While there are many different approaches to the analyzing of the markets, technical analysis initially appears to be the easiest but may prove to be the most difficult to successfully implement.
Technical Analysis is usually defined as the study of the action of the market itself. It looks at prices and volume on a historical basis in an attempt to forecast the probable future trend of prices. Technical analysts use charts and a variety of mathematical indicators based upon price or volume to help them assess the market.
There are three underlying assumptions to the study of technical analysis:
1) Market action discounts the future. Discounting the future is an accounting concept that means investors value stocks, or anything else they are trading, based upon what is going to happen in the future, not what has happened in the past. So if we see the stock of XYZ declining, investors are saying that the company will make less money in the future than they have in the past.
This assumption refers to market action because the principles of technical analysis apply to anything that is freely traded. Common examples are stocks, bonds, commodities, or foreign exchange. However, the principles also apply to houses and anything else that can be bought or sold.
2) Prices move in trends. This is because not all investors will agree on the future prospects of a particular stock or commodity. Some may think that Car Company XYZ will be able to sell more cars because they believe the economy will improve. Others think they will sell more cars because consumers will want to replace their gas guzzling SUVs with more fuel-efficient vehicles. Some may think XYZ will sell fewer cars because consumers prefer cars made by Company ABC. The price of XYZ stock will move higher and lower as different investors act on their ideas. Usually the majority opinion is right over the longer term and as investors recognize the facts about the underlying stock, they buy or sell based upon their changing beliefs. That is why trends exist - all investors eventually are forced to act on the reality of the underlying business.
3) Technical analysts assume that history repeats itself. This applies to many areas of human behavior. The markets are simply a reflection of human behavior. They are measuring what happens when millions of investors with different opinions get together to act on their ideas. Emotion is an integral part of many decisions, and we certainly saw a lot of greed in early 2000 as internet stocks soared to incredible heights. Fear took over and drove the prices of almost all stocks to incredible lows over the next two years. The same thing happened with tulips in the Netherlands in the seventeenth century. At one point in time, tulips cost ten times what the average worker made per year; it was the first speculative bubble. Human emotions always take markets to extremes and have been unchanged over hundreds of years as history has repeated itself over and over again.
Elliott Wave Theory
In addition to the standard tools used by technicians, there are more esoteric theories that many believe can be used to capture profits from the markets.
Elliott Wave theory attempts to impose an order on the markets and traders following this theory believe that the market moves in waves. A primary trend consists of five waves – three moving upward with two intervening downward waves (see chart below).
The chart below is a long-term view of the Dow Jones Industrial Average showing the five Elliott Waves as interpreted by Elliott Wave International.
Elliott Wave theory offers a sense of precision to market forecasting since price targets can be derived by the relationships between the waves. Unfortunately, it is a very complex theory and mastery of the intricacies would take years of study.
Starting with the three assumptions from the introduction, 1) market action discounts the future, 2) prices move in trends, and 3) history repeats itself, technical analysts then turn to charts.
A chart is a visual representation of price action, showing whether the stock moved higher or lower on any given day.
Over the years, several different types of charts have become popular. The figure below is a bar chart. This type of chart uses lines to show the price action. Analysts draw a vertical line from the high to the low and add a small horizontal line on the left side of the line to show the open. A small horizontal on the right side denotes the closing price. Prices are shown on the y-axis of the chart and time is shown on the x-axis. Each bar may represent any time frame, from minutes to years. Daily charts are the most common.
Because they believe that history repeats itself, technical analysts have identified specific patterns which tend to repeat in the charts. These patterns can be as simple as rectangles.
In the center of the price action shown in Figure 1, lines can be drawn to generally enclose the highs and lows and show a rectangle.
This pattern is only one example of how technicians look at charts. They look for approximate price patterns, realizing that history will never repeat exactly. Within the rectangle, the bulls are fighting the bears and the emotions of fear and hope are pretty evenly balanced. Support is found along the lower price level, which is a price point where the decline is stopped for a time and higher price action is supported. Resistance to further upward action is marked by the upper line in the rectangle. Sometimes charts will show support or resistance lines without forming a rectangle.
When the price finally breaks out of the rectangle, in this case to the downside, there is often a brief period of consolidation, where prices move in a narrow range as the bulls refuse to accept that they could be wrong. They try to hold on, but eventually they fear a downside break and begin selling which drives prices lower and lower. The fear eventually subsides and emotions tend to turn quickly in the market, leading to the sharp rebound we see on the right side of the chart.
Drawing a line connecting the highs in the downtrend can help spot the turning point. Trendlines are often drawn by technical analysts by connecting lower highs in a downtrend or higher lows in an uptrend. When the trendline is broken and prices break through it, a market reversal is indicated and traders close their positions at that point.
