Technical Analysis for Beginners

Always have a backup system in place… always.

Even in a market that’s made little-to-no sense, there’s always a way to make money.

And as promised, here’s our second, most popular way to find stocks — even options ready to bounce off lows or drop like a rock.

There’s a real beauty to combining our news dissemination and technical trading systems.

The two helped call the bottom of housing in 2004… the top of housing and subprime in 2007… the U.S. recession… the top of the UK economy and its ensuing troubles… the crash through 12,400 (as others called for Dow 15,000)… the crash to 6,500… the top of Treasuries… and the downfall of some of Wall Street’s once most respected banks, Lehman, and Bear Stearns… even the bottom of natural gas.

And we’ve already uncovered the next economic blunder with Option ARM resets, which we’ve spoken about in some depth.

Today’s lesson: technical analysis

The beauty of this system is that it can be used in any market… even in recessions.

Let’s use Tiffany & Company (TIF) as an example.

On June 22, 2009, we said:

Thoughts of an improving economy are quickly fading again, despite bullish reports that a recession is ending thanks to the World Bank, which just cut its 2009 global growth forecast. It believes the world economy will shrink 2.9% and is warning that the global recession has deepened.

More than likely, we’ll have another sideways trading market this week, which is forcing us to return to technical trading set ups, like the one we found at Tiffany’s (TIF). Thematic and momentum trading in this market these days is non-existent. In this sideways trending market, you’ll have better luck trading Bollinger Band bounces.

Here’s that chart of Tiffany’s at the time:

Notice the long-legged doji at the bottom of the recent selloff. That’s our turnaround signal. It’s the same candlestick and Bollinger Band set up that’s marked the bottoms in early March and early May.

We believe we could see at least $28 near term if this holds up.

We also have an oversold read on W%R. And we believe we’ll soon see a positive shift in MACD.

Here’s what it did after that alert. It ran to $30… and sold off on a doji cross above the upper Bollinger Band:

Profiting from technical developments has never been easier

My favorite indicators involve the use of Bollinger Bands, W%R, the news, and candlesticks. Using just these four criteria, we can call for tops and bottoms on indices, as well as individual stocks.

Let’s take a look at AIG from November 2006:

In late November 2006, shares of AIG were grossly overbought. Technically, once we got word of an extremely overbought W%R read (as seen in mid-November), we knew AIG was overdue for a correction.

Also notice at the time, the underlying stock crossed above the upper Bollinger Band with a doji cross indicating near-term reversal, which we got.

And just as we had hoped, AIG fell from about $72 to less than $69, handing us a quick gain.

AIG then bottomed out at $70. Again, technically, we had another doji reversal signal… this time at the bottom of the trend (a doji at the bottom of a trend can be used as a bullish reversal signal).

Fundamentally speaking, the company — once entangled in investigations that rocked the core of the insurance industry, and whose accounting probes led to the departure of Hank Greenberg — became quite the turnaround story.

We bought again at the bottom, marked by an oversold W%R, and rode it back from about $69.50 to more than $72 in a few short weeks.

Or look at what happened with Forest Laboratories (FRX) every time it touched the upper Bollinger Band.

We got a bit lucky with the latter portion of the chart with about a $10 dive off a double top on the upper Bollinger Band… But match up the upper Bollinger Band touches with overbought W%R reads, and you’ll see the setup for a fall was in the stars:

Confused? Don’t be…

For those of you that aren’t familiar with the terms (doji, Bollinger Band and W%R), here’s a quick tutorial:

• Dojis usually appear at times of market indecision and have called key reversals in indices and individual stocks.

• W%R (Williams % Range) is the ultimate momentum indicator that signals oversold and overbought conditions. W%R shows an overbought condition with a numerical range read of 0% to 20%. Oversold conditions are measured with a numerical range read of 80% to 100%.

• As for Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. So, when the prices (in this case with the Dow) move above the upper Bollinger Band, are coupled with a bearish candlestick read (gravestone doji, for example), and an extreme overbought W%R read is present, we expect a reversal at the top.

When we designed the system in late 2005, here were some of the original results which we still use today.

Using the W%R, the Bollinger Bands, and bearish candlesticks, we called the top of CVS before it sold off from a $36 high on Sept. 12, 2006, to less than $31 two weeks later.

Here’s how we found this.

• Step 1: On Sept. 12, 2006, the W%R peaked in overbought territory.

• Step 2: On the same day, a bearish doji made its presence known above the upper Bollinger Band.

• Step 3: We bought puts and watched as the stock sold off to $31.

Okay, but what’s a doji?

The profit stars — more commonly known as dojis — are commanding reversal signals. These are formed when the candlestick opens and closes at the same level, implying indecision in the stock price.

Depending on the location and length of the shadows, dojis can be categorized into four subcategories:

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

2. 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.

3. 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 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.

4. Gravestone doji: Gravestones are the opposite of dragonflies and indicate top reversals when confirmed with a bearish engulfing scenario (which we also use). These dojis look like gravestones and can signal the death of a stock.

The 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 2 standard deviations)…

• A lower band (SMA minus 2 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. We’re not going to get into the scientific structures and Bollinger band calculations with each trade.

We’ll be here until New Year’s 2012 doing that.

Using the Bollinger Bands, look at what happened to CVS (NYSE: CVS) after putting in a doji cross above the upper Bollinger Band. (Note: If a pattern is above the upper Bollinger Band, it’s an extremely overbought condition. We view this as a near-term reversal opportunity.) It sold off from its Sept. 12, 2006 $36 high to about $31 two weeks later.

The Williams Percentage Range (W%R)

The third component of the trade is to find an overvalued W%R read, or a chart where the W%R has peaked. According to the W%R, values of 80% to 100% indicate an oversold condition. Values of 0% to 20% are overbought.

Interesting to note: W%R has the ability to anticipate reversals. The indicator will oftentimes peak and turn down days before the stock peaks and turns down. It does the opposite with upside.

And finally, here’s a new step

This can be used with or without the above indicators. It works just as well…

Take a look at the MACD (moving average convergence-divergence indicator) and DMI (directional movement indicator) on this chart of the Dow below.

Notice in this chart the noticeable drop from 11,200. We’ll get into the candlesticks, W%R (Williams % Range) and Bollinger Bands in a moment, but just focus on DMI and MACD here.

As soon as the Dow began to show signs of cracking at the top, DMI- (red line) crossed above DMI+ (blue line).

At the same time — and this is important — MACD (12, 26), the blue line, crossed under MACD (9). When the two agreed, we had confirmation of a big move on the way, and the market collapsed.

Used alone, these two indicators — when in agreement — are powerful tools. This is our newest indicator that can be used without these next three steps.

What do we see in the future?

Option ARM resets are going to wreak economic havoc… Be prepared for another leg down — or another of the Greatest Sucker’s Rally, thanks to Bernanke’s printing press.  Either way, we’re in trouble.

Stay tuned for new trading opportunities using these very simple techniques with Options Trading Pit and Pure Asset Trader, the team that’s 62 for 65.

Booyah to ya!

Stay Ahead of the Curve,

Ian L. Cooper
Editor, Wealth Daily