The Legitimacy of Technical Analysis

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The Value of Technical Analysis

Sceptics of technical analysis often note that chart-reading is only an advanced form of reading tea leaves. Or entrails. Or old bones, I guess. I take that criticism in stride: reading charts is one form of looking for clues. In this case, though, those “clues” are previous price and volume action. And that action can often tell you something’s changed. And if you know what’s changed, you can usually trade in that direction.

Such was the case with the QQQ a few weeks ago: we knew something happened, because we saw a strong gap above a downtrend line on decent volume. That often means the new direction is now “up” and we should start looking for long plays.


However, one doesn’t always get it right. Research in Motion (RIMM: 10.89, +0.49, +4.71%) is a good example where the chart completely faked me out. But, that’s why trading via technical analysis is never done alone. No, TA gives you an edge, nothing more. The real work should always be done with your money management parameters (stops, targets, etc.) to ensure a wrong chart read doesn’t result in financial catastrophe.



On the other hand, an edge is an edge. The chart had it right with Hershey (HSY: 69.49, +0.57, +0.83%), and even with a pullback, it’s still climbing.


So, when skeptics laugh at TA, laugh along with them. It’s you that have the edge, not them.

Written by Gary Smith
The legitimacy of technical analysis is beyond dispute

Traders are looking at what makes money and what doesn't. THE debate on whether technical analysis is hocus-pocus or not has been replaced with the question: Which type of technical analysis do you employ in your trading?

Central to technical analysis is the assumption that the price of a stock already trades at a level that reflects all the relevant market information, including the company’s performance, the fears and aspirations of investors and possibly even the dealings of insider traders. In today’s markets, where the quantity and speed of information has grown to unmanageable levels, this simplified approach to financial analysis has become a more widely used and accepted form of study.

Take for example the simplest and probably the most commonly used technical indicator: the moving average. It is calculated on various periods of historical price points and overlaid on the price chart, where current price movements are evaluated against the smoothed historical ups and downs. The trader is typically looking for cross-overs where price crosses a short-term moving average, or where a shorter term moving average crosses a longer term moving average. It is a very simple, but very effective way for the trader to be alerted of a potential trade opportunity.

Lets' look at an example (pictured below).  On 13 March 2012 the price of Key Energy Services dipped below the 20-day moving average (MA) at $16.86 (point “A”) and found it hard to break back above the 20-day MA (Resistance) - This is a signal to sell. As we can see price did fall after this signal.

The 20-day MA next crossed below the 50-day MA at $14.96 on 5 April (B) - Another signal to sell and again price fall and on Monday the 16th the 50-day MA crossed below the 100-day MA at $12.58 (C) – more than a 20 per cent drop in value and another sell signal to the Technical Trader. How low will it go?

Moving Averages as an Indicator


Now, let's get this straight right from the outset.  This doesn't always happen, but these indicators as well as others that we'll discuss along with good money management can increase your chances of trading successfully in The Forex Markets, Stock Markets and Bond Markets.  The likelihood of becoming a millionaire within a year with 20K capital on hand are extremely unlikely, but if you target incremental gains and manage risk correctly, you'll increase your chances of making money.

There are more sophisticated graphing techniques for the technical analyst, where he/she looks not only at the change in price, but also on the effect it has on the collective psychology of market participants. Such effects typically manifest as imaginary linear barriers (“support” and “resistance” lines) that could slope upward or downward, suggesting that the peaks or troughs where buyers and sellers exchange roles take place at steadily increasing or decreasing price levels. The theory around this charting technique has developed since the 1930s and it is still very much applied today. Traders look for chart patterns that form between support and resistance levels, like the Triangle Chart Pattern.

Ultimately though, when it comes to trading techniques and methodologies used in the markets, one can be sure that those that do not deliver money-making results quickly fall out of use. Some things don’t change fast – like the fear and greed of humans that trade the markets. GREED WILL KILL YOU!

