview.com)
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Company share price direction
The weekly chart is used to assess the broad price direction for a company. In general, you should prefer investing in companies where the weekly price trend is upward and avoid those trending downward.
Example
Figure 13.4 shows the weekly price chart for XP Power. The investor group is in an uptrend and the trader group of moving averages is above that of the investor group. However, the candlestick is resting on the investor group of moving averages, so the weekly trend is currently defined as sideways. This suggests waiting until prices move higher.
Figure 13.4 Weekly chart – XP Power
Source: Trading View (tradingview.com)
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Daily chart set-up
Daily price charts are used to assess the daily price trend and make buy and sell decisions, having already accounted for the weekly price trend of the company.
Daily candlestick charts
Daily candlestick charts are used to represent the range of prices shares traded at each day. The body of each candlestick shows the area between the open and close of a day, while the area between the high and low of the candlestick shows the overall price range. The shadows of a candlestick show where price traded outside of the open and close price range.
Moving averages
On a daily chart, the short-term group of moving averages consists of three-, five-, eight-, ten-, 12- and 15-day moving averages, while the long-term group consists of 30-, 35-, 40-, 45-, 50- and 60-day moving averages.
Example
Figure 13.5 shows the daily chart for XP Power towards the end of May 2018.
Figure 13.5 Daily chart – XP Power
Source: Trading View (tradingview.com)
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Defining the daily trend using daily moving averages
The daily trend is defined in the same way as the weekly trend. The only differences are that the moving averages are based on daily closing prices (instead of weekly closing prices) and different moving average periods are used in the two groups.
When the daily price trend is upward, the purchase of company shares is allowed. When the daily trend is sideways, company shares can be bought when they are close to a key level of support and provided the weekly trend is upward. When both the daily and weekly trend are sideways it is worth waiting until an upward trend establishes itself. If the daily trend is downward, no buying of company shares is allowed.
Example
In figure 13.5 the daily primary trend is upward. The short-term group of moving averages is moving downwards and is meshed with the long-term group of moving averages, indicating the daily trend is currently sideways. The weekly price trend is also sideways, which suggests waiting for an upward price trend to resume.
Identifying support and resistance levels
Prices are dynamic, reflecting the continuing change in the balance between supply and demand. Identifying the price levels at which these balances may change is useful as they help plan the price levels at which to buy or sell shares.
Horizontal support
Horizontal support levels (or floors) represent the price levels where the price tends to find support. This means the price is more likely to move upwards off the level rather than break through it. The more often a level is tested (touched and bounced off by price), the more significant the support level.
If price moves significantly below a support level, it is likely to continue falling until it finds a lower support level and the trend changes. When price breaks significantly below a support level, it becomes a resistance level.
Normally the nearest three horizontal support levels relative to the current price are identified. These are referred to as S1, S2 and S3 (where S1 is above S2 and S2 is above S3) for convenience. Stop losses (discussed in chapter 14) should ideally be placed below S1 or S2, where possible.
Example
Figure 13.6 shows the horizontal support lines for XP Power on the daily chart. The horizontal support levels are S1 = 3102p, S2 = 2762p and S3 = 2560p.
Figure 13.6 Support and resistance levels – XP Power
Source: Trading View (tradingview.com)
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Horizontal resistance
Horizontal resistance levels are the opposite of horizontal support levels. They represent the price levels where the price tends to find resistance. This means that the price is more likely to move downwards off these levels rather than break through it. However, if the price moves significantly above a resistance level, price is likely to continue rising until it finds the next level of resistance and the trend changes. The previous resistance level becomes a support level.
If you are considering buying a company and the price is currently near a horizontal resistance level, you may want to wait until there is either a breakout above resistance or a pullback to support.
Example
Figure 13.6 shows the nearest horizontal resistance for XP Power is R1 = 3741p. This is the highest price level XP Power has achieved and consequently higher resistance levels are not specified.
Trend support and resistance
If the primary trend is upward, the investor group of moving averages, that is, the green ribbon, can be treated as an area of price support. Conversely, if the investor group is in a downtrend, the red ribbon can act as an area of resistance. If the investor group is in a sideways trend, the horizontal support and resistance of the trading range can be used instead.
Example
Figure 13.6 shows the primary trend is currently upward, and that the investor group of moving averages can currently be thought of as resistance. The current trend support level is 3463.6p, which is the lower edge of the ribbon. The closing share price is slightly below this at 3460p. This suggests that the trend may be about to move lower and that a wait and see approach should be adopted.
Buying strategies
Strategy 1 – Buying dips in an uptrend
When a company’s share price is trending upwards, a short-term dip in price may provide a useful opportunity to begin buying shares in a company or add to current holdings. This strategy is applicable to income, value and growth companies.
This strategy should only be applied to companies where the weekly and daily trends are upward.
