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Introduction to technical analysis

Introduction to technical analysis

Becoming a technical analyst is easy. Just draw a few lines on a chart and you are a technician. But to become a real chart-artist, and to truly make sense of charts, takes years of practice. In addition we need to learn the basics if we want to get there. And that is what I will focus on in this introduction to technical analysis.

Technical analysis, or TA, consists of looking at graphic information on charts. Price patterns, trends, momentum, lines and indicators are used to identify trading opportunities. Historical prices gets analysed to find out the probable future path of price. And by looking at the past we increase the probability of achieving future success.

Background

Technical analysis as we know it was invented by Charles Dow in the late 1800s. These concepts, later called Dow theory, is the foundation for modern technical analysis. Later technicians such as Robert Rhea, Edson Gould and John Magee all contributed to this work. But there were alternative ways of using technical analysis even before that. For example Candlestick analysis that was used in Japan as early as the 1700s.

Technical analysis is a very broad area. And I haven’t mastered all the approaches by a long shot. Ralph Nelson Elliott, John Murphy, W D Gann, Alan Andrews and Richard D Wyckoff all used different varieties. And many more with them. But in this post I will focus on the basics of technical analysis, originating in Dow Theory.

Differences from fundamental analysis

Fundamental analysis, or FA, consists of looking at economic and financial factors surrounding the investment. For example financial statements and annual reports. Fundamental analysis range from macroeconomic factors and industry conditions to studying the management. The goal is to find out the fair value, or intrinsic value, of an investment. Technical analysis, on the other hand, consists of looking at price.

There are fundamental analysts out there that think of technical analysis as some kind of Vodoo. Whereas many technical analysts call fundamental analysts ”fundamentalists”, and think of their approach as deeply dogmatic and flawed. Personally I think it is possible to make money with both. And for me technical analysis helps fill in the gaps of my fundamental analysis. Which is why I use them both.

Price moves in trends

The underlying assumption of Technical analysis is that trends exists and that price moves in trends. A market trend is a price movement, characterized by rallies, going strongly in one direction. These trends can go either up or down. A downtrend is characterized by lower lows and lower highs. Conversely an uptrend is a series of higher highs and higher lows. Different trends exist on all timeframes at all times.

An uptrend consists of higher lows and higher highs. – Chart from TradingView

One of the premises in technical analysis is that trends are more likely to continue than to reverse. And most technical strategies are based on this assumption. Isaac Newton’s first law of motion states that “an object in motion tends to stay in motion”. Which I agree with and try to use to my advantage.

History repeats

As a student of History I agree with the notion that History repeats. But my personal opinion is that History rather moves in cycles based on human behaviour. And these cycles consists of trends that are apparent in price movements. Further, since human nature does not change, these patterns and cycles repeat, over and over again. Which is why technical analysis works. Because the patterns of human behavior does not change.

Timeframes

Technical analysis works on all timeframes. But it is helpful to look at several timesframes to understand the underlying trends. You begin by identifying the primary trend, at a larger timeframe, than the one you are going to trade. And then you go down to the smaller timeframes to finetune your entries. This is called a “top down approach”.

A good way to begin is at the daily timeframe, to see where the 200 day simple moving average is going. And when you have established where it is going, you start to look for entries, on lower timeframes. This can be helpful for traders and scalpers as well.

Scaling

Charts are the key tools used in technical analysis. But they have to be properly scaled. Otherwise you don’t know what you are doing. They can be arithmetically or logarithmically scaled, depending on how you use them. And there is no right or wrong here. Some prefer log charts and others prefer linear charts. The important thing is that you find out what works for you. I prefer log charts. Because it seems to work better for long term charts in my view.

How to use technical analysis in practice

Traders use technical analysis in a variety of ways. Technical analysis can be difficult, inefficient and stressful. But it can also be simple, clean and effective. And there are hundreds of patterns, indicators, trading systems out there. But I will only touch on a few of them below. Because I like to keep it simple.

Fear, greed, overconfidence and excitement are all observable components on charts. And as traders we can look at chart patterns to understand the emotions and where the market is going. Since these patterns repeat over and over again. Because of human nature. Below is an example of a classic investment bubble.

This chart is often cited to predict bubbles in many investment types. It shows the stages of emotions that investors go through in extreme uptrends. Which eventually leads to extreme sell offs. – Chart from Dr. Jean Paul Rodrigue’s bubble model of the Hofstra University

Support and resistance

Support and resistance are essential to technical analysis. And a lot of strategies are based on these simple premises. They are areas acting as barriers for price. Support is where a downtrend expects to stop or pause. Because demand is present at this line. Resistance works the same way, but above price, at levels where lots of supply are present. Some traders trade the zigzagging moves in between support and resistance. While other traders focus on breakouts and breakdowns of these levels.

Volume

Volume gets used in a variety of ways, to find out the relative importance of trades. Volume measures the number of trades and shares traded, in a certain security, at a certain time. But it can also be the volume of an entire market, like an average. All buyers and sellers contribute to the total volume of trades. For example, if there are ten trades in a day, the volume is ten. Below is a decline on Facebook‘s chart in 2012-2013. Notice how the volume was lower on the second low. Indicating weakening selling pressure.

