The key to successful trading is having a methodical approach and not being emotional about your trading decisions. Never forget that it is always best to accept when you are wrong and cut your losses where appropriate.
Technical analysis, also referred to as ?charting?, involves the use of charts or graphs to present historical performance and price changes at a glance and the ability to use this information in order to make investment decisions.
The first golden rule of technical trading is, where possible, to keep charts as simple as possible.
Technical Analysis and Charting
Even those new to trading will be familiar with the image of a chart in relation to the financial markets. They appear on City Traders? screens, the news, financial magazines and even the City pages of newspapers.
Investment software packages have allowed private investors to operate systems that are directly comparable to the sophisticated tools used in the City.
The accessibility to this information means there is no longer a need to rely heavily on your bank, stockbroker or financial advisor. With technical trading software and a broadband internet connection, you can have all of the information and ability to analyse it needed to take control of your investment decisions.
Fundamental vs Technical Analysis
Fundamental analysis takes into consideration only those variables that are directly related to the company or instrument itself, rather than the overall state of the market or technical analysis data. For a company, these may include financial reports, sales, earnings, assets and management.
In contrast, using historical data and set variables, the technical analyst assumes that market psychology will influence trading in a way that can help predict if a price will rise or fall.
What Does a Chart Show?
In the simplest terms, charts represent the balance or imbalance between buyers and sellers in a market, which allows one to judge when the market is overbought or oversold.
Charts are powerful as they present a picture of historic price movement in clear and visually easy-to-interpret way. They also provide an immediate way to notice a major price change.
The markets very much behave like other natural phenomenon and are driven by crowd behaviour and psychology. When a large number of people are trying to get out of a certain market, people will sell until buyers start to return to the market, thus making it turn the other way. Often ?panic buying? will set in as people want to ensure they do not miss the boat. There are many factors that will affect a price but this type of cycle is seen again and again, day in, day out.
Why Does Technical Analysis Work?
Crowd behaviour can be predicted and as the markets are effectively crowd behaviour then so can they. Following natural cycles, the markets can be subjected to mathematical analysis, drawing a relation between current price movements and those that preceded them.
How Long Has Technical Analysis Existed?
A difficult question! Japanese rice traders are the first known users of technical analysis in the 18th century. However the form of technical analysis that we know today stems from Charles Dow, the father of the Dow Jones Industrial Average Index that is still used today and that many other world indices are based on. His editorials where collated in Robert Rhea?s 1932 book, Dow Theory.
To believe that technical analysis works, you must believe that history repeats itself. Remember that markets are driven by crowd behaviour and that an individual is intelligent, but a crowd is not.
Trend lines are, as their name suggests a means of identifying the trend in a market. A break of the trend line can be used to identify a possible reversal of the market.
A bullish trend, which is when the market is gradually moving upwards is identified by a series of successive higher highs and higher lows. The trendline is then drawn connecting the low points of the market. This is important as in a bullish market, it is the buyers that are driving the market, therefore whenever the market retraces back to the trendline, we are looking for buyers to step in and push the market back up above the trendline. If the trendline is broken, then it suggests possible weakness and therefore a reversal of the trend.
It is important to note that we are using a bullish trendline to identify buying opportunities, therefore we are moving with the market, not against it.
In a bear market, the opposite of the above is true; the market is trending downwards with a series of successive lower highs and lower lows. The trendline is drawn connecting the high points on the market and it identifies where the sellers are re-entering the market and driving the price lower.
A trend line can be identified with relatively few points, but obviously the more points, the stronger the relationship, and therefore the higher the confirmation of the trend.
Whereas trendlines identify the momentum in a market and assist a trader in identifying opportunities to enter the market, channels provide more information as to when to exit or close a position.
In a bear market, the trendline should have been drawn sloping downwards and connecting a series of lower highs. The channel line is then drawn below and parallel to the trendline approximately connecting the series of lower lows, thus incorporating all the market action between the two lines. In a bull market the channel line is drawn parallel to and above the trendline, connecting the series of higher highsst advantage that a channel has over a trendline is that it can show when the market is likely to reverse its direction. This can be used to either take the profit, or to place a stop loss to protect against possible market reversal. Please note it is strongly advised that even though the market may be trading within a clearly defined channel, it is not advisable to reverse a trading position as the market bounces of the channel line. Doing this would involve taking a position against the trend of the market and therefore would be breaking a fundamental rule of trading.
