MODULE 4 - INTRODUCTION TO TECHNICAL ANALYSIS
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- Technical Analysis and the Dow theory
- Principles of TA
- Trading vs. Investing
- Technical Analysis vs. Fundamental Analysis
- Technical Analysis vs. Fundamental Analysis: Case Study
- Criticisms of Technical analysis
- The Dow Theory
Technical Analysis and the Dow Theory
Technical analysis is the basic tool used by all successful traders to help them know where and how to trade. In this module we discuss just what makes up technical analysis and what its capabilities are, together with an outline of why it works, and why mastery of it is the key to successful trading in a multitude of markets.
In this course I will often refer to markets when talking about technical analysis of trading. This is just so I do not need to keep repeating ‘futures, options, financial instruments’ and other names. The basics of technical analysis apply across all markets, and in later modules we will get to any differences, such as which tools work best in different circumstances. The nuts and bolts that you learn here are what you need regardless of which way you want to take your trading career in the future.
There are a number of basic concepts which must be grasped in order to build upon them. One of these is the idea of ‘market action’, which represents all that we may know about the performance of a trading market, such as the stock market. Market action reflects the two basic facts that are available from observation of most markets, namely ‘how much’ and ‘how many’. How much is the price at which a trade happens, and how many is the quantity of shares or contracts which were bought and sold at that price, otherwise known as the volume. If you trade the Forex market, which happens around the world with no central marketplace or counting house, the movement of the price may be all you know on which to base your trades.
It doesn’t seem like much information when you think of it in those terms – just two numbers. But when you consider that there may be hundreds of trades in a day, each of them involving a different number of shares and perhaps a different price, you can see that just this basic information can build up into a picture of what the participants in the market are thinking, sometimes called the ‘market sentiment’, and how it changes over time.
A third value can be added when you trade futures or options, and that is called the ‘open interest’. When you trade futures, you are trading a promise to buy or sell something at a future date at a certain price. You don’t have to own that something right now, even if you are contracting to sell it. With options, there’s even less commitment, as the contract to buy or sell in the future may never be ‘exercised’, or taken up, and won’t be unless the buyer of the option can make a profit from it.
As futures and options don’t involve buying and selling actual shares or goods, but only a promise or possibility for future buying and selling, the number or value of contracts traded isn’t limited to the existing supply. You are free to promise as many thousands of the shares as you want to, and the number that has been promised is the open interest. I’ll go into that in more detail later.
What is Technical Analysis?
Technical analysis comprises the study and interpretation of ‘market action’ to try and project future price trends. In summary, all the information we have comes from the past, and with it we use technical analysis to try to predict the future so that we can trade profitably. In this respect technical analysis is about recognising past price patterns. You are looking for particular patterns that in the past triggered a certain outcome and these can be patterns not just in price but also in momentum.
If this seems like a difficult thing, you should take comfort in the fact that technical analysis has evolved and continues evolving thanks to the work of thousands of experts. We are not having to reinvent any wheels, but can stand on the shoulders of those who came before and made a lot of the observations which have resulted in practical tools that we can apply straight away to improve our trading.
Technical Charts (also called as Charts) are the heart and soul of technical analysis. For this reason, technical analysts are also known as ‘chartists’.
It is rightly said that a picture is worth a thousand words. A chart of a stock / commodity / forex price tells much about the probable trend of the price – if it is likely to move up, move down, or if it is moving sideways.
Most of the times, technical charts have the price on the Y-axis and the time on the X-axis. Technical analysts then apply various indicators to this chart to arrive at a buy / sell / hold strategy.
Normally, technical charts are based on the closing price of the day’s session; some indicators may require other prices (open, high, low).
Many exchanges today (stock exchanges / commodity exchanges / Forex exchanges) provide online access to the traded data on a daily basis. This enables technical analysts to construe stock charts real time.
Stock charts are one of the easiest ways to get a visual clue regarding the price of a share. And the more data you have, the more accurately you can predict the price movement. Serious stocks investing people tpically look at the long term trend of the stock chart; day traders prefer to take a look at the technical charts for a very short time span (typically 3 months or less)
Japanese candlesticks also use technical charts to predict the price movement. These patterns take cognizance of all the prices for the day’s trading session. Predictions are then made depending upon the patterns that emerge from the prices.
