Mark can be reached at www.tradermasterclass.com.
CHAPTER 1
Introduction to the Art and Science of Technical Analysis
After studying this chapter, you should be able to:
• Understand the key concepts underlying technical analysis
• Identify the different forms of chart analysis
• Describe the objectives of technical analysis
• Understand what subjectivity means in technical analysis
• Recognize the strengths and weaknesses of technical analysis
• Categorize market participants according to style and time in markets
• Identify the various styles and approaches in technical analysis
Technical analysis is a fascinating field of study. It is as much science as it is art. Its main strength is that a lot of it is visual, giving practitioners a better feel of the underlying dynamics of the markets. We shall also be looking at the various challenges to technical analysis, their resolution, and how technical analysis affects trading in general. The classification of technical approaches, market participants, and various markets will also be discussed in detail.
1.1 MAIN OBJECTIVE OF TECHNICAL ANALYSIS
It is generally accepted that human beings are born with certain instincts, tempered and molded by evolution via the passing of time. Every human being strives and seeks to fulfill these powerful instinctive forces.
The three main motivational instincts are:
1. The instinct to survive
2. The instinct for comfort
3. The instinct to propagate
The instinct to survive is probably the strongest and most overpowering. Survival almost always precedes the need for comfort or to propagate the species. The instinct to survive includes:
• The instinct to stay alive
• The instinct to satisfy hunger
• The instinct to seek safety, that is, being in a group/herd
• The instinct to avoid danger (by having natural fears like the fear of fire, loud sounds, heights, etc.)
This powerful instinct to survive is the main driving force in life for striving to make a profit. But in order to make a profit to ensure continued survival, there must be a positive change in the actual or perceived value of something that we own. This change in value of some variable may be anything that will allow us to profit from change. One very popular and convenient variable of change is price. We can participate in this price change by satisfying a very simple mechanical rule that will ensure profitability every single time, which is to always buy when prices are low and sell when they are higher, popularly referred to as the buy low, sell high principle. See Figure 1.1.
Figure 1.1 The Mechanics of Profiting from a Change.
Unfortunately, in order to satisfy this simple rule of guaranteed profitability, we need to be able to do more of one thing, which is to be able to determine the direction of price ahead of time in order to know exactly when to buy low and subsequently sell higher. Hence, it is not only the mechanical action of buying low and selling high that counts, but also the timing of the action itself that is critical. This introduces an element of chance or probability into an otherwise fairly straightforward mechanical venture. Profitability therefore requires effective and efficient action in two dimensions, that is, price and time. Traders and analysts keep track of this action using a two-dimensional visualization tool, that is, a price-time chart, which tracks price on the vertical axis and time on horizontal axis.
In short, the ability to forecast or predict price or market action in a reasonably accurate fashion represents one of the skills that may be critical for longer-term success as a professional trader or analyst.
1.2 DUAL FUNCTION OF TECHNICAL ANALYSIS
Technical analysis essentially serves two main functions:
1. For Identification: It identifies and describes past and present price action. It serves as a historical record of what has transpired in the markets. It provides a descriptive representation of market action. This allows the market practitioner to observe how the market has performed in the past, which includes its average volatility over a specified period; its highest and lowest historical price extremes; the common areas of consolidation, average duration, and price excursion of trends; the amount of liquidity and participation in the markets; the average degree and frequency of price gapping; the impact of various monetary economic announcements on price, and so on. This information is especially critical prior to any investment or trading decision.
2. For Forecasting: Once a particular price or market action is identified, the practitioner may now use this information to interpret what the data actually means before inferring future price action. This inference about potential price action is wholly based on the assumption that price patterns are repetitive to some reasonable degree and therefore may be used as a basis for price predictions.
1.3 FORECASTING PRICE AND MARKET ACTION
There are three main approaches to predicting potential future price action or behavior, namely via:
1. Fundamental Analysis
2. Technical Analysis
3. Information Analysis
See Figure 1.2.
Figure 1.2 Three Approaches to Price Forecasting.
Forecasting Stock Prices Using Fundamental Analysis
One way to gauge the potential price of a stock is by analyzing the company’s performance via its financial statements and accounts in order to determine its intrinsic value or the worth of the security in light of all its holdings, debt, earnings, dividends, income and balance sheet activity, cash flow, and so on. This accounting information is normally represented in ratio form, as in price to earnings (P/E), price to earnings growth (PEG), price to book, price to sales, and debt to equity ratios, to name but a few.
The logic is that a strongly performing company should continue to perform well into the future and garner more demand from investors excited to participate in the expected capital gains derived from the stock’s price and appreciating dividend yields. The price of a stock is expected to rise if there are sufficient buyers, signifying a demand for it. Conversely, the price of a stock is expected to decline if there are sufficient sellers, signifying an oversupply in the stock. Demand is potentially generated if the current stock price is below its estimated intrinsic value, that is, it is currently undervalued or underpriced, whereas supply is created if the current stock price is above its estimated intrinsic value, that is, it is currently overvalued or overpriced. See Figures 1.3 and 1.4 for illustrations of using intrinsic value to forecast potential stock price movements.
Figure 1.3 Price Forecasting Based on Intrinsic Value of a Stock.
