Filtering the Market Using Technical Analysis

Stock traders on the hunt for attractive trading opportunities often face a challenge: How do you quickly pull together a short list when there are so many to choose from?

If you had unlimited time, you could theoretically research every single stock until you had a more manageable list, but for most traders that's generally not an option.

That's why some traders turn to technical analysis. The idea is that using a handful of technical indicators as a kind of sieve can help you sort through the broader market to identify, first, attractive sectors and then, the potentially attractive stocks within them.

Here's how to do it.

The first step is to know your indicators. Here are four popular ones:

1. Support and resistance: If an index or stock is bouncing between a consistent low and a consistent high, it is said to be "range-bound." Drawing horizontal lines at these price levels can help you identify two key levels: support and resistance. Support is where downward trends tend to weaken as buying pressure overcomes selling pressure. Resistance is often where upward trends start to fizzle as selling pressure overcomes buying pressure. You can use these price levels to identify possible entry and exit points, whether you expect an index or stock to remain range-bound—or break through, potentially signaling the start of a strong new up or down trend.

2. Trend lines: A simple trend line can help you assess whether an index or stock has been trending in a bullish or bearish direction. To confirm a bullish trend, draw a line connecting all the price lows during a given period. If the line reveals a series of consistently higher lows, then the stock could be in a bullish trend. To confirm a possible bearish trend, draw a line connecting all the price highs. If the line reveals a series of consistently lower highs, then the stock could be in a bearish trend. Drawing one or both of these lines to create a trend channel can help you evaluate both the strength and duration of a market trend—for example, has the index or stock moved—or not—during your desired time frame, say, over the last week or month or quarter?

3. Moving averages: Moving averages reflect the recent price history of an index or stock. A simple moving average is the sum of the prices over a period of time divided by that time period. For example, a "20 day Moving Average" is the sum of the prices over 20 days divided by 20. Moving averages show you how the current price compares to an average price over an index or stock's history. An index or stock with a current price above its moving average is performing better than it has during the period used to calculate the moving average. Typical moving average time frames are 20, 50, 100, and 200 days, which approximate one month, 10 weeks, 20 weeks, and 40 weeks, respectively. Some traders look at "crossovers"—when one moving average "crosses" over another—to see if a stock or index is bullish or bearish. For example, when a short-term moving average crosses through and above a longer-term one, that's a bullish signal indicating that a stock's recent performance has been stronger than it has over the longer term.

4. Volume: Looking at volume in combination with price activity can indicate how strongly investors feel about a stock's current pricing. Larger volume indicates greater conviction from the market. Lower volume may indicate less conviction. When volume exceeds its moving average, support for the price action may be growing.

Now that you've got some technical analysis indicators in hand, you can use them to start filtering the market. You could start by looking at the performance of a major index, such as the S&P 500^® Index, the Dow Jones Industrial Average, or the NASDAQ Composite Index. Technical analysts believe that what the market is actually doing is more important than why it might be doing it. Is the overall market trending up or down? How aligned are the major indexes? Where are the indexes in relation to support and resistance? Is volume supporting the current price trend?

Next, it's time to figure out which sectors within the market are driving any trends. If the overall market is bullish, some sectors are likely to be very bullish. Likewise, if the overall market is bearish, some sectors will be particularly bearish. Identify the two or three sectors leading the trends using the indicators mentioned above.

At this point, you've already narrowed your search down to a fairly small share of the market, without having to sort through particular companies.

Now the search gets more specific. Just as you looked for sectors that were leading the market trend, now you look for the stocks that are leading those sectors. This process will help you identify the "strongest of the strong" or the "weakest of the weak."

Once you've settled on a manageable list, you can filter a few different ways: One straightforward approach is to filter for stocks with prices above their moving averages. You could also look for stocks that have broken through support or resistance and have increasing volume. 

After winnowing down the list to a handful of potential candidates, you can scan each of their charts and choose the opportunities that best fit your trading style and goals.

With a few steps and basic filters, you can effectively reduce thousands of choices to a qualified short list of stocks that meet your specific criteria while aligning with broader market trends, so you can make more objective decisions about what and when to trade.