TECHNICAL ANALYSIS – AN INTRODUCTION
Technical analysis is the study of market data such as historical and current price data and volume in an effort to forecast future market activity. Historical price data is the most commonly used available data that is implemented into the analysis.
Historical market data is saved and forms charts over various periods of time. The technical trader can analyze varying periodical charts over a specific length of time for the basic purpose of picking the entry and exit levels of a trade. By studying the chart the chartist is able to get information at a glance that will hopefully represent the direction of the instrument in the future.
There is a never-ending argument between fundamentalists and technical analysts about which method of analysis will show the best results. Technical analysts will claim that all the fundamentals are already built into the price and so, apart from natural disasters and unexpected world events, the current price shows the market's expected value taking all the known information into consideration. The chartists are in fact looking for patterns or repetitions in price movements to guess the likely outcome of future prices. In a word, they are looking for trends.
Technical analysis assumes three main points:
1. Fundamentals are already built into the price
2. History has a habit of repeating itself – find what happened in the past and project it into the future.
3. Trends are key – establish whether the instrument is moving in a trend, and then follow it. Typically there are three variations: upward, downward or sideways. Once the type of trend is established, an entry point is picked for the commencement of the trade.
Over the years various mathematical manipulations were placed upon market prices and volumes. Theses manipulations (known as studies) helped the technical analyst focus on identifying the trend and the entry and exit levels.
As with any analysis, discipline is the most important aspect of the study. If your studies showed that something was to occur, then follow your studies – do not let the market change your plan. If you were wrong then you were wrong, but stick to your game plan. (see Technical Trading Tips and Guide to Trading for helpful hints to trade).
CHARTS - TYPES
There are three main types of charts: line, bar and candle.
- Line charts are the most basic and simply join one period closing price to another.
- Bar charts give more detail than a regular line chart in that each period is represented by a bar. The bar not only shows price movements from one period to the next, they also show price movements within the period itself.
- Candlestick charts. These are very similar to bar charts except the colored bodies are able to give the viewer greater detail in movements within the period at a glance. Each period is made up of a candlestick – the candlestick is made up of a body and a wick on both ends. The candle body is then colored (typically red and either blue or green). The wick represents the high and low of the period, while the body represents the open and close of the period, the color lets us know if the price rose or fell in that period. If the candle body is red then the top of the candle represents the opening price and the bottom the closing, a green or blue candle would represent the opposite - the top of the candle would be the closing while the bottom would be the opening.
Past results are not indicative of future results and the examples are not representative of all customer accounts.
PERIODS
Charts are viewed as a sequence of periodical prices. The fastest moving chart is a tick chart. Tick charts can only be seen in a line format since the low, high, opening and closing price during that period are one and the same. Every point on the chart represents one tick or one price quote. The next period is usually a 1-minute chart and then periodically higher: 5 minutes, 10 minutes, 30 minutes, 1 hour, 4 hours, daily, weekly and monthly.
The longer the period, the slower the chart. Longer period charts tend to show more stable trends. Shorter period charts tend to be used to pick entry and exit points.
TECHNICAL INDICATORS
There are many different types of technical indicators, however they can be grouped into five categories:
1. Trend Indicators: As mentioned before, trends show the persistence of price directions, either upwards, downwards or sideways. Trend indicators smooth out the historical prices to show market direction. The most common of these are Moving Averages. Simple trend lines can also be used to the same effect by drawing a line that joins the low and high points over a period of time; these are also used to form tunnels and triangles as popular means of analysis. Trend lines are also used to pick support and resistance levels.
2. Strength Indicators: This is essentially a volume indicator and more popular in futures markets than in foreign exchange. The most popular of these is Volume.
3. Volatility: This measures and shows fluctuations over a period of time. These indicators help to pinpoint support and resistance levels. The most popular of these is Bollinger Bands.
4. Cycle: These indicators tend to find patterns or, more correctly, repetitious cycles. Once again, this is more popular in other financial markets. The most popular cycle indicator is the Elliot Wave.
5. Momentum or Oscillators: These indicators map the speed at which prices move over a given period of time. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. The most popular momentum indicators are the Stochastic, MACD and RSI.
COMMONLY USED TECHNICAL INDICATORS
Moving Averages
Moving averages are trend indicators and are used by traders as a tool to verify existing trends, identify emerging trends and signify the end of trends. Moving averages are smooth lines that enable the trader to view long-term price movements without the short-term fluctuations. Of the three types of moving averages, the most common is the simple moving average; the other two are the weighted and exponential moving averages.
