What is Technical Analysis
Technical Analysis deals with reading stock charts. The idea in the stock market is that if there is a good company with good potential, the price of the stock will naturally go up. But as you know, the price never goes up or down in a straight line. It always goes up then comes down a bit before continuing on its progress.
Technical analysis deciphers the movement of the stock price and tries to forecast and predict when the price will turnaround and by how much the price will move. By knowing these two things, the technical analyst can position the trade to profit from the expected move.
There are many types of technical analysis and technical indicators.
Trend Channels and Trend Lines
The most commonly used and the simplest form of technical analysis is using Trend Channels and Trend Lines. The price movement is usually bounded in a trend channel in either upwards, sideways or downwards direction. This serves as a guide for the price and traders look to ride these trends. A break out of the trend channel with volume and strength will setup the possibility of a trend change and this too is used by traders to change their direction of trade.
Trend lines act as support and resistance zone for the share price. When a previous support is broken, it will turn out to be the new resistance zone. Similarly, when a previous resistance is broken, it would turn into a support zone.
Traders can establish a profitable and reliable trade strategy using the Trend Channel and Trend Lines alone. A Case Study of Trend Channels and Trend Lines was done using the Apple share price and is a recommended read.
Moving average is a moving trend line that follows the price. It takes into account the most recent price of the stock. It could be the 21 Day Moving Average, 50 Day MA or 200 Day MA. The MA also acts as a support and resistance for the price. When the 21 D MA crosses the price, it is a first sign of a trend change. When a 50 D MA crosses the 200 D MA, it is taken as confirmation of a trend change.
Moving Average Convergence Divergence (MACD)
MACD is a momentum indicator that plots the difference between two Moving Averages of two periods. The common combination of periods used for MACD is the 26, 12 period MAs. The 9 period Exponential MA is added to the plot as a signal line.
MACD cannot be used by itself to make trade decision. MACD is an indication of momentum and it is usually used together with trend channels or other technical analysis to make a trade decision.
Price Gap Analysis
When a share price moves, it could register gaps when the price jumps by more than one bid. This leaves a gap on the price chart and is an indication of either strength, acceleration or exhaustion. When a trend is being established, there could be gaps appearing near the early part of the trend. That is called the beginning gaps as traders who were left behind, pay a premium to get on board a stock that has already started to move.
As the price accelerates, there could be gaps appearing near the middle of the trend. This is called the acceleration gaps. And finally towards the end of the run, gaps will appear as traders become extremely bullish and pay no regard to valuation. This is called the exhaustion gaps and you can expect the trend to change soon after.
You may read this article on Price Gap Analysis which is a detailed discussion on price gaps.
Technical Analysis using Candlesticks was invented in 17th century by rice traders in Japan. Two or three candlestick bars form a pattern and these patterns are categorized as either continuation patterns or reversal patterns. There are rules and guidelines that govern the patterns and must be followed strictly. Problem arises when the technical analyst does not follow the exact rules and that results in wrong analysis.
There are many candlestick patterns and only some are very reliable. Candlesticks is an area of Technical analysis that takes time to master.
Elliott Wave Analysis
Elliott Wave Analysis is one of the most rigorous technical analysis tools and one of the most difficult to master. Elliott Wave Analysis identifies the price movement as crowd behavior or social mood of the traders and provides for price projection and of a particular share or company.
The good thing about Elliott Wave Analysis is that it has a set of patterns, and rules and guidelines that govern these patterns. That is the reason why Elliott Wave Analysis is a rigorous analysis. The Elliottician needs to ensure that the analysis conforms to the rules and guidelines.
These patterns also provide price projection based on mathematical study called the Fibonacci numbers.
Since Elliott Wave Analysis is a study of social mood, it can flag market exuberance as well as extreme fear. It is the ultimate contrarian’s companion. The problem though is that the markets can stay exuberant for very long time and a trade strategy purely based on Elliott Wave Analysis may keep the trader out of the market and miss the big chunk of the trend.
It is best to use Elliott Wave Analysis with Trend Channels and Trend Lines as that would provide a much more reliable breakout and trend change signal.
Richard Wyckoff developed this method of technical analysis. In this method, the share price movement is divided into a phase of accumulation, price mark-up and distribution followed by price mark-down. The method is explained using a cause and effect logic as well as supply and demand.
The accumulation phase is the cause and this increases the demand. The accumulation should result in price appreciation which is the effect. The opposite is true for distribution where supply increases and this should result in price depreciation which is the effect.
The Wyckoff practitioner looks for the accumulation phase and readies to ride the price mark-up phase. A detailed explanation of this method is available at this website. http://www.readtheticker.com/Pages/IndLibrary.aspx?65tf=84_richard-wyckoff-method
Volume analysis looks at the volume of each price bar to determine whether the price movement is healthy or unhealthy. The stock price could be surging upwards but it may not be accompanied by volume. In this case, this move is said to be unhealthy or a weak move. Prices are likely to drop as there is no volume supporting the price move.
Volume Spread Analysis (VSA)
Volume Spread Analysis is an extension of the Wyckoff method. In this method of Technical Analysis, the trader is encouraged to read each price bar and the accompanying volume to interpret the actions of smart money or the institutional players. When big players in the market buy and sell their holdings which are large, they need to do it over time and under the radar of the market.
They have to do it in such a way that the price does not move too quickly. They have to spread it out so that when they sell, the market is able to absorb the supply and when they buy, they want to ensure that the supply doesn’t dry up. Once their operation is over, the price will then adjust back to the normal supply and demand dynamics.