Step 1 – Identifying a short-term dip (set-up)
The first step in this strategy is to identify when a short-term dip has occurred. A short-term dip starts when the daily primary trend remains upward but the daily secondary trend transitions from upwards to sideways. When this happens, the trader group of moving averages changes colour, from blue to grey.
Step 2 – Look for the short-term dip to end (trigger)
Once the dip has started you should wait until the width of the trader group of moving averages has compressed and there is a signal that the downward move in price has ended. This helps to lower the risk of buying into a dip that then turns into a potentially costly downtrend.
The short-term dip is determined to have ended when the secondary trend begins moving upward again. When this happens, the trader group of moving averages turns blue.
Step 3 – Determining a buy price (entry)
Once the secondary trend is upwards the shares can be bought the following day, provided the daily primary trend remains upward.
You should aim to purchase shares at a price that lies within or close to the trader group of moving averages on the day of purchase.
Example
Figure 13.7 shows the daily candlestick chart for XP Power, with the steps applied in an actual share purchase in 2017. The share price was in a strong upward trend when a short-term dip started on 24 February 2017. Several days later the secondary trend turned upward, triggering the trade on 7 March 2017. The shares were purchased the following day at 1928p, a price close to the bottom of the trader group range.
Figure 13.7 Daily chart – XP Power
Source: Trading View (tradingview.com)
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Step 4 – When to sell the shares bought (exit)
The rules for selling an investment holding are discussed in the next chapter. The rules include guidelines on setting the initial protective stop, i.e., the price level at which a decision to sell a company’s shares will be made to limit further losses should the current share price fall below it.
Typically, a 20% fall in share price will warrant the selling of shares. The additional rules in chapter 14 should always be applied to companies selected using the income or value screens.
You may want to use tighter protective stops for companies that have been selected using the growth screen, as price falls for growth shares can be more pronounced when the trend changes. In this case, you can set the initial stop just below the investor group of moving averages. Alternatively, the stop loss can be set 8–10% below the breakeven price. You then follow all other rules outlined in chapter 14.
Example
Figure 13.8 shows the horizontal support and resistance levels at the time of the trade. The nearest horizontal support level is S1 = 1874p. On the entry day, the trend support level (determined by the lower edge of the investor group of moving averages) is 1856p.
XP Power is an income company with some growth characteristics. The trend had been in place for some time, so a tight stop was used. The shares were purchased at a breakeven price of 1928p, which means a 10% stop loss would be 1735.2p (= 0.9 × 1928p). However, this was well below the nearest horizontal and trend support levels, so a stop loss of 1854p, the lower bound of the investor moving average ribbon, was chosen instead.
Figure 13.8 Daily chart – XP Power
Source: Trading View (tradingview.com)
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Strategy 2 – Buying in a strong uptrend
When a company’s share price is trending strongly upwards relative to the overall market, the share price is likely to continue to rally upwards for some time with few pullbacks to take advantage of. Identifying strong upward price trends provides an opportunity to ride the price momentum and generate capital gains. This strategy is often applicable to growth companies.
This strategy requires the daily trend to be strongly upward while the weekly trend is either upward or strongly upward.
Step 1 – Identifying a strong uptrend with relative strength against benchmark (set-up)
This strategy can only be applied to companies where the weekly and daily trend are strongly upward.
Example
Figure 13.9 shows the weekly price chart for XP Power with the weekly analysis applied for an actual share purchase in 2017. The week ending 2 October saw the price rise breakout above 2700p. The weekly price trend is strongly upward, as the investor group of moving averages is widening and rising at an upward angle.
Figure 13.9 Weekly price chart – XP Power
Source: Trading View (tradingview.com)
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Figure 13.10 shows the daily price chart for XP Power with the steps applied in an actual share purchase in 2017. On 2 October, the daily price trend was strongly upward with a widening primary trend rising at an upward angle.
Figure 13.10 Daily price chart – XP Power
Source: Trading View (tradingview.com)
www.theequityedge.com/wp-content/uploads/2020/02/Figure-13.10.png
Step 2 – Determining a buy price (entry)
Once a company’s share price is confirmed to be in a strong uptrend, the shares can be bought as long as the quoted buy price lies within the trader group of moving averages on the day of purchase.
Example
In figure 13.10, it took a few days for the price to trade within the trader group of moving averages. The shares were eventually bought on 5 October 2017 at a breakeven price of 2854p.
Step 3 – When to sell the shares bought (exit)
The rules for exiting are like the previous strategy. However, a tighter protective stop is typically used. The initial stop loss is normally set just below the investor group of moving averages on the day of entry or 8–10% below the breakeven price. You then follow the trailing stop rules proposed in chapter 14 to determine the exact exit.
Example
The nearest horizontal support at the time of purchase was R1 at 2797p, as the price rose above resistance, which then became a support level. The next horizontal support was at S1 at 2367p. The lower bound of the investor group of moving averages was 2640p on the day of purchase.
