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TECHNICAL ANALYSIS
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Technical analysis is the examination
of past price movements to
forecast future price direction. Technical analysts are sometimes
referred to as "chartists" because they rely almost exclusively on
charts for their analysis.
Technical analysis is applicable to
stocks, indices, commodities, futures or any tradable instrument where
the price is influenced by the forces of supply and demand. Price
refers to any combination of the open, high, low or close for a given
commodity/security over a specific timeframe. The time frame can be
based on intraday (tick, 5-minute, 15-minute or hourly), daily, weekly
or monthly price data and last a few hours or many years. In addition,
some technical analysts include volume and/or open interest figures
with their study of price action.
Money managers, traders and investors who find ways to outperform the
market must also remain flexible and innovative. A method that works
today does not mean it will work tomorrow.
The Beginning of Technical Analysis
At the turn of the century, the Dow Theory laid the foundations for
what was later to become modern technical analysis. Dow Theory was not
presented as one complete amalgamation, but rather pieced together from
the writings of Charles Dow over several years.
Technical analysts believe that the current price fully reflects all
information. Because all information is already reflected in the price,
it represents the fair value and should form the basis for analysis.
After all, the market price reflects the sum knowledge of all
participants, including traders, investors, portfolio managers, market
strategist, technical analysts, fundamental analysts and many others.
It would be folly to disagree with the price set by such an impressive
array of people with impeccable credentials. Technical analysis
utilizes the information captured by the price to interpret what the
market is saying with the purpose of forming a view on the future.
A technician believes that it is possible to identify a trend, and
market turning points, invest or trade based on the trend and make
money as the trend, or turning points unfolds. Because technical
analysis can be applied to many different timeframes, it is possible to
spot both short-term and long-term trends.
The IBM chart below illustrates a view on the nature of the trend. The
broad trend is up, but it is also interspersed with trading ranges. In
between the trading ranges are smaller uptrends within the larger
uptrend. The uptrend is renewed when the stock or commodity breaks
above the trading range. A downtrend begins when the stock or commodity
breaks below the low of the previous trading range.
What is more important than Why?
It's been said, "A
technical analyst knows the price of everything, but the value of
nothing". Technicians, as technical analysts as they are called, are
only concerned with two things:
- What is the current price?
- What is the history of the price
movement?
The price is the end result of the battle between the forces of supply
and demand for any particular item. The objective of analysis is to
forecast the direction of the future price. By focusing on price and
only price, technical analysis represents a direct approach.
Fundamentalists are concerned with 'why' the price is what it is. For
technicians, the 'why' portion of the equation is too broad and many
times the fundamental reasons given are highly suspect. Technicians
believe it is best to concentrate on 'what' and never mind why. Why did
the price go up? It is simple, more buyers (demand) than sellers
(supply). After all, the value of any item is only what someone is
willing to pay for it. Who needs to know why? You may never know why.
Many technicians employ a broad-based, longer term, macro, long-term
analysis first. The larger parts are then broken down to base the final
step on a more focused/micro short-term, perspective. Such an analysis
might involve three steps:
- Broad
market analysis through the major indices such as the S&P 500, Dow
Industrials, NASDAQ and NYSE Composite, or Commodity Futures Index, or
other broad indexes of various types.
- Group
analysis to identify the strongest and weakest groups within the
broader market groupings, i.e. Indexes, Meats, Grains, Currencies,
Metals, Energies, etc.
- Individual analysis to identify
the strongest and weakest within each group.
The beauty of technical analysis lies in its versatility. Because the
principles of technical analysis are universally applicable, each of
the analysis steps above can be performed using the same theoretical
background. You don't need an economics degree to analyze a market
index chart or commodity group. Charts are charts. It does not matter
if the timeframe is 2 days or 2 years. It does not matter if it is a,
market index, currency or commodity. The technical principles of
support, resistance, trend, trading range and other aspects can be
applied to any chart. While this may sound easy, technical analysis is
by no means easy. Success requires serious study, dedication and an
open mind. Technical analysis can be as complex or as simple as you
want it.
