Part 27 Technical Analysis – Using Order Book

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Technical Analysis Strategies for Beginners

Many investors analyze stocks based on their fundamentals – such as their revenue, valuation or industry trends – but fundamental factors aren’t always reflected in the market price. Technical analysis seeks to predict price movements by examining historical data, mainly price and volume.

It helps traders and investors navigate the gap between intrinsic value and market price by leveraging techniques like statistical analysis and behavioral economics. Technical analysis helps guide traders to what is most likely to happen given past information. Most investors use both technical and fundamental analysis to make decisions.

Choose the Right Approach

There are two different ways to approach technical analysis: the top-down approach and the bottom-up approach.   Often times, short-term traders will take a top-down approach and long-term investors will take a bottom-up approach.

  • Top-Down. The top-down approach is a macroeconomic analysis that looks at the overall economy before focusing on individual securities. A trader would first focus on economies, then sectors, and then companies in the case of stocks. Traders using this approach focus on short term gains as opposed to long term valuations. For example, a trader may be interested in stocks that broke out from their 50-day moving average as a buying opportunity.
  • Bottom-Up. The bottom-up approach focuses on individual stocks as opposed to a macroeconomic view. It involves analyzing a stock that appears fundamentally interesting for potential entry and exit points. For example, an investor may find an undervalued stock in a downtrend and use technical analysis to identify a specific entry point when the stock could be bottoming out. They seek value in their decisions and intend to hold a long term view on their trades. (For related reading, see: Bottom-Up and Top-Down Investing Explained.)

In addition to these considerations, different types of traders might prefer using different forms of technical analysis. Day traders might use simple trendlines and volume indicators to make decisions, while swing or position traders may prefer chart patterns and technical indicators. Traders developing automated algorithms may have entirely different requirements that use a combination of volume indicators and technical indicators to drive decision making. 

What is Technical Analysis of Stocks and Trends?

Technical analysis of stocks and trends is the study of historical market data, including price and volume. Using both behavioral economics and quantitative analysis, technical analysts aim to use past performance to predict future market behavior. The two most common forms of technical analysis are chart patterns and technical (statistical) indicators.

  • The technical analysis of stocks and trends attempts to predict future price movements, providing traders with the information needed to make a profit.
  • Traders apply technical analysis tools to charts in order to identify entry and exit points for potential trades.
  • An underlying assumption of the technical analysis of stocks and trends is that the market has processed all available information and that it is reflected in the pricing chart.

What Does the Technical Analysis of Stocks and Trends Tell You?

Technical analysis is a blanket term for a variety of strategies that depend on interpretation of price action in a stock. Most technical analysis is focused on determining whether or not a current trend will continue and, if not, when it will reverse. Some technical analysts swear by trendlines, others use candlestick formations, and yet others prefer bands and boxes created through a mathematical visualization. Most technical analysts use some combination of tools to recognize potential entry and exit points for trades. A chart formation may indicate an entry point for a short seller, for example, but the trader will look at moving averages for different time periods to confirm that a breakdown is likely.

A Brief History of the Technical Analysis of Stocks and Trends

The technical analysis of stocks and trends has been used for hundreds of years. In Europe, Joseph de la Vega adopted early technical analysis techniques to predict Dutch markets in the 17th century. In its modern form, however, technical analysis owes heavily to Charles Dow, William P. Hamilton, Robert Rhea, Edson Gould and many others – including a ballroom dancer named Nicolas Darvas. These people represented a new perspective on the market as a tide that is best measured in highs and lows on a chart rather than by the particulars of the underlying company. The disperse collection of theories from early technical analysts were brought together and formalized in 1984 with the publishing of Technical Analysis of Stock Trends by Robert D. Edwards and John Magee.

Candlestick patterns date back to Japanese merchants eager to detect trading patterns for their rice harvests. Studying these ancient patterns became popular in the 1990s in the US with the advent of internet day trading. Investors analyzed historical stock charts eager to discover new patterns for use when recommending trades. Candlestick reversal patterns in particular are critically important for investors to identity and there are several other commonly used candlestick charting patterns. The doji and the engulfing pattern are all used to predict an imminent bearish reversal.

