Technical Analysis
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Technical Analysis is based on the examination of market structure and patterns found in charts to determine future price behavior.
Contents |
[edit] Psychology
At first blush technical analysis as applied to the stock market seems to be a bunch of voodoo. Interpreting chart patterns and attempting to predict future movement based on past behavior is considered by some to be no less rational than traditional fundamental analysis. One of the most succinct explanations of why many believe technical analysis works is that PSYCHOLOGY drives the markets. Buying and selling of stocks, futures, and derivatives sets a market in motion as participants negotiate a common price point. The exchange of goods is more or less driven by human psychology and future expectations.
The primal emotions upon which expectations are built are fear and greed, which in effect compels humans to repeat the mistakes and triumphs of the past. The watershed moment came as Charles Mackay published his 1841 book Extraordinary Popular Delusions and the Madness of Crowds in which he detailed the Dutch tulip mania of 1637, and 1720 meteoric rise in the stock prices of the Mississippi and South Seas Companies. The South Seas bubble was initially started as the company was given exclusive access to the South American trade and new world colonies. The frenzy that resulted as both peasants and lords feverishly snapped up shares inevitably resulted in credit defaults, bankruptcies, and economic hardship. When Sir Isaac Newton was asked about the continuance of the rising of South Sea stock.....He answered 'that he could not calculate the madness of people'. (Spence, Anecdotes, 1820, p368) Since then, history has only to reference the stock mania which gripped the United States in 1929, the 1989 Japanese Nikkei, the 2000 technology bubble, and the 2007 global real estate boom. History is littered with booms and busts - manias that lead to unsustainable price levels based purely in our primal emotions.
- insert tulip / south seas / 1929 / Nikkei 1989 / 2000 Naz charts -
The key to technical analysis is that human behavior is considered invariant. Humans act predictably and market technicians have developed descriptions of emotional patterns that are reflected in the price action. This applies to both rational as well as erratic market gyrations. In the rare events where a mania bubble is present, they point to asymptotic lifts to unsustainable levels. Indecision is described in terms of 'consolidation ranges and triangles'. A consensus amongst market participants is reflected in a 'trend'. Incorrect assumptions and disappointment is considered a 'breakout or breakdown'. Whatever the nomenclature, these patterns simply imply a set of expectations on behalf of those with an emotional stake in the outcome. Once the market behavior is classified in terms of a pattern and context, the technical trader can then form an opinion of future price action.
- insert asymtotic / consolidation / triangles / trend / breakout charts -
[edit] Charts
Charts are the heart and soul of technical analysis. Many experienced traders wax poetically about how 'charts talk to them' and make bold statements about the future direction of a stock based on examination of price history. Yet to the untrained eye, these same graphs are but squiggles across a page with no discernible order. Beneath the surface, it is actually an accumulated history of human behavior, a voting mechanism of sorts. The technician is able to see how individuals reacted to earnings reports, economic conditions, and political ramifications over time. There is no need to re-examine those events, since informed market participants have cast their votes as prices over time reflect different expectations.
A chart represents of the demand and supply of a stock or commodity. The horizontal axis represents time, with the price drawn as a line connecting consecutive closing values. More sophisticated charts will show more detail; bar charts also include the range from high to low, candlestick charts include the open price along with a color and fill which reflects change relative to the previous close. A chartist will examine clusters of these marks and categorize them into behavioral patterns. The nomenclature used depends on the chart style as well as the theory to describe price action. Candlestick charts have become very popular since Steve Nison published Profiting With Japanese Candlestick Charts in 1991. This approach was used to trade rice in late 1600s, and consists of such colorful descriptions such as 'spinning tops', 'evening doji star', '3 soldiers', 'dark cloud cover', or 'hammer'. There are also different ways of filtering out noise and reducing detail - Point and Figure, Renko and Kagi will combine several bars and ignore the time scale axis. What is key to any charting method and classification is the context in which the pattern appears. This is true for all sub-disciplines of technical analysis.
- insert line / bar / candle / p&f / kanji chart here -
[edit] Support and Resistance
What most often stands out are price extremes, both high and low. At those junctures, one set of market participants will succeed in driving the prices in the other direction. It is often the inflection point at which expectations change on the underlying asset. These levels present the technicians with the first level of information - support and resistance. In the simplest terms, support is a price level at which a asset experiences buying and downward motion is halted, whereas resistance is a level at which one would expect profit taking and selling pressure, halting upward momentum. These prices can be determined by a number of factors, but most often produce a price extreme visible on the chart.
