Technical Analysis

Charting the Course of Price Movements

Technical analysis offers a contrasting approach to fundamental analysis, focusing on historical price and volume data to attempt to predict future price movements.

Basic Tenets of Technical Analysis :

• Market Discounts Everything: All known information is reflected in the price.
• Prices Move in Trends: Prices move in sustained directions (up, down, sideways).
• History Tends to Repeat: Patterns and behaviors recur.

Tools of Technical Analysis:

1. Charts: Visual representations of price data.

   • Line Chart : Connects closing prices. Simplicity is its asset.
   • Bar Chart : Shows OHLC (Open, High, Low, Close). Example: See previous iterations.
   • Candlestick Chart : Shows OHLC with "body" and "wicks" (tails). Key patterns include:
     • Doji: Small body, long wicks. Signals potential reversal.
     • Hammer: Small body at the top, long lower wick. Bullish reversal signal.

   

   • Point and Figure Chart: A more customized chart without a time aspect.

3. Technical Indicators:

   • Moving Averages (SMA & EMA):
     • Example: A 50-day SMA is often used to gauge the intermediate-term trend of a stock. A stock consistently above its 50-day SMA might be considered in an uptrend.

* Relative Strength Index (RSI): * Example: If the RSI is above 70, the stock is “overbought,” which could indicate an oncoming correction. If it’s below 30, then the stock is likely oversold. * Bollinger Bands: * Example: A strong surge towards the upper Bollinger band is a bullish signal and vice versa. * MACD: * Example: When the MACD line crosses above the signal line, it is a bullish signal (buy). When it crosses below the signal line, it is a bearish signal (sell).

4. Trendlines and Channels: One of the foundations of TA

   • The direction of the line must always be correct to be effective and tell the correct information.
   • Example: A price chart is clearly trending upwards if its price, with oscillations, is consistently moving higher. Conversely, if the peaks are consistently moving lower, then it’s trending downwards.

5. Volume Analysis

   • Volume precedes price

     • To properly assess the current position of the market, volume must be looked at before price.

     

6. Fibonacci Retracements:

   • Uses Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, 78.6%) as potential support or resistance levels.
   • Example: If a stock retraces to the 61.8% Fibonacci level after an upward move, it may find support there and resume its uptrend.
   • Note: The golden ratio is 61.8%, is one of the most accurate measurements in TA.

6. Chart Patterns:

• These are geometric shapes formed on price charts that suggest future price movements.

  • Head and Shoulders:

    • Example: The stock price is a shoulder, then goes high to form a new shoulder, and a new high. It’s a signal that the upwards trend is done. Look to see if it goes down after this.

  • Inverse Head and Shoulders :

  • Double Top and Double Bottom :

  • A clear signal that the price action has been tested and a new direction is upcoming.

  • Triangles:

  • Is generally a continuation pattern, with one side remaining flat.

  • Flags and Pennants

    • Indicate the prior trend is likely to resume once the pattern completes.

• The Dow Theory: The Dow Theory helps analysts to define and predict broad market trends, but is not a precise tool for short-term predictions.

Limitations of Technical Analysis :

• Subjectivity: Interpretation varies.

• Lagging Indicators: Indicators confirm after the fact.

• Short-Term Focus: Best for short-term trading.

• Self-Fulfilling Prophecy: Patterns can become self-fulfilling. If enough think that patterns will work, their very volume can cause such to happen.

• Efficient Market Hypothesis (EMH) Challenge: EMH suggests technical analysis is ineffective.

• Novel Events cannot be foreseen - TA is based on past data.

• New Data Nullification: new data can nullify prior data and thus create false results. TA is, therefore, most effective if all prior data is accurate and complete.

Key Points:

• Use in conjunction with other forms of analysis.
• Combine multiple indicators and patterns.
• Acknowledge the limitations.

In summary, technical analysis provides a framework for identifying potential trading opportunities by studying historical price and volume data. However, it's important to use it with caution and to understand its limitations. A blended approach is generally considered more effective. Furthermore, one needs to be on guard that there is never a certainty of returns using TA.