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notes-technical-analysis

Notes taken from the bible of technical analysis - Technical Analysis Of the Financial Markets

Introduction

Before studying the techniques and tools used in technical analysis, we must first:

Definition

Let’s define technical analysis:

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.

The term “market action” includes price and volume (also open interest for options).

Philosophy

The technical approach is based on three premises:

  1. Market action discounts everything.
  2. Prices move in trends.
  3. History repeats itself.

1. Market action discounts everything

The statement “market action discounts everything” is at the essence of technical analysis. Until the meaning of this premise is fully understood and accepted, the rest won’t make sense.

The technician believes that anything that can possibly affect the price,

is all reflected in the price of that market. Following that logic, a study of price action is all that is required.

While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning.

All this is really claiming is that price action should reflect shifts in supply in demand.

This action is the basis of all economic and fundamental forecasting.

The technician turns this statement around to arrive at the conclusion that if prices are rising, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish. The technician is indirectly studying fundamentals. It is the underlying forces of supply and demand that cause bull and bear markets. The charts do not in themselves cause markets to move up or down. They simply reflect the psychology of the marketplace.

Chartists do not try to find the reason why prices rise or fall. No one knows exactly why a market is performing a certain way. While the technical approach may seem simplistic in its claims, the logic behind the first premise becomes more compelling the more market experience one gains.

By studying price charts and supporting technical indicators, the chartist lets the market tell him which way it is most likely to go. He does not try to outsmart or outguess the market. He knows there are reasons why markets go up or down, he just doesn’t believe that knowing what those reasons are is necessary in the forecasting process.

The concept of trend is essential to the technical approach. Unless one accepts the premise that markets do in fact trend, there’s no point in reading any further.

The whole purpose of charting the price action of a market is to identify trends in early stages of their development. In fact, most of the techniques used in this approach are trend-following in nature.

There is a corollary to the premise that prices move in trends- a trend in motino is more likely to continue than to reverse. This is an adaptation of Newton’s first law of motion. Another way to state this is that a trend in motion will continue in the same direction until it reverses. This is another one of those technical claims that seems circular. But the entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing.

3. History repeats itself

A big part of technical analysis and the study of market action has to do with the study of human psychology. For example, chart patterns reflect certains pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change.

Another way of saying this is that the key to understanding the future lies in a study of the past.

Technical versus fundamental forecasting

While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that causes prices to move higher, lower or stay the same.

The fundamental approach examines all of the relevant factors affecting the price of a market in order to determine the instrinsic value of that market. The instrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand. If this instrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is below the instrinsic value, then the market is undervalued and should be bought.

Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions. The fundamentalist studies the cause of market movement, while the technician studies the effect. The technician, of course, believes that the effect is all that he needs to know and that the causes are unnecessary. The fundamentalist always has to know why.

Most traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap. Many fundamentalists have a working knowledge of the basic tenets of chart analysis. At the same time, many technicians have at least a passing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually they come back into sync at some point, but often too late for the trader to act.

One explanation for the discrepancies is that market price tends to lead the known fundamentals. State another way, market price acts as a leading indicator of the fundamentals or the convetional wisdom of the moment. While the known fundamentals have already been discounted and are already “in the market”, prices are now reacting to the unknown fundamentals. By the time those changes became known, the new trend was well underway.

After a while, the technician develops increased confidence in his or her ability to read the charts. The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom. A technician begins to enjoy being in the minority. He knows that eventually the reasons for market action will become common knowledge. It is just that the technician isn’t willing to wait for that added confirmation.

In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technicial. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial markets using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone with no consideration of the technical side of the market.

Analysis versus timing

This last point is made clearer if the decision making process is broken down into two separate stages - analysis and timing.

Because of the high leverage factor in the futures markets, timing is especially crucial in that arena. It is quite possible to be correct on the general trend of the market and still lose money. Because margin requires are so low in futures trading, a relatively small price move in the wrong direction can force the trader out of the market. In stock market trading, by constrast, a trader who finds himself on the wrong side of the market can simply decide to hold onto the stock, hoping that it will stage a comeback at some point.

Futures traders don’t have that luxury. A “buy and hold” strategy doesn’t apply to the futures arena. Both the technical and the fundamental approach can be used in the first phase, the forecasting process. However, the question of timing, of determining specific entry and eit points, is almost purely technical. Therefore, considering the steps the trader must go through before marking a market commitment, it can be seen that the correct application of technical principles becomes indispensable at some point in the process, even if fundamental analysis was applied in the earlier stages of the decision. Timing is also important in individual stock selection and in the buying and selling of stock market sector and industry groups.

