TECHNICAL ANALYSIS

At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:
·         Price Discounts Everything
·         Price Movements Are Not Totally Random
·         "What" Is More Important than "Why"

One very popular form of technical analysis until the mid-1960s was "tape reading". It consisted in reading the market information as price, volume, orders size, speed, conditions, bids for buying and selling, etc.; printed in a paper strip which ran through a machine called a stock ticker. 

Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future performance.  Technical analysts consider the market to be 80% psychological and 20% logical. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others.

Since a market's price reflects all relevant information, their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Therefore, price action would also tend to repeat itself due many investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.

So based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what investors think of that information, known and perceived.  Technical analysts examine what investors fear or think about those developments and whether or not investors have the wherewithal to back up their opinions; these two concepts are called psych (psychology) and supply/demand. Technicians employ many techniques, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns.  Technicians use various methods and tools, the study of price charts is but one.

Many technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve three steps:

1. Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
2. Sector analysis to identify the strongest and weakest groups within the broader market.
3. Individual stock analysis to identify the strongest and weakest stocks within select groups.

Technical analysis is not limited to charting, but it always considers price trends.  For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment.  Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.

The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2 years. It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart.

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.

Technicians using charts search for archetypal price chart patterns, such as the well-known head and shoulders or double top/bottom reversal patterns, study technical indicators, moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns.

Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in Options (implied volatility) and put/call ratios with price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc.

There are many techniques in technical analysis. Adherents of different techniques (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one technique. Some technical analysts use subjective judgment to decide which pattern(s) a particular instrument reflects at a given time and what the interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to pattern identification and interpretation.

Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, business cycles, stock market cycles or, classically, through recognition of chart patterns.

Charting Terms and Indicators

Concepts:

• Resistance – a price level that may prompt a net increase of selling activity
• Support – a price level that may prompt a net increase of buying activity
• Breakout – the concept whereby prices forcefully penetrate an area of prior support or resistance, usually, but not always, accompanied by an increase in volume.
• Trending – the phenomenon by which price movement tends to persist in one direction for an extended period of time
• Average true range – averaged daily trading range, adjusted for price gaps
• Chart pattern – distinctive pattern created by the movement of security prices on a chart
• Dead cat bounce – the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
• Elliott wave principle and the golden ratio to calculate successive price movements and retracements
• Fibonacci ratios – used as a guide to determine support and resistance
• Momentum – the rate of price change
• Point and figure analysis – A priced-based analytical approach employing numerical filters which may incorporate time references, though ignores time entirely in its construction.
• Cycles – time targets for potential change in price action (price only moves up, down, or sideways)

Types of charts:

• Open-high-low-close chart – OHLC charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.
• Candlestick chart – Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.
• Line chart – Connects the closing price values with line segments.
• Point and figure chart – a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.

Overlays:

Overlays are generally superimposed over the main price chart.

• Resistance – a price level that may act as a ceiling above price
• Support – a price level that may act as a floor below price
• Trend line – a sloping line described by at least two peaks or two troughs
• Channel – a pair of parallel trend lines
• Moving average – the last n-bars of price divided by "n" -- where "n" is the number of bars specified by the length of the average. A moving average can be thought of as a kind of dynamic trend-line.
• Bollinger bands – a range of price volatility
• Parabolic SAR – Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
• Pivot point – derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices
• Ichimoku kinko hyo – a moving average-based system that factors in time and the average point between a candle's high and low

Price-based indicators:

These indicators are generally shown below or above the main price chart.

• Average directional index – a widely used indicator of trend strength
• Commodity Channel Index – identifies cyclical trends
• MACD – moving average convergence/divergence
• Momentum – the rate of price change
• Relative strength index (RSI) – oscillator showing price strength
• Stochastic oscillator – close position within recent trading range
• Trix – an oscillator showing the slope of a triple-smoothed exponential moving average
• %C – denotes current market environment as range expansion or a range contraction, it also forecast when extremes in trend or choppiness are being reached, so the trader can expect change.

Breadth Indicators

These indicators are based on statistics derived from the broad market

• Advance–decline line – a popular indicator of market breadth
• McClellan Oscillator - a popular closed-form indicator of breadth
• McClellan Summation Index - a popular open-form indicator of breadth

Volume-based indicators

• Accumulation/distribution index – based on the close within the day's range
• Money Flow – the amount of stock traded on days the price went up
• On-balance volume – the momentum of buying and selling stocks