The second advantage that a channel can give a trader is a minimum price objective should a channel breakout occur.
A channel breakout occurs when a confirmed move out of the channel occurs. (Remember confirmation is often found by investigating other indicators including the moving averages and volume) In a bear market, a channel breakout occurs when the market reverses its direction and breaks out of the channel to the upside. A minimum price objective line should then be drawn parallel to and above the trendline, an equal distance from the trendline as the original channel line was. This distance is known as the channel range.
If the channel breakout is true, then it is to be expected that the market will eventually rise to touch the minimum price objective line. When this happens, the initial short-term market trend has ended, and confirmation of the new market direction should be sought. Meanwhile the profit made should either be taken or protected by the use of a stop loss.
Support and Resistance
A support level can be thought of as a floor and the resistance as a ceiling.
If a market has a minimum price that it keeps touching, but then has a strong reversal from, then a line can be drawn through these lows to form a floor for the market. If the market does not bounce strongly off this floor, and instead gets gradually closer to it, then it is possible that the floor is about to be broken.
A resistance level is exactly the opposite, a ceiling that the market keeps rising up to touch, but cannot break through.
If either the support or resistance is broken, it is likely that the move, once established could be extensive and a breakout. For example, if the support level is breached, then it would be like falling through the floor and into the room below, you might not stop until you hit the floor below, or at least a temporary obstacle such as a table, which will probably break in relatively short time allowing the fall to continue.
Any chart pattern that repeatedly appears in the markets movements could and should be used as an indicator to the future movements of the market.
The most common patterns are outlined below.
Flags and Pennants
These are a form of continuation pattern, a pattern that indicates that the market is currently pausing before continuing in its previous direction. They often occur just after a large move has occurred in the market and are often due to traders realising their positions and consolidating.
Not only do these patterns indicate when a trade should be entered (when the pattern of the flag or pennant is confirmed broken in the original direction), but they also indicate a minimum price objective.
Measuring the distance of the original move, and then projecting this distance from the point of breakout in the same direction as the original move you can find the minimum price objective.
Triangles can fall into two categories, either as a continuation or a reversal pattern. However care should be taken that confirmation of a breakout is found before a trade is entered in to.
Care should also be taken to confirm that a triangular pattern has indeed formed. If a breakout occurs of a suspected pattern before the triangle can be clearly seen to exist, or if a breakout fails to occur approximately three quarters of the way to the point of the triangle, then the pattern should be considered nullified.
A bearish or descending triangle is perhaps better thought of as a support triangle. The market dropping to a prior support level forms the triangle. At the support level, the market bounces as shorts are closed and hasty buyers attempt to pre-empt the market direction. However with the volume of sellers outweighing the volume of buyers, the market soon retreats back down to the support level again. This repeats with a series of lower highs as the volume of buyer?s decreases until eventually the support level is breached and the market continues its fall.
Head and Shoulders
A head and shoulders pattern is a reversal pattern and looks exactly as it sounds. The market climbs to a peak before falling a short distance to form the left shoulder, followed by a rise to a higher peak that is the head and then falling back to the neckline (formed by drawing a line from the lowest point between the left shoulder and the head though the lowest point between the head and the right shoulder), before rising one last time to a lower peak to form the right shoulder. The market should then drop again through the neckline. Once this happens confirmation of the pattern should be sought from other indicators.
A double top or triple top (or more) is exactly the same but with more than one ?head? at approximately the same height.
Once the market has dropped below the neckline it should continue down to a minimum price objective that is the same distance below the neckline as the head was above the neckline.
The tools outlined above are intended to provide you with the basic knowledge of how technical analysis works. However, as the old saying goes, knowledge is power, and in technical analysis this could not be truer, although perhaps it should be adapted to read ?knowledge is profit?.