Introduction to Technical Analysis

There are 2 primary methods of analyzing securities/currencies/financial instruments in order to judge fair value and likely future price movements; fundamental analysis, and technical analysis.

Fundamental analysis looks at statistics such as assets on a company's balance sheet, management, similar companies, etc. The technical analyst argues that it is futile to assign an intrinsic value to a stock certificate as even a novice market participant can see that stocks regularly fluctuate, being worth $80 one day and $180 the next; in the end, supply and demand are what determine a stocks market price.

For the technical analyst, all of the information that is knowable about an instrument is discounted and included in the current market price.

Technical Analysis refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals.

Technical analysis has it's roots in Dow Theory, developed in the late 1800's by Charles Dow and formalized after his death. It's main tenets (simplified) are;

1. The Averages Discount Everything - Big market indexes like the S&P 500 or the DJIA reflect the combined market activities of thousands of investors, including those with the greatest foresight and access to the best information. The averages discount everything known, everything foreseeable, and every condition which can affect supply and demand.

2. The 3 Trends - Primary trends are the extensive up or down movements which usually last for a year or more, and result in a move of more than 20%. The primary trend is interrupted by secondary swings (reactions) which occur in the opposite direction when the primary trend has "gotten ahead of itself." The secondary trends also include minor trends, or day-to-day fluctuations which are unimportant.

3. The Bull Market - Primary up trends are usually divisible into three phases. Accumulation, Advance, Exhaustion - Intelligent market participants pick up stocks cheap when news is bad and earnings are poor. Eventually things pick up and a steady advance begins - the public eventually get invovled. In the late stages, smart participants unload their shares as they foresee poorer conditions ahead. The public become frustrated with fewer opportunities for profit.

4. The Bear Market - Distribution, Decline, Depression - Smart participants offload stocks at the late stages of the bull market. When everyone realizes the top is in, urgency becomes evident and panic sets in, causing an almost vertical drop. In the late stages, those who bought 'cheap' or held on with conviction are forced to capitulate as they need to raise funds for other reasons.

5. Volume goes with the trend - Basically this means that in a bear market, the rallies will be accompanied by higher volume (more trading activity), while the reactions will have less. This is over all volume rather than from a single trading day.

6. Lines may substitute for secondaries - in other words, consolidation, or ranging prices (within 5%) can take the place of reactions. The formation of a line signifies that pressure of buying and selling is more or less in balance. The longer the duration of a line, or the narrower its price range, the greater the significance of its ultimate breakout.

7. Only closing prices used - Dow theory pays no attention to any extreme highs or lows which may be registered during a day and before the market closes, but takes into account only the closing figures. The reasoning is that the close contains within it a full days trading information, and it has stood the test of time. Higher highs and lows then, use candle closes, and even the smallest 0.01% close above is regarded as continuing the trend.

8. A trend should be assumed to continue in effect until such time as its reversal has been definitely signaled - It is a warning against changing one's market position too soon. Odds are in favor of the man who waits until he is sure, and against the other fellow who buys or sells prematurely. A reversal in trend can occur any time after that trend has been confirmed.

The Dow Theory is over 100 years old and when we day trade or swing trade we must employ other techniques, but for the long term investor the theory stands to this day and can give a strong indication as to the prevailing tide.

As traders, we want to know whether price is trending or ranging.

- that is, moving in one direction (on average), or going back and forth between defined boundaries.

We want to know how strong a trend is and if it is likely to continue, and also when it is likely to stop and go in the other direction. Similarly, we want to know when price is going to continue to respect the boundaries of a range, or whether it is going to break out of the range - which typically results in an aggressive move.

In the analysis, a trader will use various tools such as;

• Market Structure

• Support & Resistance

• Trend Lines

• Indicators

• Volume analysis

• Price patterns

• Fibonacci levels

But of primary importance are Price, Momentum, Volume, and Time.

That is, what is price doing? is it moving up or down? How fast or slow is it moving? Is it accelerating or decelerating? Is this an area of interest? Are a lot of trades happening or is there relative disinterest? How long has price spent in this area?

All of our tools above are used to find the answer to these questions, and the answer to these questions help us to determine how to position ourselves in the market.

Technical Analysis often gets besmirched by traders and investors who haven't studied it, or who have tried to apply it to no avail. They take it at face value.

I view Technical Analysis as something like blood spatter analysis, or perhaps weather forecasting. Two vastly different fields I imagine, which to the uninitiated can seem daunting, gimmicky, and unreliable. To the trained individual with experience, however, who knows what to look for, who can spot warning signs, and who knows when an aspect of the scene is out of place, it can be extremely valuable. You may be unable to accurately recreate the entire crime scene, or maybe a storm dissipates unexpectedly, but it is far from redundant, and is sure to help you avoid disaster.