What is technical analysis?
Technical analysis is the study of financial market action. The technician looks at price changes that occur on a day-to-day or week-to-week basis or over any other constant time period displayed in graphic form, called charts. Hence the name chart analysis.
A chartist analyzes price charts only, while the technical analyst studies technical indicators derived from price changes in addition to the price charts.
Technical analysts examine the price action of the financial markets instead of the fundamental fac- tors that (seem to) effect market prices. Technicians believe that even if all relevant information of a particular market or stock was available, you still could not predict a precise market “response” to that information. There are so many factors interacting at any one time that it is easy for important ones to be ignored in favor of those that are considered as the “flavor of the day.”
The technical analyst believes that all the relevant market information is reflected (or discounted) in the price with the exception of shocking news such as natural distasters or acts of God. These fac- tors, however, are discounted very quickly.
Watching financial markets, it becomes obvious that there are trends, momentum and patterns that repeat over time, not exactly the same way but similar. Charts are self-similar as they show the same fractal structure (a fractal is a tiny pattern; self-similar means the overall pattern is made up of smaller versions of the same pattern) whether in stocks, commodities, currencies, bonds. A chart is a mirror of the mood of the crowd and not of the fundamental factors. Thus, technical analysis is the analysis of human mass psychology. Therefore, it is also called behavioral finance.
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Technical analysis pre-empts fundamental data
Fundamentalists believe there is a cause and effect between fundamental factors and price changes. This means, if the fundamental news is positive the price should rise, and if the news is negative the price should fall. However, long-term analyses of price changes in financial markets around the world show that such a correlation is present only in the short-term horizon and only to a limited extent. It is non-existent on a medium- and long-term basis.
In fact, the contrary is true. The stock market itself is the best predictor of the future fundamental trend. Most often, prices start rising in a new bull trend while the economy is still in recession (position B on chart shown above), i.e. while there is no cause for such an uptrend. Vice versa, prices start falling in a new bear trend while the economy is still growing (position A), and not providing fundamen- tal reasons to sell. There is a time-lag of several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock market and the economy, but also for the price trends of individual equities and company earnings. Stock prices peak ahead of peak earn- ings while bottoming ahead of peak losses.
The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trend.
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Mood governs ratio
Know yourself and knowledge of the stock market will soon follow. Ego and emotions determine far more of investors´ stock market decisions than most would be willing to admit.
For years, we have dealt with professional money managers and committees and found they were as much subject to crowd following and other irrational emotional mistakes as any novice investor. They were, for the most part, better informed, but facts alone are not enough to make profitable deci- sions. The human element, which en-
compasses a range of emotions from fear to greed, plays a much bigger role in the decision-making process than most investors realize.
In a practical sense, most investors act exactly opposite to the rational wisdom of buying low and selling high based on very predictable emotional responses to rising or falling prices. Falling prices that
at first appear to be bargains generate fear of loss at much lower prices when opportunities are the greatest. Rising prices that at first appear to be good opportunities to sell ultimately lead to greed- induced buying at much higher levels. Reason is replaced by emotion and rationalization with such cyclical regularity, that those who recognize the symptoms and the trend changes on the charts can profit very well from this knowledge.
Investors who manage to act opposite to the mood of the crowd and against their own emotions are best positioned to earn money in the financial markets. Financial risk and emotional risk correlate inversely.
Optimism, pessimism, greed and fear
Why aren´t more people making more money in the financial markets? Because, as we have seen, people are motivated by greed (optimism) when buying and by fear (pessimism) when selling. People are motivated to buy and sell by changes in emotion from optimism to pessimism and vice versa. They formulate fundamental scenarios based on their emotional state (a rationalization of the emo- tions), which prevents them from realizing that the main drive is emotion.
The chart above shows that if investors buy based on confidence or conviction (optimism) they BUY near or at the TOP. Likewise, if investors act on concern or capitulation (pessimism) they SELL near or at the BOTTOM. Investors remain under the bullish impression of the recent uptrend beyond the forming price top and during a large part of the bear trend. Vice versa, they remain pessimistic under the bearish impression from the past downtrend through the market bottom and during a large part of the next bull trend. They adjust their bullish fundamental scenarios to bearish AFTER having become pessimistic under the pressure of the downtrend or AFTER having become optimistic under the pres- sure of the uptrend. Once having turned bearish, investors formulate bearish scenarios, looking for more weakness just when it is about time to buy again.
The same occurs in an uptrend when mood shifts from pessimism to optimism. Investors formulate bullish scenarios AFTER having turned bullish, which is after a large part of the bull trend is already over. Emotions are the drawback of fundamental analysis. Investors must learn to buy when they are fearful (pessimistic) and sell when they feel eu- phoric (optimstic). This may sound easy (simple contrary opinion), but without Technical Analysis it is hard to achieve.