How to Use the Technical Analysis of Stocks and Trends

The core principle underlying technical analysis is that the market price reflects all available information that could impact a market. As a result, there’s no need to look at economic, fundamental, or new developments since they’re already priced into a given security. Technical analysts generally believe that prices move in trends and history tends to repeat itself when it comes to the market’s overall psychology. The two major types of technical analysis are chart patterns and technical (statistical) indicators.

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Chart patterns are a subjective form of technical analysis where technicians attempt to identify areas of support and resistance on a chart by looking at specific patterns. These patterns, underpinned by psychological factors, are designed to predict where prices are headed, following a breakout or breakdown from a specific price point and time. For example, an ascending triangle chart pattern is a bullish chart pattern that shows a key area of resistance. A breakout from this resistance could lead to a significant, high-volume move higher.

Technical indicators are a statistical form of technical analysis where technicians apply various mathematical formulas to prices and volumes. The most common technical indicators are moving averages, which smooth price data to help make it easier to spot trends. More complex technical indicators include the moving average convergence-divergence (MACD), which looks at the interplay between several moving averages. Many trading systems are based on technical indicators since they can be quantitatively calculated.

The Difference Between the Technical Analysis of Stocks and Trends and Fundamental Analysis

Fundamental analysis and technical analysis are the two big factions in finance. Whereas technical analysts believe the best approach is to follow the trend as it forms through market action, fundamental analysts believe the market often overlooks value. Fundamental analysts will ignore chart trends in favor of digging through the balance sheet and the market profile of a company in search of intrinsic value not currently reflected in the price. There are many examples of successful investors using fundamental or technical analysis to guide their trading and even those who incorporate elements of both. On the whole, however, technical analysis lends itself to a faster investing pace, whereas as fundamental analysis generally has a longer decision timeline and holding period by virtue to the time going into doing the due diligence.

Limitations of the Technical Analysis of Stocks and Trends

Technical analysis has the same limitation of any strategy based on particular trade triggers. The chart can be misinterpreted. The formation may be predicated on low volume. The periods being used for the moving averages may be too long or too short for the type of trade you are looking to make. Leaving those aside, the technical analysis of stocks and trends has a fascinating limitation unique to itself.

As more technical analysis strategies, tools and techniques become widely adopted, these have a material impact on the price action. For example, are those three black crows forming because the priced in information is justifying a bearish reversal or because traders universally agree that they should be followed by a bearish reversal and bring that about by taking up short positions? Although this is an interesting question, a true technical analyst doesn’t actually care as long as the trading model continues to work.

Technical Analysis

What Is Technical Analysis?

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.

Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study or price and volume. Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume and implied volatility. Technical analysis is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve there overall valuation estimate.

Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.

Key Takeaways

  • Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts.
  • Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
  • Technical analysis may be contrasted with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.

Understanding Fundamental Vs. Technical Analysis

The Basics Of Technical Analysis

Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s.   Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.

Technical analysis operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules. Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.

Among professional analysts, the CMT Association supports the largest collection of chartered or certified analysts using technical analysis professionally around the world. The association’s Chartered Market Technician (CMT) designation can be obtained after three levels of exams that cover both a broad and deep look at technical analysis tools. Nearly one third of CMT charter holders are also Certified Financial Analyst (CFA) charter holders. This demonstrates how well the two disciplines reinforce each other. 

The Underlying Assumptions of Technical Analysis

There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.

Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.

  1. Markets are efficient with values representing factors that influence a security’s price, but
  2. Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time. 

Today the field of technical analysis builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:

1: The market discounts everything

Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market. 

Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption. 

3: History tends to repeat itself

Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. 

How Technical Analysis Is Used

Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.

Across the industry there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages and momentum indicators.

In general, technical analysts look at the following broad types of indicators:

  • Price trends
  • Chart patterns
  • Volume and momentum indicators
  • Oscillators
  • Moving averages
  • Support and resistance levels

The Difference Between Technical Analysis And Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets and liabilities are all important characteristics to fundamental analysts.

Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.

Limitations Of Technical Analysis

Some analysts and academic researchers expect that the EMH demonstrates why they shouldn’t expect any actionable information to be contained in historical price and volume data. However, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view are known as the weak form and semi-strong form of the EMH.

Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices seem to be better modeled by assuming a random walk.

A third criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophesy. For example, many technical traders will place a stop-loss order below the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.

Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now. In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run this sole group of traders cannot drive price.

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