The Principles of Technical Analysis
The Market Discounts Everything
It is generally recognized that there are three basic principles or tenets that underlie technical analysis. The first is that the action of the market reflects everything there is to know about the price. This is extremely important, because underpinning technical analysis is the concept that just by studying market action we can get a good idea of future movements.
There are many things that can affect the price. These include fundamental factors, such as how well products are selling and what profit margin can be achieved; political or corporate factors, such as legislation, the installation of a new CEO or changes in working practices; and psychological factors, such as whether the latest toy will become a teenage fad, or the Blackberry becomes a must-have for business reasons. By cutting across this, and declaring that all these factors which may or may not be knowable become included in the price by market action, the technical analyst can focus on the market alone, and doesn’t need a squad of research assistants.
In case it seems that this is oversimplifying the situation, consider that all it really means is that supply and demand is demonstrated in market action. Classic economics teaches us that supply and demand set the price – if demand exceeds supply, then in time the price will rise, also known as a bullish market. On the other hand, a surfeit of supply and little demand will inevitably lead to a falling price, or a bearish move. What causes supply to increase or reduce need not concern the technical analyst; the same with demand. The result is all that matters.
If you think about it, this makes our task a lot easier. If we can rely on just looking at the price and volume (and we can) to give us information on the effects of all these different influences, then we reduce the whole problem that we might have had down to a manageable size. In fact, it’s rather neat the way it works out, since many of those factors that affect the price would probably be hard to quantify.
By tapping into what market action tells us about a stock or security price, we are letting the market tell us in which direction it will go, rather than trying to second-guess the buyers and sellers. While there are certainly reasons that the prices go up and down, it is just not necessary to know those reasons when making a prediction of future movement.
It’s an important principle of trading that you let the market tell you where it is going. Some people seem to think that they can control the market, or at least tell it where it ‘should’ go, based on all sorts of common sense ideas. If you set yourself up to fight the market in this way, you’re bound to lose in the end as the market is bigger than any single participant. You have to learn to anticipate and go with the flow.
The Market Exhibits Trends
The second tenet of technical analysis is that prices tend to move in trends. By this we mean that if the price is rising, it will in all likelihood continue to rise; when falling, it will keep going down; and when hovering at about the same level, it will keep doing that, sometimes known as moving sideways. Of course, none of these things goes on forever, but it is generally expected that a trend will go on for a while before changing. A lot of trading plans are based on this premise—you may have heard the expression ‘let the trend be your friend’, which means you should trade to follow the existing trend. Whilst doing otherwise is possible, it exposes you to more risk.
We start getting into charting and the different types of chart in the next module, but just to illustrate a ‘trend’ here is a simple chart. You may well be familiar with charts if you have been considering trading. If not, then you must understand that they are one of the core tools available to the trader. You need to learn everything you can about them.
Most charts you will use have the same basic layout. The time is along the horizontal, or X-axis, and the price is in the vertical or Y-axis. The time may show minutes or hours during the day, or days, weeks, or months. You will commonly see charts with the time scale marked in days, and it is the custom to only include working days, five days a week.
This chart shows an uptrend, with the price rising over time. Notice that it usually does not go straight up, but goes up in a series of spurts, with what are called ‘retracements’ in between. This chart shows a fairly clear uptrend overall. Sometimes it helps to look at different time scales so you can identify which way the trend is going – for instance, if you looked at a chart of the same stock as shown above, but with a different timescale that only showed you a retracement, you might think the stock was in a downtrend.
When trading with the trend, your task reduces to identifying the trend as soon as possible, so that you can enter the trade early, and staying with it until it shows signs of failing, or reversing. Unless you are psychic, you probably shouldn’t expect to get into a trade at the beginning of a trend and exit it at the end. That doesn’t really matter. You just need to capture the greatest gain you can, while being confident enough that what you have identified is a real trend.
History Repeats Itself
The third tenet is merely a statement that we don’t expect people to change their behavior. In other words, we rely on history repeating itself, with patterns and actions that have happened in the past leading to the same results when they happen in the future. Georg Hegel once said cynically that ‘We learn from history that we do not learn from history. ‘ The task of the technical analyst is to learn what history has to teach. The psychology of traders and investors has not changed over decades, and this fact can be used to advantage in technical analysis.