Flexibility and adaptability of technical analysis

One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension. There is no area of trading in either stocks or futures where these principles do not apply.

The chartist can easily follow as many markets as desired, which is generally not true of his fundamental counterpart. Because of the tremendous amount of data the latter must deal with, most fundamentalists tend to specialize. The advantages here should not be overlooked.

For one thing, markets go through active and dormant periods, trendings and nontrendings stages. The technician can concentrate his attention and resources in those markets that display strong trending tendencies and choose to ignore the rest. As a result, the chartist can rotate his or her attention and capital to take advantage of the rotational nature of the markets. At different times, certain markets become “hot” and experience important trends. Usually, those trending periods are followed by quiet and relatively trendless market conditions, while another market or group takes over. The technical trader is free to pick and choose. The fundamentalist, however, who tends to specialize in only one group, doesn’t have that kind of flexibility. Even if he were free to switch groups, the fundamentalist would have a much more difficult time doing so than would the chartist.

Another advantage the technician has is the “big picture.” By following all of the markets, he gets an excellent feel for what markets are doing in general and avoids the “tunnel vision” that can result from following only one group of markets. Also, because so many of the markets have built-in economic relationships and react to similar economic factors, price action in one market or group may give valuable clues to the future direction of another market or group of markets.

Technical analysis applied to different trading mediums

The principles of chart analysis apply to both stocks and futures. Actually, technical analysis was first applied to the stock market and later adapted to futures. With the introduction of stock index futures, the dividing line between these two areas is rapidly disappearing. International stock markets are also charted and analyzed according to technical principles.

Financial futures, including interest rate markets and foreign currencies, have become enormously popular over the past decade and have proven to be excellent subjects for chart analysis.

Technical principles play a role in options trading. Technical forecasting can also be used to great advantage in the hedging process.

Technical analysis applied to different time dimensions

Another strength of the charting approach is its ability to handle different time dimensions. Whether the user is trading the intra-day tic-by-tic changes for day trading purposes or trend trading the intermediate trend, the same principles apply. A time dimension often overlooked is longer range technical forecasting. The opinion expressed in some quarters that charting is useful only in the short term is simply not true. It has been suggested by some that fundamental analysis should be used for long term forecasting with technical factors limited to short term timing. The fact is that longer range forecasting, using weekly and monthly charts going back several years, has proven to be an extremely useful application of these techniques.

Once the technical principles discussed in this book are thoroughly understood, they will provide the user with tremendous flexibility as to how they can be applied, both from the standpoint of the medium to be analyzed and the time dimension to be studied.

Economic forecasting

Technical analysis can play a role in economic forecasting. For example, the direction of commodity prices tells us something about the direction of inflation. They also give us clues about the strength or weakness of the economy. Rising commodity prices generally hint at a stronger economy and rising inflationary pressure. Falling commodity prices usually warn that the economy is slowing along with inflation. The direction of interest rates is affected by the trend of commodities. As a result, charts of commodity markets like gold and oil, along with Treasury Bonds, can tell us a lot about the strength or weakness of the economy and inflationary expectations. The direction of the U.S. dollar and foreign currency futures also provide early guidance about the strength or weakness of the respective global economies. Even more impressive is the fact that trends in these futures markets usually show up long before they are reflected in traditional economic indicators that are released on a monthly or quarterly basis, and usually tells us what has already happened. As their name implies, futures markets usually give us insights into the future. The S&P 500 stock market index has long been counted as an official leading economic indicator. A book by one of the country’s top experts on the business cycle, Leading Indicators for the 1990s (Moore), makes a compelling case for the importance of commodity, bond and stock trends as economic indicators. All three markets can be studied employing technical analysis.

Technician or chartist?

There are several different titles applied to practitioners of the technical approach:

Up until recently, they all meant pretty much the same thing. But with increased specialisation, further distinction were made.

Technical analysis is being increasingly divided into two types of practitioners:

There is a lot of overlap between categories but most seem to fall into one or the other.

Whether or not the traditional chartist use quantitative work to supplement his analysis, charts remain the primary working tool. Everything else is secondary. Charting, of necessity, remains somewhat subjective. The success of the approach deoends, for the most part, on the skill of the individual chartist. The term “art charting” has been applied to this approach because chart reading is largely an art.

By contrast, the statistical, or quantitative, analyst takes these subjective principles, quantifies, tests and optimizes them for the purpose of developing mechanical trading systems. These systems, or trading models, are then programmed into a computer that generates mechanical “buy” and “sell” signals. These systems range from the simple to the very complex. Hoewever, the intent is to reduce or completely eliminate the subjective human element in trading, to make it more scientific. These statisticians may or may not use price charts in their work, but they are considered technicians as long as their work is limited to the study of market action.

