The Basics of Technical Analysis

With the very basic outline you've been given on chart-reading, let's take a jump ahead, as a bit of a teaser, and see a pattern, in this case, a head-and-shoulders reversal pattern, the beginning of which is actually on the right hand side of the chart above, and see the promise that technical analysis offers.

A head-and-shoulders pattern is a reversal pattern, meaning that one would look for the stock to reverse its current trend and head in the opposite direction. If there is no trend to reverse, then it's not really a head-and-shoulders. In this case, the downtrend is a short one, but it is established by the gap down. As you can see in the chart, price makes three moves: a left shoulder, a head and a right shoulder.

What happens is that a new low is formed, then price moves up, forming the left shoulder. Price then declines further, with a subsequent rise that will sometimes break the downtrend by itself. This is the head. A third trough -- preferably symmetrical to the other shoulder, but not required -- is then formed, making the right shoulder.

A neckline is then drawn from the high that makes the left base of the head to the high that makes the right base of the head. In order for the pattern to be complete, this line must be broken, and in the case of a head-and-shoulders bottom, the break must be accompanied by strong volume. A break on light volume would call into question whether or not the upward move would continue. You would also like to see heavier volume on the up moves and lighter on the down, which we have to some degree.

As you can see on the circled bar, the stock broke through the neckline on a wide-range bar and had the proper heavy volume accompanying it. The breakout spent a short time consolidating, and then took off, ultimately peaking at $31.48 after another break forward on good volume.

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Source: Quote LLC

This example is not meant as a prediction that all head-and-shoulders patterns would have the same result. Nonetheless, it provides some insight into the way technical analysis works, which is that it gauges the market's mentality regarding a particular stock through the price bars and accompanying volume to give one an idea of whether a stock has the possibility of moving upward.