This again is a central belief to trading using technical analysis. We rely on a study of history to tell us what normally happens in a certain set of circumstances, and then we expect that the same thing will happen again. The outcomes are seldom or never sure, but trading is a percentage game. We stack the odds in our favour, and then use shrewd money management to make sure that the end result is a decent profit. No one should expect to win all the time, and in a later module about money management we cover how to keep your losses small.
Trading vs. Investing
Many people get confused between trading and investing, as on the one hand the goal of both is the same, making money, yet on the other hand when you look at the details they are really quite different. Trading and investing both involve the use of your capital, sometimes leveraged to greater effect as with spread betting, Forex, or commodity trading, with the goal of growing your funds. Generally speaking, anything that you can invest in you can probably trade in too; though there are more ways to trade than invest.
It does not help that we tend to misuse these words, using them interchangeably and even incorrectly in common parlance, for instance talking about our homes as “the largest investment we make”. Except in exceptional circumstances, the home is not an income producer but a net drain on our resources, and many have not even produced capital gain in recent years. Given the nature of people to move house every few years, arguably it could be considered a “trade” rather than investment.
Considering first investing, it is fairly well understood that this involves using capital with the goal of growing its value over time and/or deriving an income over time. This means investors may be interested in dividends and bond interest payments, for example, much more than traders are. And in keeping with this mindset, once they have made their initial allocations many investors are content to check on their investments’ progress every few months or even each year. In fact, some investments such as retirement funds may be seldom reviewed and reallocated.
Curiously, even though buying stocks is a legitimate investment activity, share buyers are seldom investing to the benefit of the named company. The only time that the company makes any money out of the stocks is during the Initial Public Offering (IPO) when they are sold. Every transaction after that is between third parties.
Part of the investors’ mindset is that there is no predefined exit strategy when the initial purchase is made. The company has been fully researched, sales and earnings figures dissected, and the expectation is that there will be capital growth and quite possibly income from the investment until such time as the money is needed elsewhere. Often the shares will simply form a part of the estate when the investor passes on.
Trading is concerned with making money by short-term fluctuations in the price of the financial security. In this context, short-term has a wide definition, varying from a few seconds for the really fast-paced daytrader to as much as a few weeks, but seldom longer. Because of this, traders are usually have their exit strategy fully defined before opening the trade – in fact, arguably, it is important for them to do so.
Trades are usually ended on one of three circumstances. Firstly, a successful trade may be closed when it appears that no more may be gained from continuing to stay in the trade – “let your winners run” as the saying goes. Secondly, an unsuccessful trade should be exited before the loss is significant to your account – “cut your losses”. The third, sometimes forgotten, reason for exiting the trade is when it has had a reasonable amount of time to work out, but the price is stuck and seems to be going nowhere.
Almost invariably, a trade will have a limited life expectation, and is much less open ended than an investment. As the world is becoming more impatient, people are becoming more interested in trading than investing, wanting to see rapid results rather than waiting for years to grow their money.
Comparison of Attitudes
This leads to a stark contrast between the attitudes towards the use of the funds in the account. An investor will look at what the price “should” be, given the costs of manufacture and production, both potential and actual sales, and future prospects. The overriding idea is that investments should have the potential to increase in value on the basis of the fundamentals and viability of the business. A stock, for instance, is valued on the basis of its future worth, both in terms of capital gains and dividend income, compared to the perceived risk for the business.
By their nature, traders are much more interested in transient effects, mainly resulting from the psychology of the market and how other traders are reacting. A trader will not be in the market long enough for a significant impact of, for example, income from sales increasing. Certainly, an announced sales increase may result in the share price growing, but mainly in anticipation of future profits, not because of actual cash flow.
Pros and Cons
Nowadays, to some extent investments are looking less secure than they used to. Buy and hold does not necessarily work out in the long run. Investing can still work, and the billionaire Warren Buffett is evidence of this, but he is extremely careful to select the companies that he believes have a long-term future. In comparison, in trading you expect to take an active role in monitoring your account, and therefore you have a closer control on the outcome.
It is not a good idea to consider that you can combine both trading and investing, as they require totally different approaches. In fact, one philosophy could have you buying a stock at the same time that the other approach requires you to sell.