The main purpose of technical analysis is to help investors identify turning points which they cannot see because of individual and group psychological factors.
- Bar charts
Four bar charts of the Swiss Market Index are shown above. They are the most widely used chart types.The bar charts are: High-low charts orHigh-low-close charts or Open-high-low-close chartsOne single bar shows the high and the low of the respective trading period. A vertical bar is used to connect the high and the low. Horizontal lines are used to show the opening price (left) of that spe- cific trading period and the closing price (right) at the end of the period. For example, on the monthly chart, a bar indicates the high and the low at which the SMI traded during that single month.
Line charts
Sometimes we use line charts, especially for Elliott wave analysis. A line chart is the simplest of all methods. It is constructed by joining together the closing price of each period, for example daily closings for the daily line chart, weekly closings for the weekly chart or monthly closings for the monthy line chart.
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Support and resistance
Resistance lines are horizontal lines that start at a recent extreme price peak with the line pointing horizontally into the future. Support lines are horizontal lines that start at a recent extreme of a cor- rection low and also point toward the future on the time axis. An uptrend continues as long as the most recent peak is surpassed and new peak levels are reached. A downtrend continues as long as past lows are broken, sustaining a series of lower lows and lower highs. Notice that the previous support often becomes resistance and resistance becomes support. A resistance or a support line becomes more important and breaks above or below these lines gain more credibility as the number of price extremes (peaks for resistance; or lows for support) that can be connected by a single line increases.
Some examples for Microsoft are shown on the chart above. Microsoft reached a high of 19 in July 1997. The price started to correct from there and Microsoft remained below this level until February 1998. The 19 level became the resistance, meaning that only if 19 (the highest peak so far in the uptrend) had been broken on the upside would the stock have confirmed its uptrend. The same is true for the peak at 30 in July 1998. The uptrend was confirmed when the price rose above this resistance in November 1998.
Support levels are positioned for example at 11, 15, 20.5 or 22. As long as the price pushes above past peaks (resistance levels) and holds above past support levels (does not break them) the uptrend remains intact. The same is true for the bear trend. The downtrend remains intact as long as the price falls below the recent lows (support levels) and fails to rise above past resistance levels.
A bearish trend reversal occurs when the price breaks through the most recent support after failing to rise above the most recent resistance. A bullish trend reversal occurs when the price penetrates the most recent resistance after holding above the most recent support.
Trendlines
Resistance levels can either be drawn by horizontal lines (as discussed on the previous page) or can be uptrending or downtrending lines.
The trendline is nothing more than a straight line drawn between at least three points. In an upmove the low points are connected to form an uptrend line. For a downtrend the peaks are connected. The important point is that it should not be drawn over the price action. Trendlines must encorporate all of the price data, i.e. connect the highs in a downtrend and the lows in an uptrend.
The trendline becomes more important and gains credibility as the number of price extremes that can be connected by a single line increases. The validity and viability of a line that connects only two price extremes (for example the starting point and one price low) is questionable.
The trend is broken when the price falls below the uptrend line or rises above the downtrend line. Some analysts use a 2-day rule, meaning that the trend is only seen as broken if the price closes above/below the trendline for at least two days. Others use a 1% stop (could be higher depending on market volatility), meaning the trend is only seen as broken if the price closes over 1% above/below the trendline.
The chart above shows Intel´s rise from July 1996 to March 1997. Based on the uptrend line, inves- tors would have held onto the position from around 38/40 until 66 or even 74/76. Most often inves- tors take profits much too early. Stay with a trend until it breaks, avoiding the urge to sell too soon because the profit could be higher than you originally thought.
Investment horizons
The charts on the previous pages show that investors require perspective. It is imperative to differen- tiate between a short-term, a medium-term and a long-term trend. If somebody tells you to buy the US dollar because it is likely to rise, make sure you understand whether the dollar is expected to rise over a few days or a few months and if you should buy the dollar with the intention to hold it for several days, several weeks or several months.
For a technician on the trading floor, the long-term horizon is entirely different from that of an institu- tional investor. For a trader, long-term can mean several days, while for the investor, it can mean 12 to 18 months.
We can compare the charts and indicators to a clock (shown above). Short-term trends (the seconds) are best analyzed on daily bar charts. Medium-term trends (the minutes) are best seen on weekly bar charts and long-term trends (the hours) are best seen on monthly bar charts. Some investors only want to know the hour, some want to know the seconds and some want to know the exact time.
The best investment results are achieved when all three trends on the daily, weekly and monthly charts point in the same direction.