Technical analysis isn’t infallible

But it can work as part of a wider trading strategy

IF YOU talk to particularly dogmatic technical analysts, you often come away with the feeling that their idea of the perfect trader would have zero contact with the outside world – no City A.M., no Bloomberg and no Twitter. The ideal trader would instead fuel themselves on Fibonacci retracement points and takeaway pizza.

But though it can be a useful tool for gaining a clearer picture of a stock’s potential future actions – based on its past performance – technical analysis is not a foolproof or infallible method of making money from the markets. And, despite the way a lot of technical studies of charts are presented, technical analysis is not a science. You don’t get many hedge funds taking on billions in investment because they’re running an algo on Elliott waves.

But technical analysis is a useful study of human behaviour. A stock is more likely to encounter resistance at 1,000p, rather than 999p, because that resistance has a scientific basis. It encounters resistance at that level because there are a lot of humans sat at their computers who think that if the stock falls below that point it is going to keep on falling, but if it stays above that level then everything is going to be ok.

And though some may trade purely on technicals, there are many strategies that work well which combine fundamental and technical analysis with risk management. For example, when you are looking at a stock, it can be handy to know whether there is a bulk of other investors who are thinking along the same lines as you. Volume indicators, such as oscillators, can help to give you greater insight into a stock, reinforcing your views on its fundamentals. Traders will often watch for a sudden spike in volume for an indication that an identified trend is gaining momentum. Similarly, when volumes drop, it can be seen as a sign that the wind has gone out of the sails of a stock and that a reversal could be on the horizon.

Of course, there are downsides to this kind of approach. Technical analysis of charts is, by its very nature, a backwards-looking approach. And, as the disclaimer goes: “past performance does not guarantee future performance”. Charts don’t take into account an unexpected poor earnings report, for example, though they may indicate that that report has been leaked to the market.

While there are limitations to both technical and fundamental analysis, if you want to be a profitable trader, understanding the limits of both can be the difference between success and failure. By combining the two, you can gain a much clearer and well-rounded picture of the markets, and where they will go next.

Written by Craig Drake





=======

The Value of Technical Analysis

Sceptics of technical analysis often note that chart-reading is only an advanced form of reading tea leaves. Or entrails. Or old bones, I guess. I take that criticism in stride: reading charts is one form of looking for clues. In this case, though, those “clues” are previous price and volume action. And that action can often tell you something’s changed. And if you know what’s changed, you can usually trade in that direction.

Such was the case with the QQQ a few weeks ago: we knew something happened, because we saw a strong gap above a downtrend line on decent volume. That often means the new direction is now “up” and we should start looking for long plays.


However, one doesn’t always get it right. Research in Motion (RIMM: 10.89, +0.49, +4.71%) is a good example where the chart completely faked me out. But, that’s why trading via technical analysis is never done alone. No, TA gives you an edge, nothing more. The real work should always be done with your money management parameters (stops, targets, etc.) to ensure a wrong chart read doesn’t result in financial catastrophe.



On the other hand, an edge is an edge. The chart had it right with Hershey (HSY: 69.49, +0.57, +0.83%), and even with a pullback, it’s still climbing.


So, when skeptics laugh at TA, laugh along with them. It’s you that have the edge, not them.

Written by Gary Smith
The legitimacy of technical analysis is beyond dispute

Traders are looking at what makes money and what doesn't. THE debate on whether technical analysis is hocus-pocus or not has been replaced with the question: Which type of technical analysis do you employ in your trading?

Central to technical analysis is the assumption that the price of a stock already trades at a level that reflects all the relevant market information, including the company’s performance, the fears and aspirations of investors and possibly even the dealings of insider traders. In today’s markets, where the quantity and speed of information has grown to unmanageable levels, this simplified approach to financial analysis has become a more widely used and accepted form of study.

Take for example the simplest and probably the most commonly used technical indicator: the moving average. It is calculated on various periods of historical price points and overlaid on the price chart, where current price movements are evaluated against the smoothed historical ups and downs. The trader is typically looking for cross-overs where price crosses a short-term moving average, or where a shorter term moving average crosses a longer term moving average. It is a very simple, but very effective way for the trader to be alerted of a potential trade opportunity.

