An Introduction to Technical Analysis

There are two ways to analyse the financial markets – Fundamental and Technical.

Fundamental deals with company or economic research, focusing on data such as earnings, growth rates, dividends, economic releases such as retail sales and unemployment. This all helps to build a  picture on how companies and the economy is developing by focusing on value. This can help you judge the future direction of a market and possibly even the magnitude of the move but it is very little use in calculating when the anticipated move will commence. It may also be difficult to work out how much of the analysis is already priced in to the market – we have all heard of the buy the rumour sell the fact rule. Before you can analyse the bullishness or bearishness of a report, you have to be fully aware of the expectations of that report before it was released.

Please note that fundamental analysis does not include the news. If the market rallied due to ‘some hedge funds believing the next move in interest rates may be down’ this is not a categorised as fundamental analysis but it is the media looking for a single reason for a market move. This is really a nonsense as all market participants do not act for exactly the same reason all at once.

Technical Analysis (TA) ignores the fundamental view and focuses solely on historic price action to attempt to determine the flow of demand and supply. It is far more relevant to the short term or day trader as it allows for an greater degree of market timing with the fundamental view playing out over a longer time period.

Charts are the footprint of the markets and are a useful tool in locating areas where buyers over power sellers and vice versa.  TA is increasing in popularity in recent years as traders discover the benefits and software packages have become more available and affordable to the retail trader. This means that even if you do not study charts yourself you need to be aware of where others are locating support and resistance levels to ensure you do not enter or exit the market at an inappropriate point. 

Identify the trend

When analysing a chart, step one is to identify the trend.  In order to do this one needs to define time frames. Longer term time frames have greater importance and therefore it is wise to start at a monthly or weekly chart and identify the trend – Up, Down or Sideways….do not forget that ‘sideways’ is a trend and the markets spend more time on average in this trend. In an up trend you are attempting to find support levels to buy in to the market and as a rule you should not go short. 

In a down trend you are attempting to find resistance levels to sell the market and as a rule should not go long.

Trading a sideways trend is easier in theory as the parameters are more clearly visible. The problem lies in deciding at what stage we are in a sideways trend and being quick to cut positions on a breakout.

A line can be drawn to emphasis the trend but bear in mind that three points need to be joined to form a proper trend line. Once established one would expect the market to remain within the trend line with a break suggesting the trend has ended. Remember that if an uptrend is broken it does not mean that a down trend will start it only means that the up trend may have ended and the most likely scenario is some sideways actions as bulls and bears battle it out for supremacy. 

From here we move to shorter time frames as we move towards our trading parameters. Weekly - daily – hourly. Again we are attempting to identify the trend in these time periods and be aware that they can differ.

Note: We find it unwise to look much more short term than 1 hour as this can give too many false signals but some traders go all the way down to a tick chart.

Trading involves limiting your risk as far as possible. If the trends all coincide in different time frames you need to be sure you do not trade against this trend as the odds will not be in your favour!

Support and Resistance

As mentioned earlier the longer the time frame, the more effective the signal so weekly support levels in an uptrend are worth buying where as 30 minute support levels are less likely to hold.

Support and resistance levels are prices areas where the market has previously held or turned. They become ‘support’ as prices rise above them and ‘resistance’ as prices fall below. If a market has risen to a particular level and halted for a while before turning lower, then those that had bought on the approach to this level will be nursing losses. Those that had taken some profit will wish they had taken more.

Therefore this level tends to have a strong psychological and emotional significance as we approach it for the second time. Those that are long from this level will be keen to exit and minimise those losses. Those that missed selling the first time will be highly motivated not to miss it a second time and risk feeling the pain of seeing their profits evaporate once again.  Those selling short will have made a nice profit and may wish to try their luck again. This is how support and resistance levels develop and our job is to locate them. If this point has marked the high for a week as opposed to a day, it will have affected and been observed by  more participants and will therefore have a greater significance. This is why longer time frames carry greater weight. Once we break above a resistance level it will still be remembered by many and will then act as support if we fall back towards it.

So Support levels are areas where the market can attract an increased buying interest from those wishing to enter the market and also from those wishing to cover short positions. Therefore one can expect the market to at least pause here if not bounce.

Resistance levels work in the exact opposite way. Traders will be keen to take profits at these levels and sellers may try to short the market which can stop prices from travelling any higher, at least in the short term.