Even computer technicians can be subdivided further into those who favor mechanical systems and those who use computer technology to develop better technical indicators. The latter group maintains control over the interpretation of those indicators and also the decision making process.

One way of distinguishing between the chartist and the statistician is to say that all chartists are technicians, but not all technicians are chartists. Although these terms are used interchangeably throughtout this book, it should be remembered that charting represents only one area in the broader subject of technical analysis.

A brief comparison of technical analysis in stocks and futures

It is often asked if technical is applied the same to futures and stocks. The answer is both yes and no. The basic principles are the same, but there are some significant differences. The principles of technical analysis were first applied to stock market forecasting and later adapter to futures. Most of the basic tools - bar charts, point and figure charts, price patterns, volume, trendlines, moving averages and oscillators, for example, are used in both areas. However, there are some general areas of difference having more to do with the different nature of stocks and futures than with the actual tools themselves.

Pricing structure

The pricing structure in futures is much more complicated than in stocks. Each commodity is quoted in different units and increments. Grain markets are quoted in cents per bushel, livestock markets in cents per pound, gold and silver in dollars per ounce and interest rates in basis points. The trader must learn the contract details of each market: which exchange it is traded on, how each contract is quoted, what the minimum and maximum price increments are and what these price increments are worth.

Limited life span

Unline stocks, futures contracts have expiration dates. A march 1999 Treasury Bond contract, for example, expires in march of 1999. The typical futures contract trades for about a year and a half before expiration. Therefore, at any one time, at least a half dozen different contract months are trading in the same commodity at the same time. The trader must know which contracts to trade and which ones to avoid. This limited life feature causes some problems for longer range price forecasting. It necessitates the continuing need for obtaining new charts once old contracts stop trading. The chart of an expired contract isn’t of much use. New charts must be obtained for the newer contracts along with their own technical indicators. This constant rotation makes the maintenance of an ongoing chart library a good deal more difficult. For computer users, it also entails greater time and expense by making it necessary to be constantly obtaining new historical data as old constrats expire.

Lower margin requirements

This is probably the most important difference betweek stocks and futures.

All futures are traded on margin, which is usually less than 10% of the value of the contract. The result of these low margin requirements is tremendous leverage. Relatively small price moves in either direction tend to become magnified in their impact on overall trading results. For this reason, it is possible to make or lose large sums of money very quickly in futures. Because a trader puts up only 10% of the value of the contract as margin, then a 10% move in either direction will either double the trader’s money or wipe it out. By magnifying the impact of even minor market moves, the high leverage factor sometimes makes the futures markets seem more volatile than they actually are. When someones says that he was “wiped out” in the futures market, remember that he only committed 10% in the first place.

From the standpoint of technical analysis, the high leverage factor makes timing in the futures markets much more critical than it is in stocks. The correct timing of entry and exist points is crucial in futures trading and much more difficult and frustrating than market analysis. Largely for this reason, technical trading skills become indispensable to a successful futures trading program.

Time frame is much shorter

Because of high leverage factor and the need for close monitoring of market positions, the time horizon of the commodity trader is much shorter of necessity. Stock market technicians tend to look more at the longer range picture and talk in time frames that are beyong the concern of the average commodity trader. Stock technicians may talk about where the market will be in three or six months. Futures traders want to know where prices will be next week, tomorrow, or even later this afternoon. This has necessitated the refinement of very short term timing tools. One example is the moving average. The most commonly watched averages in stocks are 50 and 200 days. In commodities, most moving averages are under 40 days. A popular moving average combination in futures is 4, 9 and 18 days.

Greater reliance on timing

Timing is everything in futures trading. Determining the correct direction of the market only solves a portion of the trading problem. If the timing of the entry point is off by a day, or sometimes even minutes, it can be mean the difference between a winner or a loser. It’s bad enough to be on the wrong side of the market and lose money. Being on the right side of the market and still losing money is one of the most frustrating and unnerving aspects of futures trading. Timing is almost purely technical in nature, because the fundamentals rarely change on a day-to-day basis.

Less reliance on market averages and indicators

Stock market analysis is based heavily on the movement of broad market averages such as the Dow Jones Industrial Average or the S&P 500. In addition, technical indicators that measure the strength or weakness of the broader market, like the NYSE advance-decline line or the new highs-new lows list, are heavily employed. While commodity markets can be tracked using measures like the Commodity Research Bureau Futures Price Index, less emphasis is placed on the broader market approach.

Commodity market analysis concentrates more on individual market action. That being the case, technical indicators that measure broader commodity trends aren’t used much. With only about 20 or so active commodity markets, there isn’t much need.