The breakeven price was 2854p. The 8% stop loss level is therefore 2625.7p (= 0.92 × 2854p), while the 10% stop loss level is 2568.6p (= 0.9 × 2854p). These stop levels are below R1 but above S1. The final stop loss was therefore set at 2552p so that it was below a natural level of support observed on the chart; this moved the stop closer to S1.
Strategy 3 – Buying support during sideways trading
If a company’s share price is trending sideways, buying at a price close to a horizontal support level is a good way to minimise early price downside while the sideways move continues. If the market is in a recovery stage, it may also provide an early opportunity to benefit from a share price rise due to a general market recovery.
This strategy is normally applied to income and value companies. For growth companies, the preference is to buy companies with upward price trends that reflect improving earnings over time. For this reason, strategies 1 and 2 are usually preferred for growth companies.
Step 1 – Identifying a sideways price trend
The set-up for this strategy requires that the company’s share price is moving sideways in a range. A company’s share price is determined to be trending sideways when the daily trend is sideways and the long-term group of moving averages are relatively compressed.
Example
Figure 13.11 shows another trade in XP Power, which qualifies as an income investment. The price started to trend sideways on 6 June 2017 and was eventually confirmed by the primary trend on 3 July 2017.
Step 2 – Determine the trading range
Once a company’s share price is determined to be trading sideways, the next step is to determine the trading range. The bottom of the trading range is determined by the nearest confirmed horizontal support level (S1), while the top is determined by the nearest confirmed horizontal resistance level (R1).
Ideally you will want the top of the trading range to be at least 10% higher than the bottom. This ensures that the trading range is wide enough to profit from.
Example
Examining the chart, horizontal support is S1 = 2371p and resistance is R1 = 2752p. The distance between horizontal support and resistance is 381p. The resistance level is 16% higher than the support level, which is wide enough for a trade to be placed.
Step 3 – Wait for the price to close above the investor group of moving averages
Once a sideways price trend has been identified, you need to wait until the price closes above the investor group of moving averages. This signals a bounce from support is confirmed and the shares can be bought the following day.
Figure 13.11 Weekly price chart – XP Power
Source: Trading View (tradingview.com)
www.theequityedge.com/wp-content/uploads/2020/02/Figure-13.11.png
Example
The price closes at 2526.1p on 21 July 2017. The distance to support is 155.1p (= 2526.1p – 2371p) and the distance to resistance is 225.9p (= 2752p – 2526.1p), so there is still more upside than downside.
Step 4 – Determining a buy price (entry)
Once the price closes above the investor group of moving averages the shares can be bought the following day, provided the price lies within the bottom third of the trading range.
Example
The shares were purchased the following day at a breakeven price of 2480p. The distance to support is 109p (= 2480p – 2371p) and the distance to resistance is 272p (= 2752p – 2480p). The upside to downside ratio is a healthy 2.5 (= 272 ÷ 109) and the buy price lies within the lower third of the trading range. That is, it lies within 127p (= 381p ÷ 3) of support S1.
Step 5 – When to sell the shares bought (exit)
To sell the shares, you can follow the selling guidelines outlined in the next chapter. However, additional (optional) price-based selling rules can be applied when the share price is at extremes of the trading range.
If the share price falls below 97% of the bottom or rises to the top eighth of the trading range, the shares can be voluntarily sold.
If the share price rises to the top eighth of the trading range and isn’t sold, and subsequently falls back to the middle of the trading range, you can again optionally decide to sell the shares; typically this will allow you to take a few percentage points of profit, while allowing you to set-up for another trade at a better price.
Example
The bottom of the trading range is 2371p. Thus, if the share price falls below 2299.9p (= 0.97 × 2371p) the shares can be sold. This helps to keep losses small.
An eighth of the trading range is 47.6p (= 381p ÷ 8). The top eighth of the trading range is therefore 2704.4p (= 2752p – 47.6p) to 2752p. If the price trades above 2704.4p, the shares can be voluntarily sold for a profit.
Summary
Before buying shares in a company you should always use price charts. Looking at price charts allows for price trends to be identified, which incorporate a reflection of fundamental news and market psychology.
When the market is trending downwards share prices will tend to fall together as market sentiment is bearish. During these periods you can partially avoid large drawdowns in portfolio value, which ultimately adds to overall returns. This can lead to significant outperformance relative to the market over the long term.
Similarly, when a company’s share price is in a downtrend, the price will often continue to fall. Buying in a downtrend is therefore likely to lead to unnecessary losses. It is far better to wait for the trend to reverse, buying in at a low price with less downside risk, or to look at other companies that are trending upwards and have better price momentum.
This chapter has outlined three strategies to buy shares at an advantageous time. The aim of these strategies is to limit the short-term downside risk and take advantage of positive price momentum, which makes it more likely that an investment will move into profit.