All the moving averages are calculated as the average of a specified number of either low, high or closing prices of the period. The difference between the three types is the weighting or importance placed on each particular period. For example, the weighted and exponential moving averages give greater importance to the latest prices, whereas the simple moving average gives equal importance to all the periods chosen.
Each new point of the moving average drops off the oldest period and brings in the newest period. A moving average line will change depending on the number of periods chosen – the greater the number the slower the average. Some traders will play with a different number of moving averages, all with different periods, until they find a series of moving averages that they feel best indicates the behavior of the particular instrument being studied.
When choosing a moving average to work with, ideally in an upward trending market the current price should not fall beneath the moving average line chosen more than once. The moving average should form a support line during upward trends and a resistance line during downward trends. If the upward trend continues, yet it breaks the moving average line on more than one occasion, then it is a good indication that the moving average line chosen is too fast, and has not been smoothed out enough. If, for example, a 30-day moving average was used, then a 45-day moving average may be more appropriate for this particular instrument.
Once a trader is content with the behavior of the moving average line against the actual prices, he may use the line to signify the continuation of a trend or the end of a trend. If the price closes below the moving average line on two occasions in an upward trending market, it is an indication of the end of the trend and time to exit a long position. The same logic follows in a downward trending market except in reverse: the current price needs to close above the moving average on two occasions to indicate that the downtrend is over.
Another way of using moving averages is in pairs. Many traders will first find the long-term moving average as described above and add a faster moving average (smaller period) as an even earlier indication of the end of a trend. If the shorter moving average crosses the slower moving average, it may signal an earlier exit point for a trend.
The most commonly used stochastic is the slow stochastic. Stochastic oscillators are also used to determine either the strength of a trend or when the end of a trend is approaching. Stochastics are displayed by two lines known as %K (faster) and %D (slower) that oscillate between a scale ranging from 0 to 100.
The mathematics behind the oscillators is unimportant; what is important is the meaning and placement of the lines. When the lines cross above the 80 line, it represents a strong upward trend; when they cross below the 20 line, it represents a strong downward trend. When the %K line crosses over the %D line it could indicate a change in the trend, and a possible exit point. When prices are fluctuating, a normal appearance for the stochastics will be for them to cross over one another in mid range – which indicates the lack of a trend.
The stochastics give their best signal when both the lines are moving to new ground at the same time as the actual price. This is a good indication of the continuation of a trend. However when the stochastics cross in a different direction of a prolonged trend this could be an indication to either exit or switch directions.
RSI is another momentum oscillator. RSI attempts to pick reversals in the trend. As with Stochastics, they are read on a scale between 0 and 100. A reading above 80 indicates an overbought market and readings below 20 indicate an oversold market. Trading on RSIs should occur only when there is a direction change above or below the 80 and 20 lines, as RSI lines can often remain above or below the 80, 20 levels for prolonged periods of time during strong trending markets.
The shorter the RSI period, the faster it will be and the more signals will be issued. Here a trader needs to find his balance. Day-traders will often use shorter lines for more regular signals and longer-term traders will use longer RSIs.
Bollinger Bands are volatility indicators and are used to identify extreme highs or lows in relation to the current price.
Bollinger Bands are based on a set number of standard deviations from the moving average. It essentially tries to indicate support and resistance levels or bands of expected trading.
As with the moving average, here too the trader can pick and adjust the moving average on which to base his Bollinger Bands and the number of standard deviations to use. The trader can adjust these over time to suit his individual trading style. The default used is usually a 20-day moving average and two standard deviations from the moving average.
A break above or below the Bollinger Bands may show an exit point or a reversal.
MACD is an enhanced study of the moving averages and behaves as an oscillator. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning that when the MACD crosses below this trigger it is a bearish signal, and when it crosses above it, it"s a bullish signal.
Traders use the MACD for trend reversals. For instance, if the MACD indicator turns higher while prices are still falling, this could be an exit point and a possible reverse trade.
Fibonacci retracement levels are a sequence of numbers that indicate changes in trends from previous peaks or troughs. After a significant price move, prices will often retrace a significant portion of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci retracement levels.
In the forex trading markets, the commonly used sequence of ratios is 23.6%, 38.2%, 50% and 61.8%. Fibonacci retracement levels are drawn by joining a trend line from a significant high point to a significant low point. The pullback simply represents a correction in the trend and not an end to the trend. The most significant pullbacks are the 38.2%, and 61.8% levels.
Source: http://www.avafx.com
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