Lets' look at an example (pictured below).  On 13 March 2012 the price of Key Energy Services dipped below the 20-day moving average (MA) at $16.86 (point “A”) and found it hard to break back above the 20-day MA (Resistance) - This is a signal to sell. As we can see price did fall after this signal.

The 20-day MA next crossed below the 50-day MA at $14.96 on 5 April (B) - Another signal to sell and again price fall and on Monday the 16th the 50-day MA crossed below the 100-day MA at $12.58 (C) – more than a 20 per cent drop in value and another sell signal to the Technical Trader. How low will it go?

Moving Averages as an Indicator


Now, let's get this straight right from the outset.  This doesn't always happen, but these indicators as well as others that we'll discuss along with good money management can increase your chances of trading successfully in The Forex Markets, Stock Markets and Bond Markets.  The likelihood of becoming a millionaire within a year with 20K capital on hand are extremely unlikely, but if you target incremental gains and manage risk correctly, you'll increase your chances of making money.

There are more sophisticated graphing techniques for the technical analyst, where he/she looks not only at the change in price, but also on the effect it has on the collective psychology of market participants. Such effects typically manifest as imaginary linear barriers (“support” and “resistance” lines) that could slope upward or downward, suggesting that the peaks or troughs where buyers and sellers exchange roles take place at steadily increasing or decreasing price levels. The theory around this charting technique has developed since the 1930s and it is still very much applied today. Traders look for chart patterns that form between support and resistance levels, like the Triangle Chart Pattern.

Ultimately though, when it comes to trading techniques and methodologies used in the markets, one can be sure that those that do not deliver money-making results quickly fall out of use. Some things don’t change fast – like the fear and greed of humans that trade the markets. GREED WILL KILL YOU!

Technical analysis isn’t infallible

But it can work as part of a wider trading strategy

IF YOU talk to particularly dogmatic technical analysts, you often come away with the feeling that their idea of the perfect trader would have zero contact with the outside world – no City A.M., no Bloomberg and no Twitter. The ideal trader would instead fuel themselves on Fibonacci retracement points and takeaway pizza.

But though it can be a useful tool for gaining a clearer picture of a stock’s potential future actions – based on its past performance – technical analysis is not a foolproof or infallible method of making money from the markets. And, despite the way a lot of technical studies of charts are presented, technical analysis is not a science. You don’t get many hedge funds taking on billions in investment because they’re running an algo on Elliott waves.

But technical analysis is a useful study of human behaviour. A stock is more likely to encounter resistance at 1,000p, rather than 999p, because that resistance has a scientific basis. It encounters resistance at that level because there are a lot of humans sat at their computers who think that if the stock falls below that point it is going to keep on falling, but if it stays above that level then everything is going to be ok.

And though some may trade purely on technicals, there are many strategies that work well which combine fundamental and technical analysis with risk management. For example, when you are looking at a stock, it can be handy to know whether there is a bulk of other investors who are thinking along the same lines as you. Volume indicators, such as oscillators, can help to give you greater insight into a stock, reinforcing your views on its fundamentals. Traders will often watch for a sudden spike in volume for an indication that an identified trend is gaining momentum. Similarly, when volumes drop, it can be seen as a sign that the wind has gone out of the sails of a stock and that a reversal could be on the horizon.

Of course, there are downsides to this kind of approach. Technical analysis of charts is, by its very nature, a backwards-looking approach. And, as the disclaimer goes: “past performance does not guarantee future performance”. Charts don’t take into account an unexpected poor earnings report, for example, though they may indicate that that report has been leaked to the market.

While there are limitations to both technical and fundamental analysis, if you want to be a profitable trader, understanding the limits of both can be the difference between success and failure. By combining the two, you can gain a much clearer and well-rounded picture of the markets, and where they will go next.

Written by Craig Drake





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