Specific technicals tools

While most of the technical tools originally developed in the stock market have some application in commodity markets, they are not used in the exact same way. For example, chart patterns in futures often tend not to form as fully as they do in stocks.

Futures traders rely more heavily on shorter term indicators that emphasize more precise trading signals.

Finallly, there is another area of major difference between stocks and futures. Technical analysis in stocks relies much more heavily on the use of sentiment indicators and flow of funds analysis. Sentiment indicators monitor the performance of different groups such as odd lotters, mutual funds and floor specialists. Enormous importance is placed on sentiment indicators that measure the overall market bullishness and bearishness on the theory that the majority opinion is usually wrong. Flow of funds analysis refers to the cash position of different groups, such as mutual funds or large institutional accounts. The thinking here is that the larger the cash position, the more funds that are available for stock purchases.

Technical analysis in the futures markets is a much purer form of price analysis. While contrary opinion theory is also used to some extent, much more emphasis is placed on basic trend analysis and the application of traditional technical indicators.

Some criticism of the technical approach

A few questions generally crop up in any discussion of the technical approach. One is the self-fulfilling prophecy. Another is the question of whether or not past price data can really be used to forecast future price direction. The critic usually says something like: “Charts tell us where the market has been, but can’t tell us where it is going.” For the moment, we’ll put aside the obvious answer that a chart won’t tell you anything if you don’t know how to read it. The Random Walk Theory questions whether prices trend at all and doubts that any forecasting technique can beat a simple buy and hold strategy. These questions deserve a response.

The self-fulfilling prophecy

The question of whether there is a self-fulfilling prophecy at work seems to bother most people because it is raised so often. It is certainly a valid concern, but of much less importance than most people realize. Perhaps the best way to address this question is to quote from a text that discusses some of the disadvantages of using chart patterns:

The use of most chart patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a “self-fulfilling prophecy”, as waves of buying or selling are created in response to “bullish” or “bearish” patterns…

Chart patterns are almost completely subjective. No study has yet succeeded in mathematically quantifying any of them They are literally in the mind of the beholder…

These two criticism contradict one another and the second point actually cancels out the first. If chart patterns are “completely subjective” and “in the mind of the beholder”, then it is hard to imagine how everyone could see the same thing at the same time, which is the basis of the self-fulfilling prophecy. Critics of charting can’t have it both ways. They can’t, on the one hand, crititcze charting for being so objective and obvious that everyone will act in the same way at the same time (thereby causing the price pattern to be fulfilled), and then also criticize charting for being too subjective.

The truth is that charting is very subjective. Chart reading is an art (or skill). Chart patterns are seldom so clear that even experienced chartists always agree on their interpretation. There is always an element of doubt and disagreement. As this book demonstrates, there are many different approaches to technical analysis that often disagree with one another.

Even if most technicians did agree on a market forecast, they would not all necessarily enter the market at the same time and in the same way. Some would try to anticipate the chart signal and enter the market early. Other would buy the “breakout” from a given pattern or indicator. Still others would wait for the pullback after the breakout before taking action. Some traders are aggressive; others are conservative. Some use stops to enter the market, while others like to use market orders or resting limit orders. Some are trading for the long pull, while others are day trading. Therefore, the possibility of all technicians acting at the same time and in the same way is actually quite remote.

Even if the self-fulfilling prophecy were of major concern, it would probably be “self-correcting” in nature. In other words, traders would rely heavily on charts until their concerted actions started to affect or distort the markets. Once traders realized this was happening, they would either stop using the charts or adjust their trading tactics. For example, they would either try to act before the crowd or wait longer for greater confirmation. So, even if the self-fulfilling prophecy did become a problem over the near term, it would tend to correct itself.

It must be kept in mind that bull and bear markets only occur and are maintained when they are justified by the law of supply and demand. Technicians could not possibly cause a major market move just by the sheer power of their buying and selling. If this were the case, technicians would all become wealthy very quickly.

Of much more concern than the chartists is the tremendous growth in the use of computerized technical trading systems in the futures market. These systems are mainly trend-following in nature, which means that they are all programmed to identify and trade major trends. With the growth in professionally managed money in the futures industry and the proliferation of multimillion dollar public and private funds, most of which are using these technical systems, tremendous concentration of money are chasing only a handful of existing trends. Because the universe of futures markets is still quite small, the potential for these systems distorting short term price action is growing. However, even in cases where distortions do occur, they are generally short term in nature and do not cause major moves.

Here again, even the problem of concentrated sums of money using technical systems is probably self-correcting. If all of the systems started doing the same thing at the same time, traders would make adjustments by making their systems either more or less sensitive.