To trade effectively, you need to overcome some natural inclinations, and this can be difficult. Greed, fear, and hope are powerful emotions that are hard to control, but must be conquered if you intend to trade successfully. For instance, when you are losing on what you feel should be a winning trade, the tendency is to hold on in hope, believing that the price will turn around, when you should really be closing the trade quickly out of fear that you may lose more. If your trade is winning, you may be tempted out of fear to close it and capture the gains rapidly, when the correct thing to do is to wait for as much profit as you can get – “let your winners run”.
When you are investing, you are not worried by such concerns. The investor can sleep easily at night, as the approach is not to attempt to “micromanage” by moving in and out of positions, but to let the investments ride the natural ebbs and flows of the market. Although this usually results in some gain over the years, trading to follow price movements is increasingly popular and potentially more profitable.
Technical Analysis v. Fundamental Analysis
The argument for technical analysis vs fundamental analysis often comes up when people examine the available methods for making money in the stock market.
Is one type of analysis better than the other? Should you concentrate on one method? Can they be used together?
Let’s find out…
Technical Analysis Defined
Technical analysis is the study of a stock’s price and volume data. Its purpose is to determine which way a stock is likely to move in the near future.
The stock chart is the weapon of choice for this type of analysis.
There are a few different types of technical analysis, but generally speaking, it’s used to evaluate trends, identify significant price levels, and ultimately locate trade entry and exit points.
Technical analysis can also be used to select markets to trade.
Fundamental Analysis Defined
Fundamental analysis is the study of a company’s or economy’s financial and economic details. Its purpose is to determine whether a company would make a good investment based on an assessment of its financial health, potential for profitability, growth prospects, and the value of the company compared to the price of its shares.
The balance sheet, profit & loss statement, and cash flow statement are the focus of this type of analysis.
Fundamental analysis can also include a consideration of a company’s ‘story’. To examine a company’s story you look at what it does, how it makes its money, and how it is positioned to perform in the future given the current economic climate.
Comparing the two types of Analysis
Technical Analysis Advantages:
Technical analysis is based on objective data. You can look at a stock chart and plainly see what’s happening right now. You can see which direction the price is moving in. You can see how popular the stock is based on its volume characteristics.
Technical Analysis Disadvantages:
Technical analysis doesn’t care about the company behind the stock. You might want to know what industry the company is in, but apart from that, the underlying company isn’t really a concern.
The company might be carrying more debt than it can handle, its revenues and cash flows might be weak, and it might not even be making a profit – who knows? Technical analysis doesn’t concern itself with such matters.
For most investors, technical analysis is about “timing” your entries and exits. For traders using technical analysis exclusively (i.e. no fundamental analysis), they also use technical analysis to determine which stocks to buy.
Fundamental Analysis Advantages:
Fundamental analysis gives you an idea of what a company’s future prospects are likely to be. Large institutional investors like to buy shares in companies with good fundamentals.
Fundamental Analysis Disadvantages:
The timing of the financial statements used with fundamental analysis can sometimes cause problems. If you get the information too late you might end up buying the stock after it leaves the buy zone.
Also, do the numbers make sense? Do they tell a story, or do they just add to the confusion?
Fundamental analysis is useful for stock selection. It isn’t ideal for determining entry and exit points, and for this reason, it’s mostly used by the long-term buy and hold crowd.
The Market Rally
Over the past couple of years the markets have rallied sharply from their lows. The economy on the other hand has hardly improved and everyday there is more and more negative news about how things are not getting better or actually getting worse fundamentally. Sure over the long run the fundamentals and the technicals will merge, but over the short to intermediate term they can diverge wildly, case in point, right now!
While I respect the fundamentals I never defer to them. Market psychology, sentiment, and technical forces significantly outweigh fundamentals 80% of the time. Those odds are all I need to know and want to know.
Let’s take, for example, the financial crisis of 2008, the technicals clearly showed you that the markets were reversing their trends and it was time to get out or go short. The fundamentals lagged by 3-6 months before telling you the same thing. Then in early 2009 the markets reversed course and by late spring, early summer the technicals told you to reverse your positions again, while the fundamentals were just telling you that nothing was improving. While some of the fundamentals have turned positive, the technicals turned positive well in advance of any of those fundamental indicators.