- insert charts with ring high / low here -
Some of the most powerful pieces of trading information are revealed when a price spike is retested. This is a bold statement, since it implies that tops and bottoms aren't ever really formed in isolation, but instead an attempt is made to revisit a previous price level. Market technicians make careful observations of how traders behave around previous support and/or resistance levels. If the price fails to break below a previous spike low, we can say that the support level has been confirmed. The same principal applies to resistance if rising prices fail to penetrate above a previous spike high.
- charts with retest / support / resistance here -
[edit] Trends
There is a vital piece of information that is revealed when confirming support or resistance. It is the notion of a trend. An uptrend is a situation in which we experience rising prices in the form of new highs and shallow pullbacks. Similarly, a downtrend has lower peaks and prices continue to make new lows. If the price oscillates without any clear direction, it is said to be range-bound or in consolidation. Decreasing ranges between highs are lows are considered triangle patterns.
- uptrend / downtrend / oscillating / triangle examples -
At certain junctures, prices seem to accelerate either up or down and go for long stretches without a pause. This is considered an impulse, and often lead to incredible gains or drops in price. These impulses cannot continue indefinitely, and at some point must pause or reverse direction. During these periods, it lacks clear direction and is considered in a consolidation sequence. Even though it seems that prices should continue forever, these pauses are in fact quite healthy. They serve a vital role in forecasting price targets once the trend continues or reverses.
- chart delineating impulse vs. consolidation -
[edit] Patterns
Much in the way that stars are strung together in different ways across the sky to create constellations, price spikes are examined to 'paint a picture' of a known configuration. Some of the most common patterns are channels and triangles. In both of these cases, a minimum of four points are required - two spike highs and two spike lows. The lines which connect the extremes are extended to the right (where no price history exists), so we have some notion of where prices should be at some time in the future. In some cases, the lines are almost horizontal, which implies a trading range. Parallel lines which slant up or down indicate a trend direction within a channel. If lines converge, it is considered a triangle, and there are special cases for each of the various slant directions - symmetrical, flat-topped or flat-bottomed, ascending or descending triangles, and rising or falling wedges.
- kiwi examples of theoretical stock movements -
If prices break above or below the bounds of either channels or triangles, then it can be said that one set of market participants have overwhelmed the other side. Traders call these breakouts and breakdowns. These are particularly relevant if accompanied by an increase in volume. In essence, it gives credibility to the market direction and signifies that prices are ready to change their behavior. If prices are heading up, we say the price action is bullish. Tumbling lower is classified as bearish. In either case, the market is tipping its hat in a particular direction as investors, traders, and financial institutions pile onto the winning side. This behavior is the reason that trading desks chant 'the trend is your friend', in other words, don't get in the way of a mob rushing in either direction - join the winning side and trade in the direction of the trend.
- examples of triangle breakouts / breakdowns / volume (+ bull vs. bear) -
[edit] Targets
The final step is to put all this information together and examine how the patterns interact with one another, to determine the price structure and context. If there is a clear impulse leading into a channel or triangle, we can start talking about pennants, bull flags and bear flags. This is considered good market structure, since participants need to pause for a bit before resuming an impulse. The amount of price movement leading into the consolidation can be considered a target to reach once there is a breakout (in case of rising prices) or breakdown (declines before pausing). This is known as a measured move and is probably the most common target known to traders. If a stock appreciates +5 before forming a triangle, when it breaks above the upper bounds a technical analyst will call for a price target +5 higher from the breakout point.
- examples of good market structure / price targets -
So when can a technician determine that markets are in a bubble scenario? When it exhibits poor market structure, most often in the form of prices that seem to defy gravity and logarithmic scale, with little or no pauses for consolidation. A true one-sided exhibition of delusional behavior that this trend will continue forever. Psychologically, this is complete lack of fear and greed at its best without any consideration of reasonable expectations. In the end, for each seller there must be a buyer, and once the final marginal buyer is in, there is nothing left to buoy prices. A technical trader will look for the first correction after the meteoric rise to get out; after a pullback the rebound cannot reach the lofty price experienced at the peak, the first lower-high. Prices collapse in the sheer panic that ensues as behavior shifts to fear of losing.
- examples of poor market structure / air lifts -
[edit] Trading Approaches
Trading can be characterized as short-term decisions made in accordance with information gleaned from technical analysis. Traders usually move in and out of the market at a rapid pace in hopes of repeatedly extracting small profits. Trading is helpful in that it serves the useful purpose of enhancing liquidity. Full time traders often use multiple computer screens to monitor prices closely throughout the trading day. For people who cannot spend all day in front of a computer monitor, one option is to anticipate substantial price moves so that the associated risk of taking a position is justified by the upside profit potential. "( Source: Pattern Recognition and Trading decisions, SatchWell,Chris 2005)
