Technical analysis:::::
Table of Contents
Table of ContentsWhat is Technical Analysis?
Technical Analysis is the forecasting of future financial price
movements based on an examination of past price movements. Like weather
forecasting, technical analysis does not result in absolute predictions
about the future. Instead, technical analysis can help investors
anticipate what is "likely" to happen to prices over time. Technical
analysis uses a wide variety of charts that show price over time.
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 security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.
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 security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.
The Basis 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. Of the many theorems put forth by Dow, three stand out:
- Price Discounts Everything
- Price Movements Are Not Totally Random
- "What" Is More Important than "Why"
Price Discounts Everything
This theorem is similar to the strong and semi-strong forms of market
efficiency. 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,
buy-side analysts, sell-side analysts, 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.
Prices Movements are not Totally Random
Most technicians agree that prices trend. However, most technicians
also acknowledge that there are periods when prices do not trend. If
prices were always random, it would be extremely difficult to make money
using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:
"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."
A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's 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 breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."
A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's 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 breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
"What" is More Important than "Why"
In his book, The Psychology of Technical Analysis,
Tony Plummer paraphrases Oscar Wilde by stating, "A technical analyst
knows the price of everything, but the value of nothing". Technicians,
as technical analysts are called, are only concerned with two things:
- What is the current price?
- What is the history of the price movement?
General Steps to Technical Evaluation
Many technicians employ a top-down approach that begins with
broad-based macro analysis. The larger parts are then broken down to
base the final step on a more focused/micro 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.
- Sector analysis to identify the strongest and weakest groups within the broader market.
- Individual stock analysis to identify the strongest and weakest stocks within select groups.
Chart Analysis
Technical analysis can be as complex or as simple as you want it. The
example below represents a simplified version. Since we are interested
in buying stocks, the focus will be on spotting bullish situations.
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.
Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.
Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.
Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
- Strength of the current trend.
- Maturity or stage of current trend.
- Reward to risk ratio of a new position.
- Potential entry levels for new long position.
Top-Down Technical Analysis
For each segment (market, sector and stock), an investor would analyze
long-term and short-term charts to find those that meet specific
criteria. Analysis will first consider the market in general, perhaps
the S&P 500. If the broader market were considered to be in bullish
mode, analysis would proceed to a selection of sector charts. Those
sectors that show the most promise would be singled out for individual
stock analysis. Once the sector list is narrowed to 3-4 industry groups,
individual stock selection can begin. With a selection of 10-20 stock
charts from each industry, a selection of 3-4 of the most promising
stocks in each group can be made. How many stocks or industry groups
make the final cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which
to choose. These stocks could even be broken down further to find the
3-4 of the strongest of the strong.
Strengths of Technical Analysis
Focus on Price
If the objective is to predict the future price, then it makes sense to
focus on price movements. Price movements usually precede fundamental
developments. By focusing on price action, technicians are automatically
focusing on the future. The market is thought of as a leading indicator
and generally leads the economy by 6 to 9 months. To keep pace with the
market, it makes sense to look directly at the price movements. More
often than not, change is a subtle beast. Even though the market is
prone to sudden knee-jerk reactions, hints usually develop before
significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, Demand, and Price Action
Many technicians use the open, high, low and close when analyzing the
price action of a security. There is information to be gleaned from each
bit of information. Separately, these will not be able to tell much.
However, taken together, the open, high, low and close reflect forces of
supply and demand.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
Support/Resistance
Simple chart analysis can help identify support and resistance levels.
These are usually marked by periods of congestion (trading range) where
the prices move within a confined range for an extended period, telling
us that the forces of supply and demand are deadlocked. When prices move
out of the trading range, it signals that either supply or demand has
started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Pictorial Price History
Even if you are a tried and true fundamental analyst, a price chart can
offer plenty of valuable information. The price chart is an easy to
read historical account of a security's price movement over a period of
time. Charts are much easier to read than a table of numbers. On most
stock charts, volume bars are displayed at the bottom. With this
historical picture, it is easy to identify the following:
- Reactions prior to and after important events.
- Past and present volatility.
- Historical volume or trading levels.
- Relative strength of a stock versus the overall market.
Assist with Entry Point
Technical analysis can help with timing a proper entry point. Some
analysts use fundamental analysis to decide what to buy and technical
analysis to decide when to buy. It is no secret that timing can play an
important role in performance. Technical analysis can help spot demand
(support) and supply (resistance) levels as well as breakouts. Simply
waiting for a breakout above resistance or buying near support levels
can improve returns.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
Weaknesses of Technical Analysis
Analyst Bias
Just as with fundamental analysis, technical analysis is subjective and
our personal biases can be reflected in the analysis. It is important
to be aware of these biases when analyzing a chart. If the analyst is a
perpetual bull, then a bullish bias will overshadow the analysis. On the
other hand, if the analyst is a disgruntled eternal bear, then the
analysis will probably have a bearish tilt.
Open to Interpretation
Furthering the bias argument is the fact that technical analysis is
open to interpretation. Even though there are standards, many times two
technicians will look at the same chart and paint two different
scenarios or see different patterns. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify
their position. While this can be frustrating, it should be pointed out
that technical analysis is more like an art than a science, somewhat
like economics. Is the cup half-empty or half-full? It is in the eye of
the beholder.
Too Late
Technical analysis has been criticized for being too late. By the time
the trend is identified, a substantial portion of the move has already
taken place. After such a large move, the reward to risk ratio is not
great. Lateness is a particular criticism of Dow Theory.
Always Another Level
Even after a new trend has been identified, there is always another
"important" level close at hand. Technicians have been accused of
sitting on the fence and never taking an unqualified stance. Even if
they are bullish, there is always some indicator or some level that will
qualify their opinion.
Trader's Remorse
Not all technical signals and patterns work. When you begin to study
technical analysis, you will come across an array of patterns and
indicators with rules to match. For instance: A sell signal is given
when the neckline of a head and shoulders pattern is broken. Even though
this is a rule, it is not steadfast and can be subject to other factors
such as volume and momentum. In that same vein, what works for one
particular stock may not work for another. A 50-day moving average may
work great to identify support and resistance for IBM, but a 70-day
moving average may work better for Yahoo. Even though many principles of
technical analysis are universal, each security will have its own
idiosyncrasies.
Conclusions
Technical analysts consider the market to be 80% psychological and 20%
logical. Fundamental analysts consider the market to be 20%
psychological and 80% logical. Psychological or logical may be open for
debate, but there is no questioning the current price of a security.
After all, it is available for all to see and nobody doubts its
legitimacy. The price set by the market reflects the sum knowledge of
all participants, and we are not dealing with lightweights here. These
participants have considered (discounted) everything under the sun and
settled on a price to buy or sell. These are the forces of supply and
demand at work. By examining price action to determine which force is
prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
No comments:
Post a Comment