Support and resistance levels can be marked by a horizontal line connecting two or more adjacent tops or bottoms.

Pivot points

Using pivot points as a trading strategy has been around for a long time and was originally used by floor traders. This was a nice simple way for floor traders to have some idea of where the market was heading during the course of the day with only a few simple calculations.

The pivot point is the level at which the market can change direction for the day. Using some simple arithmetic and the previous days high, low and close, a series of points are derived. These points can be critical support and resistance levels. The pivot level, support and resistance levels calculated from that are collectively known as pivot levels.

The reason pivot points are so popular is that they are predictive as opposed to lagging. You use the information of the previous day to calculate potential turning points for the day you are about to trade (present day).

Because so many traders follow pivot points you will often find that the market reacts at these levels providing you with an opportunity to trade.

If you want to calculate your own pivot points, click here for our pivot point calculator

Indicators.

Technical indicators tend to be either trend following, such as Moving averages and MACD or oscillators such as RSI and stochastics.

Everyone knows that the trend is your friend and moving averages help to keep you in the direction of the trend. We find 9, 21 and 55 period moving averages to be the most effective. Moving averages have a built in inertia because it is a lagging indicator and takes an average of the last X amount of price data. This works brilliantly in a big trend and will stop you from exiting too early. However the flip side of course is that being a lagging indicator it will be too late in telling you when the trend has changed. The three moving average periods are used to identify longer and shorter trends and many practitioners watch for moving averages that turn either up or down and then cross as confirmation of the trend.

Moving averages can also work as outright support and resistance levels. You will often observe a market hit a moving average hand hold this level. If the moving average ties in with a previous support or resistance level this will increase the significance of that level and can give you greater confidence to enter or exit the market according to your view.

Oscillators work better than moving averages in a ranging market by showing when markets are overbought or oversold.

The Stochatic oscillator measures the capacity of bulls to close prices as close to the top of the trading range as possible  and bears to close as near to the bottom as possible.  It measures the high, low which is the maximum power of the bears vs the bulls against the  close which in effect is the result of the battle for that time period. If we have traded higher but failed to close in the upper part of the range then the stochastic indicator will show weakness and turn lower.

 As over bought stochastics turn lower and cross this can indicate the market is about to fall. As stochastics turn higher in over sold conditions and cross over , this can indicated the market is about to rally. However the flip side is that in a strong up trend the market can remain over bought for a long period of time as the market rises higher and higher. The reverse is of course true for a market in a strong down trend.

When a market does appear to have turned in favour of the dominant trend, for example from a correction lower in an uptrend, once the stochastics have turned and crossed and are heading higher, by staying in the trade until the stochastics have hit over bought territory AND turned lower to cross over you should be able to take the maximum amount from the trade.

Again having long and short term stochastic trends matching, reduces your risk. For example if the daily stochastics are pointing higher having turned from the lower end of the range it would be wise to wait for hourly stochastics to bottom and turn higher, then enter a long position. It would be unwise to use the short term indicators to pick a top when the daily stochastics are indicating a move higher.  

Measuring divergence is another useful way of using the stochastic indicator as a tool. When the market makes a new high but this is not confirmed by a new high in the stochastics we note that the two are diverging. This is a warning that the up trend is running out of steam.  Another example would be if you spot a double top in the market, it is useful if it is confirmed by a divergence in the stochastics…that is to say the second peak on the stochastic is lower then the first as compared to the price where the peaks are at the same level.

There are no certainties in trading and therefore the objective is to reduce your risks and increase your odds of making a profit. The more indicators and support and resistance levels that line up within in a trend, the greater the chance that you can enter at a low risk level and see the market head in the anticipated direction. If the market is in a clear up trend, confirmed by the moving averages has and pulled back to an important support level just as stochastics begin to turn up over sold territory, the risk in establishing a long position is reduced. If the support level is broken or the moving average pierced you already know that you will need to exit your position for a relatively small loss and as long as you keep to a 2:1 or 3:1 profit to loss ratio you should be able to stay in the game.

Suggested reading for traders:

Financial Freedom Through Electronic Day Trading (Hardcover) by Van K. Tharp

The Disciplined Trader: Developing Winning Attitudes by Douglas

Come into My Trading Room: A Complete Guide to Trading (Wiley Trading) by Alexander Elder