What is Technical Analysis?
Technical analysis or "charting" is the study of price and volume behavior in financial markets in order to anticipate their future performance. I have deliberately used the word "anticipate" rather than "forecast" or "predict":
The market can go up or down at any time -- it is only the probability (of each move) that varies.
Technical Analysis - Not An Exact Science
Technical Analysis should not be used to make predictions because we never know the outcome of a particular pattern or series of events with 100 per cent certainty. The best that we can hope to achieve is a probability of around 80 per cent for any particular outcome, which means that something unexpected will occur at least one in five times.
My approach is to assign probabilities to each possible outcome. Assigning actual percentages would imply a degree of precision which, is normally unachievable. Most of the time, however, we can tell that price is at least twice as likely to move in a certain direction, as it is to move in the other. That is sufficient edge for a good trader to out-perform the general market.
Foundations of Technical Analysis
Technical analysis is based on three basic beliefs:
* Price discounts everything.
All fundamental, political and economic information available to the market is reflected in the price.
* Price tends to move in trends.
Charles Dow developed the Dow Theory based on his empirical observation of trends more than a century ago.
* History tends to repeat itself.
Basic human nature does not change and the market, reflecting the sum of all participants actions, behaves in identifiable patterns.
Does Technical Analysis Really Work?
Some academic studies claim that price movements in financial markets are entirely random, with no recognizable pattern. Other studies have shown that buy and sell orders are not randomly distributed -- they tend to cluster around key price levels in the market -- the basic tenet of support and resistance.
Technical analysis further enjoys the support of large numbers of short- and medium-term traders -- evidence of its practical application.
Support and Resistance
The foundation of all classical technical analysis is support and resistance: the behavior of buyers and sellers at key price levels. Trend theory is based on the performance of price at key support and resistance levels. Chart patterns similarly identify the behavior of buyers in relation to support and resistance.
Learning About Technical Analysis
Moving Average Systems
The Two Moving Averages system is particularly useful for identifying trends. The fast moving average should be about 5 or 7 days. The slow moving average should be varied according to the cycle you intend to trade (see Indicator Time Frames for details). Try 50 or 63 days for the secondary cycle and 120, 150 or 200 days for the primary cycle.
Exponential moving averages are more responsive and not prone to "bark twice" as with simple moving averages.
Use the slow moving average as a directional filter: only go long if the moving average is rising.
This makes a simple but effective trading system when combined with Stop Losses. Adjust the stops over time in the direction of the trend. Stan Weinstein's Breakout Model provides a useful variation where the stops are only moved above the slow moving average if the moving average stops rising.
1. Enter when the fast moving average rises above the slow moving average and the slow moving average starts rising. Wait for the breakout above the $28.00 resistance level [R] and volume confirmation. Place a stop-loss below the Low of the signal day [1].
2. Stops are adjusted upwards with each successive trough in the short cycle. Do not raise the stop above the slow moving average if it is rising. If the slow moving average is no longer rising, adjust the stop to just below the latest trough.
3. Exit when the fast moving average crosses below the slow moving average or price falls below the latest stop level [3].
Breakout Model
Stan Weinstein, in Secrets for Profiting in Bull and Bear Markets, provides one of the most complete models for trading long-term trends. The model employs a combination of proven techniques to identify breakouts from a trading range, to follow the progress of a trend and to identify appropriate exit points. It is important to read the book to understand the full model which is briefly summarized below
Trading Ranges
The long-term cycle has four distinct phases:
* phases 1 and 3 being trading ranges or reversal patterns; and
* phases 2 and 4 being trends.
The phases are not always as easy to identify as in the above illustration: a trend may last more than a year and a reversal pattern may be over within a week. Up-trends (or down-trends) may also be interrupted by a trading range before continuing the trend.
The model uses trendlines and breakouts above resistance levels to identify the start of a new trend.
Volume Confirmation
The breakout must be confirmed by higher than usual volume activity.
30 Week Moving Average
No trades may be entered if price is below the 30-week weighted moving average or if the moving average slopes downwards.
Trailing Sell-Stops
Stop-losses are moved up to below the Low of each successively higher trough in the up-trend or the 30-week MA, whichever is the lower. See Adjusting Stop Levels for details.
If the 30-week MA starts to level out and it appears that the stock is entering a Phase 3 top, then the stops are moved up to below the bottom of each successive trough and the 30-week MA is ignored.
Exit
Trailing sell-stops account for most of the exits from the trend. Exit immediately, however, if price falls below the 30-week MA and the MA is no longer rising.
It is important to build a sound understanding of the basic concepts before progressing to indicators and more complex chart patterns.
Indicators
Ensure that you have a sound grasp of technical analysis before moving on to indicators.
All that indicators do is summarize price and volume behavior in different ways to highlight important features. Bear in mind that whenever you summarize you sacrifice. All that an indicator does is to present a particular feature of the data in a more readable format -- while eliminating all other features.
Indicators, in the right hands, are useful and important tools but they are not the holy grail. The big picture, presenting all the data, is always the price and volume chart.
Dow Theory - Market Movements
The ideas of Charles Dow, the first editor of the Wall Street Journal, form the basis of technical analysis today.
Dow created the Industrial Average, of top blue chip stocks, and a second average of top railroad stocks (now the Transport Average). He believed that the behavior of the averages reflected the hopes and fears of the entire market. The behavior patterns that he observed apply to markets throughout the world.
Three Movements
Markets fluctuate in more than one time frame at the same time:
Nothing is more certain than that the market has three well defined movements which fit into each other.
* The first is the daily variation due to local causes and the balance of buying and selling at that particular time.
* The secondary movement covers a period ranging from ten days to sixty days, averaging probably between thirty and forty days.
* The third move is the great swing covering from four to six years. (Nelson, 1903)
* Bull markets are broad upward movements of the market that may last several years, interrupted by secondary reactions. Bear markets are long declines interrupted by secondary rallies. These movements are referred to as the primary trend.
* Secondary movements normally retrace from one third to two thirds of the primary trend since the previous secondary movement.
* Daily fluctuations are important for short-term trading, but are unimportant in analysis of broad market movements.