The objective of Volume Spread Analysis is to identify such a buy or sell operation and detect the end of the operation. After a big buy operation, the price will naturally rise and the intention of VSA analyst is to ride the price gain. In the case of a big selling operation, the VSA analyst would be preparing to short the stock.
VSA is also a very difficult area of technical analysis to master. It is very subjective trying to read into the actions of the institutional players.
Bollinger bands are similar to Moving Average but it is made of a pair of MAs spaced at a set distance apart from the price. This creates a band within which the price moves. Sometimes, when the price accelerates, it will break out of the band temporarily before coming back into the band. The price will also move from one side of the band to the other side.
One important information that is obtained from Bollinger bands is when the band tightens into a small range, it is usually a sign of a big move ahead. The issue with Bollinger bands is that the price can become range bound and trade in small trading range for a long time before breaking out. Also, Bollinger bands is probably one of the most subjective technical indicators. It is best used with other technical indicators as a confirmation of price breakout.
Benefits of Technical Analysis
Here are some of the main benefits of Technical Analysis.
- Price Never Lies
- Trade Signals
- No Holding Up of Investment
- Target Price
- Well Established
- Technical Analysis Can Be Done Quickly
- Trend Analysis
Price Never Lies
The movement of a share’s price reflects the commitment shown by the market participants of being either bullish or bearish on a particular stock. This commitment is real especially if it is accompanied with volume and it can be used as a basis to make trading decisions.
Technical Analysis gives trade signals that can be used to make trades. It will also provide a stop loss level. This gives the trader the opportunity to evaluate each trade using Reward Risk Ratio to determine whether the target potential gain is worth the amount of risk taken.
No Holding Up of Investment
Once a buy or sell signal is given, the price will move in due course to meet the target price. There is no holding up of invested money in slow moving or stagnant shares. This also means that the trader can trade in fast moving investments such as futures and options.
Technical Analysis can give target price for a share’s price movement. This gives the trader the opportunity to move the investment money into other shares once the target is hit for the current investment.
Technical Analysis is a well established technique. Share price moves in patterns and there are many reliable patterns that have been identified and used for a long time. Some of these patterns have been used for decades and has been proven to provide reliable buy and sell signals.
Technical Analysis Can Be Done Quickly
Although technical analysis is a rigorous analysis, you can do it quickly to determine the status of the share price and make a trade decision.
Technical analysis can tell immediately whether a particular stock is in an uptrend or a downtrend. Based on the trend, you would want to wait for pull backs or rebounds before getting on board to ride the trend.
Problems with Technical Analysis
There are some drawbacks to using Technical Analysis as well.
- Difficult to Master
- Accuracy and Reliability
- Paralysis of Analysis
- Validation of a Biased View
Difficult to Master
Technical Analysis is very difficult to master. You need to learn the various indicators as well as patterns. You need to understand how these indicators and patterns relate to investor sentiment and psychology. You need to understand how all of these will impact the share price.
Accuracy and Reliability
Technical Analysis is not 100% percent accurate or reliable. It depends very much on the technical analyst, the technical analysis tool as well as the stock or market itself. Successful traders would be happy if they are accurate 60% of the time as their technical analysis is accompanied by trade plan with a stop loss in place. Even if they are wrong, the stop loss will get triggered and they will walk away with a small loss but preserving a large portion of their capital. If they are right, then, they will let the profits rise and cover all the previous losses and make a tidy sum.
Paralysis of Analysis
Paralysis of Analysis is when there is contradicting results from the technical analysis resulting in a situation where no trade can be made. An example of this is when the overall market is heading in one direction and the particular share price is pointing to the opposite direction. What will you do in this situation? The general advice is that you must trade with the major trend and if the general market is down, how can the share price be moving up? This situation happens quite often and can create confusion to make the trade decision.
Another example is when some technical indicators point to one direction and a few other indicators point to the opposite direction. This too can cause paralysis of analysis.
The interpretation of technical indicators is subjective. The same indicator could be interpreted as bullish by one side of the camp and as bearish by the other side of the technical camp. The same thing can happen to price charts as well. There can be more than one interpretation. This may not be a bad thing if the technical analyst takes an objective view.
In Elliott Wave Analysis for example, the Elliottician is encouraged to perform a rigorous analysis and to finally narrow down the analysis to at least two views. One view is the bullish view and the other view is the bearish view. This gives you the ability to take a primary view and should the share price move in the opposite direction, you can quickly close the trade and re-evaluate the views again.
Validation of a Biased View
The subjective aspect of Technical Analysis gives way to another drawback of technical analysis which is validation of a biased view. The technical analyst may have already formed a view based on the state the economy is currently or the situation of the market and sector the company is operating in. When doing technical analysis, the technical analyst would look for clues to support the biased view that has already been formed and use the technical analysis as a validation tool to justify that view.
I’m sure you would have heard the terms perma bull or perma bears. This is what usually the perma camp does. They will use technical analysis (as well as many other tools and techniques) to justify their position.
This is a dangerous and useless usage of technical analysis. The perma bears have been calling for a market collapse since 2007 and yet the the markets have been making record highs. The gold bugs who are perma gold bulls have been calling for gold to hit $5,000 dollar per troy ounce and yet gold is in a major correction.
In summary, technical analysis can be be a reliable tool to trade the markets but you have to spend time and effort to learn it and practice it correctly. Also, you have to use Technical Analysis objectively on its own without any other distorting information in order to derive the maximum value from the analysis.
This is part of a series of articles on Fundamental Analysis vs Technical Analysis. Do check out the other articles on this topic which talks about a trade strategy of using the best of both analysis to greatly improve the success rate of trades.