The self-fulfilling prophecy is generally listed as a criticism of charting. It might be more appropriate to label it as a compliment. After all, for any forecasting technique to become so popular that it begins to influence events, it would have to be pretty good. We can only speculate as to why this concern is seldom raised regarding the use of fundamental analysis.

Can the past be used to predict the future?

Another question often raised concerns the validity of using past price data to predict the future. It is surprising how often critics of the technical approach bring up this point because every known method of forecasting, from weather predicting to fundamental analysis, is based completely on the study of past data. What other kind of data is there to work with?

The field of statistics makes a distinction between descriptive statistics and inductive statistics.

Therefore, the price chart itself comes under the heading of the descriptive, while the analysis technicians perform on that price data falls into the realm of the inductive.

As one statistical text puts it, “The first step in forecasting the business or economic consists, thus, of gathering observations of the past.” Chart analysis is just another form of time series analysis, based on a study of the past, which is exactly what is done in all forms of time series analysis. The only type of data anyone has to go on is past data. We can only estimate the future by projecting past experiences into that future.

So it seems that the use of past price data to predict the future in technical analysis is grounded in sound statistical concepts. If anyone were to seriously question this aspect of technical forecasting, he would have to also question the validity of every other form of forecasting based on historical data, which includes all economic and fundamental analysis.

Random Walk Theory

The Random Walk Theory, developed and nurtured in the academic community, claims that price changes are “serially independent” and that price history is not a reliable indicator of future price direction. In a nutshell, price movement is random and unpredictable. The theory is based on the efficient market hypothesis, which holds that prices fluctuate randomly about their intrinsic value. It also holds that the best market strategy to follow would be a simple “buy and hold” strategy as opposed to any attempt to “beat the market”.

While there seems little doubt that a certain amount of randomness or “noise” does exist in all markets, it’s just unrealistic to believe that all price movement is random. This may be one of those areas where empirical observation and practical experience prove more useful than sophisticated statistical techniques, which seem capable of proving anything the user has in mind or incapable of disproving anything. It might be useful to keep in mind that randomness can only be defined in the negative sense of an inability to uncover systematic patterns in price action. The fact that many academics have not been able to discover the presence of these patterns does not prove that they do not exist.

The academic debate as to whether markets trend is of little interest to the average market analyst or trader who is forced to deal in the real world where market trends are clearly visible. If the reader has any doubts on this point, a casual glance through any chart book will demonstrate the presence of trends in a very graphic way. How do the “random walkers” explain the persistence of these trends if prices are serially independent, meaning that what happened yesterday, or last week, has no bearing on what may happen today or tomorrow? How do they explain the profitable “real life” track records of many trend-following systems?

How, for example, would a buy and hold strategy fare in the commodity futures markets where timing is so crucial? Would those long positions be held during bear markets? How would traders even know the difference between bull and bear markets if prices are unpredictable and don’t trend? In fact, how could a bear market even exist in the first place because that would imply a trend?

It seems doubtful that statistical evidence will ever totally prove or disprove the Random Walk Theory. However, the idea that markets are random is totally rejected by the technical community. If the markets were truly random, no forecasting technique would work. Far from disproving the validity of the technical approach, the efficient market hypothesis is very close to the technical premise that markets discount everything. The academics, however, feel that because markets quickly discount all information, there’s no way to take advantage of that information. The basis of technical forecasting, already touched upon, is that important market information is discounted in the market price long befire it becomes known. Without meaning to, the academics have very eloquently state the need for closely monitoring price action and the futility of trying to profit from fundamental information, at least over the short term.

Finally, it seems only fair to observe that any process appears random and unpredictable to those who do not understand the rules under which that process operates. An electrocardiogram printout might appear like a lot of random noise to a layperson. But to a trained medical person, all those little blips make a lot of sense. The working of the markets may appear random to those who have not taken the time to study the rules of market behavior. The illusion of randomness gradually disappears as the skill in chart reading improves. Hopefully, that is exactly what will happen as the reader progresses through the various sections of this book.

There may even be hope for the academic world. A number of leading American universities have begun to explore Behavioral Finance which maintains that human psychology and securities pricing are intertwined. That, of course, is the primary basis of technical analysis.

Universal principles

When an earlier version of this book was published, many of the technical timing tools that were explained were used mainly in the futures markets. Over the past decade, however, these tools have been widely employed in analyzing stock market trends. The technical principles that are discussed in this book can be applied universally to all markets - even mutual funds. One additional feature of stock market trading that has gained wide popularity in the past decade has been sector investing, primarily through index options and mutual funds.