Technical Analysis

Technical Analysis

It is the analysis of the movement of prices, volumes and open interests - using historical data - based on the study of past behavior of currency, indices and commodities markets.

Technical analysis is a technique used to forecast the future direction of prices through the study of historical market data, primarily price, volume and open interest.

Technical traders use trading information (such as previous prices and trading volume) along with mathematical indicators to make their trading decisions. This information is usually displayed on a graphical chart updated in real time that is interpreted in order to determine when to buy and when to sell a specific instrument.


Dow Theory

The ideas of Charles Dow, the first editor of the Wall Street Journal, form the basis of modern technical analysis. They are based upon three main premises:

  • 1. The price is a comprehensive reflection of all market forces. At any given time, all market information and forces are reflected in the prices.
  • 2. Prices move in trends that can be identified and turned into profit opportunities.
  • 3. Price movements are historically repetitive.
ADVANTAGES OF TECHNICAL ANALYSIS

It requires much less data than fundamental analysis. From price and volume, a technical trader can obtain all the information he needed.|As it is focused on identifying trend reversal, the question of timing to enter a trade is easier to address with technical analysis.

DRAWBACKS OF TECHNICAL ANALYSIS

Technical analysis can become a self fulfilling prophecy. When many investors, using similar tools and following the same concepts, shift together the supply and demand, this can lead to the prices moving in the predicted direction.


Technical and/or Fundamental Analysis

Technical Analysis is one of the most significant tools available for forecasting financial market behaviour. It has been proven to be an effective tool for investors and is constantly becoming more accepted by market participants. When used in conjunction with fundamental analysis, technical analysis can offer a more complete valuation, which can make the difference in executing profitable trades.


Technical Indicators

Trend is the most important concept in technical analysis. A trend designates the general direction of a market movement. It is important to identify trends so that you can trade with them rather than against them.

TYPES OF TREND

A trend may be:

  • Upward – this is called a Rally ; the market trends the way up
  • Downward – this is called a Downtrend ; the market trends the way down
  • Sideways / Horizontal – this is called "flat market" or "trendless" ; the market trends nowhere
TREND LENGTHS

A trend of any direction can be classified according to its length

  • Short-term Trend ; it usually lasts no more than three weeks
  • Intermediate Trend ; it usually lasts somewhere between 3 weeks to several months
  • Long-Term or Major Trend ; it is considered to last for a year or more. It is composed of several intermediate trends, which often move against the direction of the Major Trend
TRENDLINES

A trendline is a simple charting technique that consists of connecting the significant highs (peaks) or the significant lows (troughs) to represent the trend in the market. These lines are used to clearly show the trend and also help in the identification of trend reversals.

A trendline may be classified as:

  • Rising trendline
  • Declining trendline
  • Sideways trendline
CHANNELS

A price channel is the addition of two parallel trendlines that act as strong areas of support and resistance. One trendline connects a series of price highs while the other connects a series of lows. A channel can slope upward, downward or sideways. Traders expect a given security or currency to trade between the two levels of support and resistance until it breaks beyond one of the levels. They used channel lines to point out where to place "take profit order" and "Stop Loss Order".


Chart

A price chart is a sequence of prices plotted over a specific time frame. On the chart, the vertical axis represents the price scale while the horizontal axis represents time.


Chart properties

When looking at a chart, there are several factors that you should be aware of as they affect the information that is provided. They include the time frame and the price scale used.

TIME FRAME

Each bar, candlestick or dot in a chart contains information regarding a defined time interval. The length of this interval is the chart interval.

Deciding on which chart interval to use depends on your trading style and investment horizon. Day traders may use chart intervals as short as 1 minute, while swingers (traders that hold trades between several days to a couple of weeks) usually use intervals varying from several hours to a day.

PRICE SCALE

There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic.

On an arithmetic price scale, each price point is separated by the same vertical distance no matter what the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 100 over a 6-month period, the move from 10 to 20 (+100% variation) will appear to be the same distance as the move from 90 to 100 (+11% variation). Even though this move is the same in absolute terms, it is not the same in percentage terms.

On a logarithmic scale, each price point is separated by a vertical distance that is equal in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale.


Type of Charts

There are three main types of charts that are used by traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart and the candlestick chart.

LINE CHART

INTERPRETATION: The line chart is the most basic type of chart. The line shown in the chart connects single prices over a selected period of time. The most popular line chart is the daily chart. Although any point in the day could be plotted, most traders focus on the closing price, which they consider the most important. However this presents an immediate problem; using a daily line chart, one cannot see the price activity that occurred during the rest of the day.

BENEFIT: A line chart gives the trader a fairly good idea of where the price of an asset has traveled over a given time frame.

BAR CHART

INTERPRETATION: Each vertical bar represents one period of price activity from the chosen periodicity, which could be as short as 1 minute for intraday charts, or as long as several years for historical charts. On a daily chart, the vertical bar represents one day's trading whereby:

  • the top of the bar represents the market's high price
  • the bottom of the bar represents the low
  • the left hash mark on the bar indicates the opening price
  • the right hash mark on the bar indicates the closing price

BENEFIT: By including open, high, low and close information, bar charts allow more detailed analysis than standard line charts.

CANDLESTICK CHART

INTERPRETATION: The candlestick chart is closely related to the bar chart, as it also represents the four major prices: high, low, open, and close. Each candle represents a timescale of your choice. The following timescales are offered by different chart software: 1 min, 15 min, 30 min, 1 hour, 2 hour, 4 hour, 8 hour, daily, weekly and monthly.

For a daily chart, each candlestick represents one day's trading range and is displayed as "open" or "closed":

  • An open candlestick represents a higher close than open and is shown in blue.
  • A closed candlestick represents a lower close than open and is shown in red.
  • Each candlestick consists of two components, the real body and the shadows.
  • The real body is the thick part of the candlestick that represents the open and the close.
  • The thin lines above and below the real body are the shadows that represent the session's price extremes. The upper shadow (above the real body) measures the high of the session and the lower shadow (below the real body) measures the low of the session.

BENEFIT: The candlestick chart is the most common chart used for technical analysis. Many trading strategies are based upon patterns in candlestick charting.