Volume can gather valuable information about an investment. The higher the volume the more important the move. The lower volume at the second low can be a bullish sign. – Facebook chart from Tradingview

Moving averages

Both beginners and pros use moving averages. A moving average is an average made up of price, for a given time period. It smooths out price into a line that is not as volatile as the price itself. Which means you are able to spot standard deviations away from this line, when price trades away from it. If you are a short term trader you might want to try several versions of these. Such as exponential or weighted moving averages.

For swingtraders like me a commonly used moving average is the 200 day moving average. Below is an example of how a swing trader can use the 200 day moving average, which I have written an earlier article on here.

The 200 day moving average is an an important indicator for evaluating the long term trend. If you want to read more about it you can do it here – Chart provided by TradingView

Since the moving average don’t trade as violently, as price itself, a trader can look for bigger than usual deviations from this line. And see if the primary trend is moving up, down or sideways.

Trendlines

A trendline is a very simple tool and therefore one of the best. Because its strength lies in its simplicity. You can clutter your brain with all kinds of lines and indicators on your charts. But simple is often best. Therefore a simple trendline gives clarity and perspective. Below is an example of Facebook, trading between two trendlines, on a long term chart.

Draw lines from tops to tops and from bottoms to bottoms to create simple and effective trendlines. This Facebook chart is scaled logarithmically which I find works best for long term charts. – Chart from Tradingview

Sometimes an inner trendline develops inside a bigger trendline channel. As in the picture below of the steep downtrend that followed the crash in 1929, on the Dow Jones Industrial average.

The crash of 1929 on the Dow Jones Industrial average – Chart from TradingView

Oscillators

Oscillators are indicators that are banded between two extremes. And these indicators show overbought and oversold conditions. The oscillator is set between two values and are said to “oscillate” between the two. When the value approaches extremes it indicates oversold or overbought conditions. The RSI and Stochastics are two examples of oscillators. Below is an example of overbought and oversold conditions on the RSI of an Oat chart.

The arrows point to overbought and oversold areas. Every time the RSI got above these levels price went though a correction after. A trader could consider above 70 as overbought and below 30 as oversold. But some traders think it is not overbought until it gets above 80 or below 20. – Chart from TradingView

The RSI measures the speed and change of price movements. It can be used in several ways. Below is a picture of a “failure swing” strategy, which rely completely on the RSI for confirmation of reversals. And not price.

Failure swings consist of four stages that can be either bullish or bearish. Here is an example of a bearish “failure swing”, on the RSI. The sell setup happens at point D. – Chart from TradingView

The Stochastics display the close compared to the high and low range over a predetermined number of periods.

The Stochastics are used to find divergences and overbought/oversold conditions. Or as in this picture on a “bull setup”. Chart from TradingView.

The creator of the Stochastics indicator said “Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”

Criticisms of technical analysis

Some people think that technical analysis works like a self-fulfilling prophecy. Meaning that when enough people think the same thing, it tends to come true. But there are an infinite amount of subjective and differing opinions among technical traders. Further, even if it was a self-fulfilling prophecy it would mean that the system is working pretty well. And should therefore be interesting to all traders wanting to make money.

Another criticism is that technical analysis only looks at the past. But the counter-argument to this is of course: Should it look at the future instead? When I look at fundamentals I look at the past as well. And so far I haven’t figured out a way to look at the future charts or future fundamentals. Because I don’t have a crystal ball. But maybe the critics do. But I sure don’t.

Predictions

Predictions made with both fundamental and technical analysis are often wrong. Many traders are only right about 50-60 percent of the time. And the very best ones might have a win ratio of above 80 percent. The good news is that we don’t have to be right that often to make money. At least if we use stop losses. And that is something I can’t emphasize enough. Because stop losses are crucial to your future success. Believe me. I have felt the pain of not using them.

The stop loss

The stop loss is the airbag that saves the technical trader’s ass from disaster. A stop loss is a predetermined automatic sell point that is set electronically. For example if stock A goes below 39 you would automatically sell it, or “get stopped out” of it. And this works like a charm. Because when you let your winners run and cut your losses short you are going to make money. It is simple math. If you are right only about 50 percent of the time but cut your losses at five percent you will make money. If you hold on to your winners.

Below is an example of where a stop loss could be placed. In this case below a higher low.

A stop loss should be below a level where there are likely to be a lot of buyers present. Because if these buyers loose control and price breaks through it could sell off even faster on the downside. The stop is there to protect us from that. – Chart from TradingView

A stop loss is simple to follow in theory, but hard to follow in practice. Because of our innate human psychology. Being right is more important to us than making money. Although the logical thing should be the opposite.

Why people go wrong

Technical analysis is not the holy grail. And it has to be used with caution and along with other tools. Further, you need to protect yourself by using stop losses. Because you might only be right about 50 percent of the time, which is actually quite a good average.

Personally I don’t consider myself an accomplished trader yet. At least not when I compare myself to the best guys in this field. Which is why I want to research several technical methods on this website going forward. Because I am curious and want to learn more about them. And hopefully you can benefit from that research.

Conclusion

Some investors use fundamentals. Others use technicals. And some use them both. For me technical analysis often fills in the gaps of my fundamental analysis. But it does not come easy to get good at it. It is like any other job. You need to carve up your sleeves and get to work. And put in the hours to get good at it. And you might have do some painful mistakes along the way before you know what you are doing. At least so did I.

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