Overall Trend:
The first step is to identify the overall trend. "The trend is your
friend". This can be accomplished with trend lines, or moving averages,
or both. A Moving Average (MA) is an average of data for a certain
number of time periods. It "moves" because for each calculation, we use
the latest "x" number of time periods' data. As long as the price
remains above its uptrend line, or selected moving average or previous
lows, the trend should be considered bullish. The trend theory holds
that an uptrend remains intact as long as each successive intermediate
high is higher than those preceding it and each reaction low stops and
holds at a higher point than did earlier reaction lows. Conversely, a
downtrend prevails when each intermediate decline allows prices to fall
below previous lows and rallies fall short of earlier rally highs.
Support and Resistance Areas:
Support and resistance levels are unquestionably among the most
important of all technical considerations. They are areas, which prices
are expected to have difficulty moving above and beyond (resistance and
support), and they therefore deserve especially careful considerations
in buying and selling decisions. Support areas are areas of price
congestion or previous lows, below the current price, which mark
support levels. A break below support would be considered bearish.
Resistance areas are areas of congestion or previous highs above the
current price which mark resistance levels. A break above resistance
would be considered bullish. The basic idea behind resistance and
support theory is simply that price levels that were significant in the
past will have significant impact on price action in the future.
Random Walk Theory:
The basic "random walk premise" is that price movements are totally
random. Prices move at random and adjust to new information as it comes
available. The adjustment to this new information is so fast that it is
virtually impossible to profit from it. Furthermore, news and events
are also random and trying to predict these (fundamental analysis) is
also a lesson in futility. While there are some good points to be
gleaned from the random walk theory, it appears to be a bit dated and
does not accurately reflect the current investment climate. Random walk
theory was introduced over 25 years ago when institutions dominated the
market. These institutions had superior access to resources and the
individual was at the mercy of the large brokerage houses for quality
research. With the advent of online trading, power and influence are
shifting from the institutions to the individual. Resources are now
widely available to all at minimal cost, if not free. Not only can
individuals access information, but the internet ensures that everyone
will receive it almost instantaneously. They also have access to real
time data and can trade like the pros. With the availability of real
time data and almost instant executions, individuals can act on
information like never before.
General Chart Analysis:
What Are Charts?
A price chart is a sequence of prices plotted over a specific
timeframe. In statistical terms, charts are referred to as time series
plots, usually containing the open, high, low, and closing prices.
Chart Patterns:
Much of our understanding of chart patterns can be attributed to the
work of Richard Schabacker. His 1932 classic, Technical Analysis and
Stock Market Profits, laid the foundations for modern pattern analysis.
In Technical Analysis of Stock Trends (1948), Edwards and Magee credit
Schabacker for most of the concepts put forth in the first part of
their book. We would also like to acknowledge Messrs. Schabacker,
Edwards and Magee, and John Murphy as the driving forces behind our
understanding of chart patterns.
Pattern analysis may seem straightforward, but it is by no means an
easy task. Schabacker states: �The science of chart reading, however,
is not as easy as the mere memorizing of certain patterns and pictures
and recalling what they generally forecast. Any general chart is a
combination of countless different patterns, some being continuation
patterns and some reversal patterns, and its accurate analysis depends
upon constant study, long experience and knowledge of all the fine
points, both technical and fundamental, and, above all, the ability to
weigh opposing indications against each other, to appraise the entire
picture in the light of its most minute and composite details as well
as in the recognition of any certain and memorized formula.
To name just a few there are; Double tops and bottoms, Head and
Shoulder tops and bottoms, Wedges, Flags, Triangles, Channels, Gaps
(four types), Key Reversals, Island reversals, and more. There are also
Candlestick charts which provide a different way of looking at, and
analyzing, the same basic price data, open, high, low, and close.
A few other tools used on charts are Trend Lines, Support and
Resistance areas, percentage retracements, Fibonacci retracements, Time
cycles, Elliot Wave Theory Analysis, Gann Analysis, and more. Technical
Indicator Analysis:
There are many ways to crunch the numbers and endless combinations.
Here is a list of some of the more popular Technical Indicators:
- Accumulation Distribution
- Advance-Decline lines and ratios
- Arms Index (TRIN)
- Bollinger Bands
- Commodity Channel Index
- Moving Averages (of various types)
- Moving Average Convergence
Divergence
- McClellan Osc
- Momentum
- On Balance Volume
- Parabolic SAR
- Relative Strength Index (RSI)
- Stochastic (fast and slow)
- Volatility
Markets move on anticipation, and often reverse on realization! A twist
on the old stock market adage buys the rumor, sell the news.
Trade the expectation, reverse on the realization! |
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