Technical Analysis

A Technical Trader trades only on price information. In fact a true technical trader could make money sitting in a windowless room with no information coming in except price (and in some cases volume) information. So this means no news, no commentaries, no CNBC, no newspapers, no conversations – nothing except price information.

Such a trader relies only on Technical Analysis to make buying and selling decisions. Technical Analysis then is simply the study of price information.

I particularly like this quote from Wikipedia:

“Traders generally share the view that trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John W. Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes via the use of technical analysis and its concepts.”

The most common format for viewing Technical information is in the form of a picture because human beings process information faster in this format. Thus we have Charts or Graphs. Most traders now use Candlestick Charts. Candlestick charts simply show high, low and close prices in an easily visualized way. Candles that show an advance in the price are green. Candles that show a decline in price are red (sometimes white and black respectively).

Before the advent of computers, charts had to be drawn by hand and were very time consuming. Now charts are created in seconds and include huge levels of detail.

As with any series of numbers, price information can be analyzed using all different types of statistical and mathematical analysis. Some of the most common Technical Indicators are outlined here:

1. Moving Averages

A moving average simply averages the prices in the previous number of periods you are interested in. So for example if you overlay a ten day moving average over a daily chart you will have a line which at any point on that line is the average price of the preceding ten days. It is a lagging indicator which can show a trend change.

2. Relative Strength Index (RSI)

The RSI is a measure of the current and historical strength or weakness of a particular financial instrument. It measure between 0 and 100. In simple terms a reading above 70 shows extreme strength (sometimes considered “overbought”) and a reading below 30 shows extreme weakness (sometimes considered “oversold”). Interestingly William O’Neil notes in his book “How to Make Money in Stocks” that a high RSI score for a stock is a bullish sign.

I was fortunate enough to interview J. Welles Wilder the inventor of the Relative Strength Index. You can read the interview at www.TradingBook.org/trader-interviews.

3. Moving Average Convergence Divergence (MACD)

The MACD shows the difference between a fast and a slow exponential moving average (a type of moving average) of closing prices. Just like a moving average it is a lagging indicator. But it is used to confirm trend changes and the strength of price movements.

NB Technical Traders (including me) often use the RSI and MACD to confirm a price move. If the RSI and MACD move at the same time and in the same direction of the price move, and make corresponding highs (or lows) with the price, this adds weight to the expectation of further prices moves in the same direction.

4. Bollinger Bands

Bollinger bands are used to measure the relative distance of the current price to its standard deviation (statistical distance) and can be compared to a previous standard deviation from the price at an earlier time.
There are three Bollinger Bands consisting of the middle band which is a simple moving average, an upper band which is a specified standard deviation above the middle band, and a lower band which is a specified standard deviation below the middle band. When the outer bands widen out it indicates a trend is underway, and when the outer bands tighten in it indicates no trend is underway.

5. Fibonacci

The Fibonacci sequence is a sequence of numbers that continually appear in nature. It has been reasoned and tested that numbers in the Fibonacci sequence are part of price information and therefore form support and resistance levels in financial instruments. Such analysis had become mainstream. It is especially useful when combined with other technical indicators.

6. Pivot Points

A Pivot Point is simply the average of three numbers:

  • The high price
  • The low price
  • The close price

So a Daily Pivot Point would be the average of the previous day’s high, low and closing prices.

The most common Pivot levels are:

  • Daily Pivot
  • Weekly Pivot
  • Monthly Pivot

It is uncanny how often such points provide support or resistance to prices.

Convergence of two or three pivot points at the same level adds significant strength to the support or resistance.

7. Convergence

It appears that when there is a convergence of different technical indicators pointing to the same or a very similar price point, this does indeed provide support or resistance to prices. So for example a pivot point converging with a Fibonacci level and/or a previous high price or low price, adds strength to the support or resistance of that price level.

Critics argue that such convergence is simply a self fulfilling prophesy i.e. it becomes a support or resistance point simply because so many people have identified it as such.

These are just some of the dozens of technical indicators available on almost all trading platforms.

Every trader develops favorite technical indicators which are usually based on that trader’s personality.

I am a technical trader, in fact I have a rule which is on my wall:

 

Price is King
I will only Trade Price
 
 
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