The fundamentalist will argue that the technicals have predicted impending recessions 26 times over the past 30 years and yet we have only had 4 or 5 real recessions. I would counter that by saying risk management, protecting capital, and making money are more important than being right over the long term.
Do the technicals always get it right? The answer is no. Do the fundamentals always get it right? Again, the answer is no. Can you make money using either methodology? Yes. The caveat is that you need to manage your risk and whether or not you believe in technicals you must always remember to protect your capital by managing your risk. I just happen to find the technicals more responsive and thus better for making money trading.
Lastly, fundamentals work great in normal market environments, but last time I checked we seem to be experiencing 50 year storms every 5-7 years . Case in point, 1974, 1981, 1987, 1994, 2000, 2001, 2008. In addition, we have gone nowhere for the past 10 year, the lost decade as it is being called, and yet many technical money managers have made considerable amounts of monies.
Combining the Merits of TA and FA
Technical analysis vs fundamental analysis – is this the right question to be asking in the first place?
Some people use only one type of analysis and that’s fine. As long as they’re making money, I don’t think it really matters. Personally though, I like to use both methods of analysis.
I use fundamental analysis as an initial filter to determine what to buy. The second part of my stock filtering process uses technical analysis. Once I’ve found a batch of fundamentally sound stocks, I analyze those stocks further to find the ones with the best stock chart patterns. It’s a two-tiered filtering approach.
When will I buy and when will I sell? That’s where technical analysis comes in.
Criticisms of Technical Analysis
Efficient Market Hypothesis
You may have heard of something called the Efficient Market Hypothesis, which was originally proposed in the United States in the 1960s by Eugene Fama of the University of Chicago. This controversial theory suggests that it is impossible to beat the market because the existing prices already incorporate all that can be known, which means investors would not be able to find undervalued stocks. The best an investor can do is buy and hold, benefiting from future growth of the company.
Contrary to the way it is sometimes expressed, the Efficient Market Hypothesis doesn’t in fact say that the market price is right – the price may be wrong, but there is no consistent way to determine whether it is too high or too low. The idea is that the markets are random, then there’s no forecasting technique that would be successful. Of course, technical analysts totally reject this idea.
The paradox about the Efficient Market Hypothesis is that if everyone believed the market was efficient, then no-one would analyze it any more, and the market would not be efficient. Therefore, one prerequisite for an efficient market is that there are traders who do not believe in it and continue to trade to try to beat the market.
In practice, we know by the tools of technical analysis that we can form a reasonable judgment of future price movement by considering the historical data. Of course we can be wrong, but we can determine a market bias, at least. This empirical finding is all the reassurance we need to know that technical analysis is worthwhile and can lead to profitable trading. The Efficient Market Hypothesis and the Random Walk Theory are interesting sidelines, but we really don’t need to bother about them.
Is It Self-Fulfilling?
Another criticism that you may hear about technical analysis is that it is self-fulfilling, and has no real basis. The argument is that because traders all see the same signals, they trade so that the market moves in accordance with the overriding wisdom. Some analysts believe that charts are just for fun, BUT so many people join in the fun and believe in the charts that the fun becomes a reality in influencing the shareprice. That is why so many chartists take this seriously… When traders see what they consider to be a bullish pattern, then they all buy in the expectation of the market going up, which makes the market go up. On the other hand, if traders believe that a downtrend in price is about to start, of course they will sell the securities and everybody doing that will make the price go down.
At first sight, that sounds very convincing. No wonder the patterns work so well, if traders are forcing the markets in this way. But my first reaction to that idea is ‘So what?’ – if the trading methods work, then we have the means to trade profitably! It shouldn’t change us from using the patterns that work. That said, perhaps the idea deserves to be answered in more depth and possibly refuted.
The Dow Theory
Dow identified three types of trend, and these correspond to the three types I introduced in the technical analysis section. Dow defined them as follows:
- An uptrend is when each successive high point is higher than the previous high, and the low points on the price chart also rise progressively.
- A downtrend is the opposite situation. Each successive low point is lower than the previous one, and retracements rise to progressively lower levels.
- The third trend is when both averages fluctuate within a range of about 4% of the same value. Commonly referred to as ‘trading sideways’, Dow called this a ‘line’.
August 20, 2019