Technical Analysis

Introduction

When it comes to stock analysis, there are two main schools of thought: Fundamental analysis and technical analysis. 

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. 

Market Action includes the three principal sources of information available to the technical analysts - price, volume and open interest. 

Technical analysts "technician" believes on the following three premises:

  • Market action discounts everything

The technician believes that anything that can possibly affect the price - fundamentally, politically, psychologically or otherwise is actually reflected in the price of the underlying securities

  • Prices move in trends

One popular phrase we heard is "A trend is your friend until it bends". A simple approach to trading is by following the trend. 

This is because a trend in motion is more likely to continue than to reverse.

  • History repeats itself

The key to understanding the future lies in a study of the past, or that the future is just a repetition of the past. Chart pattern, for example, reflect certain pictures that appear on a price charts. These patterns reveal the bullish or bearish psychology of the market. 

One key characteristic that made Technical Analysis is different from Fundamental Analysis is, the fundamentalist studies the cause of market movement while the technician studies the effect.

Why Technical Analysis seems to be working? 

This goes back to the argument of efficient market hypotheses where based on Random Walk Theory, price changes are serially independent. However, due to the certain amount of randomness or "noise" in all markets, it is just unrealistic to believe that all price movement is random. 

What to look for
  • Focus on price action - by focusing on price, you're focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. In addition price action tells the story of supply and demand of a certain underlying security

Strengths and Weaknesses 
  • Analyst Bias - technical analysis is subjective and our personal biases can be reflected in the analysis. In addition, Tehnical Analysis is open to interpretation

Technician would approach Technical Analysis from a Top-Down Approach. That means: 

  • Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ, NYSE Composite, FTSE or KLSE Composite depending on the market we are looking at

  • Sector analysis, such as Technology, Manufacturing or Retail, to identify the strongest and weakest groups within the broader market

  • Individual stock analysis to identify the strongest and weakest stocks within select groups

For each segment of the analysis, the overall market, sector or stock, a technician would analyze long-term and short-term charts to find those that meet specific criteria.

 

Analysis will first consider the overall general market. If the general market is in a bullish mode, analysis would proceed to a selection of sector charts.

 

Those sectors that show the most promosing would be singled out for individual stock analysis. Typically technician will narrow to 2-3 industry group. 

 

With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made.

 

Number of stocks or industry groups that will be analyse further in detail will depend on the strictness of the criteria set forth. 

The world of Technical Analysis is wide, but to give readers some flavors, here are some basic Technical Analysis:

Overall Trend:

 

The first step is to identify the overall trend.

 

To identify, technician will use trend lines or moving averages.

 

For example, the trend is up as long as price remains above its upward sloping trend line or a certain moving average.

Support:

 

Consider it as the "floor" in the price movement.

 

It is the area of congestion and previous lows below the current price mark the support levels. A break below support would be considered bearish and detrimental to the overall trend.

Resistance:

 

Consider it as the "ceiling" in the price movement.

Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish and positive for the overall trend.

Momentum:

 

Momentum is usually measured with an oscillator such as RSI, MACD, CCI and Stochastic. If the oscillator line is above certain threshold, then momentum will be considered bullish, or at least improving.

Buying/Selling Pressure:

For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.

Relative Strength:

 

The price relative is a line formed by dividing the security by a benchmark. Relative Strength indicates stock is outperforming (rising) or under performing (falling) the major index.

The final step is to synthesize the above analysis to ascertain the following:

  • Strength of the current trend.

  • Maturity or stage of current trend.

  • Reward to risk ratio of a new position.

  • Potential entry levels for new long position.

  • Support/Resistance - if prices move and breaks the resistance, demand is winning and price normally will make a new high

  • Pattern and Volume tell the story - ability to identify reactions prior to and after an important event, volatility, psychology of the market and relative strength of a stock versus the overall market

  • Assist in entry point - timing can play an important role in performance. Technician uses among others demand (support) and supply (resistance) levels as well as breakouts to identify timing to buy or sell a stock

  • Too late - some signal are late. By the time the trend is identified, a substantial portion of the move has already taken place

  • No one rule fits all - what works for one particular stock may not work for another