Indicators Are Your Friends
In addition to price charts, technical analysts look at a wide assortment of indicators based on price. Indicators are designed to smooth the price moves and allow technicians to observe the underlying trend of the market. By focusing solely on the trend, the analyst should be able to make better decisions since the noise, associated with minor movements, is filtered out.
The moving average is a commonly used indicator. Analysts calculate an average price of the stock for the last few days and plot this line on a chart. It is called a moving average because each day the oldest piece of data is dropped off and the most recent closing price is used in the calculation. Common timeframes are 10 or 20 days, although periods as long as 50 or 200 days are also used. Of course, as with any indicator, analysts can use any period and any timeframe (minutes, hours, days, weeks, etc.
The moving average clearly shows the direction of the trend. If prices are above the average, traders consider the market to be in an uptrend. A downtrend is defined as prices trading below the average. Unfortunately there are many times when prices repeatedly break above and below the average, with no clear trend existing. This can cause frustration and a lot of small losses.
Another feature of some indicators is that they are calculated in such a way that they often oscillate between 0 and 100, helping analysts determine when a market has gotten ahead of itself. No market can go straight up forever, and unless a company is entering bankruptcy very few stocks fall all the way to zero. At some point a reversal is expected and oscillators show when a market has become overbought (too high in price for the short term) or oversold (where a price rise is expected because there are too many sellers relative to the number of buyers).
Over time, analysts have identified dozens of these patterns, along with theories as to why they work. Patterns are also found in other charting styles.
Candlestick charts date back hundreds of years, originating in the rice markets of feudal Japan. Instead of a bar, candlestick charts show prices with vertical rectangular boxes called bodies and thin lines known as wicks extending above and below the body. The body is defined by the open and closing prices, and the wicks extend to the highs and lows. If prices closed up for the day, the body is not colored in (floating upward), while the body is colored in for down closes (sinking lower under the weight).
Since a picture is truly worth a thousand words in this case, Figure 3 shows how candlesticks are drawn.
Note that the size of the body can vary based upon how far apart the opening and closing prices are from each other.
The patterns formed by candlesticks are given memorable names such as dragonflys, dojis, hammers, and morning or evening stars. These charts are widely used to identify potential turning points in a market.
One example of the hundreds of oscillators is the stochastics indicator. This is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods. Momentum indicators try to identify turning points by measuring how fast prices are rising or falling. The calculation of the stochastic can be confusing, but is typical of indicator calculation.
First a value known as %K is calculated with this formula:
%K = 100*((C-L14) / (H14-L14))
C is the most recent closing price; L14 is the lowest price in the last fourteen periods; and H14 is the highest price in the last fourteen periods. We used 14 as an example, but any number can be used here.
A 3-period moving average of %K is then calculated and called %D (no one really knows where the names came from, but they are widely used in almost all software packages). A buy signal is given when %K crosses above %D and sell signals occur when %K falls below %D.
An example is shown in Figure 4.
The stochastics indicator offers clear trading signals. Only one trade is highlighted in this chart, but there are more than a dozen signals shown.
One problem with using indicators to generate trading signals is that there are a large number of losing trades. One way to improve the odds of a winning trade is to ignore signals unless the market is at an oversold or overbought extreme. For stochastics, readings below 30 are considered oversold and you would only take buy signals if the indicator is below that level. A value of 70 is considered overbought and sell signals occurring below that level would be ignored. This leads to longer trades and should result in fewer losses.
Putting It All Together
Some technicians will closely examine volume, believing that it takes a large number of buyers to push prices higher. They look for above average volume to confirm price action, and this confirmation tool helps them decrease the number of losing trades.
In the end, that is the primary objective of technical analysis – find trading opportunities that minimize the risk of loss. The past is only a guide to the future, and all technical tools offer only a probability of what will unfold in the future. Managing risk is the key to making money with technical analysis. In 2008, a bear market took nearly 50 percent off the value of many stock indexes. Technical tools, such as the stochastic indicator, would have helped investors to avoid many of those losses.
Technical analysis is just one way of looking at the markets. Fundamental analysts look at factors such as earnings and sales growth to forecast future trends. They are more concerned with understanding the cause of market action, while technicians study the effect those fundamentals have on price and base their outlook on a sense of historical probabilities. Either approach can be profitable in the hands of a skilled practitioner.
If you're ready to learn more about technical analysis, I highly recommend you walk through my series of tutorials on swing trading. I'll take you through powerful concepts, from basic to advanced, as well as a series of examples and illustrations. To get started, click here to Start Swing Trading Today!