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.
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.
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
- Arms Index (TRIN)
- Bollinger Bands
- Commodity Channel Index
- Moving Averages (of various types)
- Moving Average Convergence Divergence
- McClellan Osc
- On Balance Volume
- Parabolic SAR
- Relative Strength Index (RSI)
- Stochastic (fast and slow)
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!