Today's course will look at the importance of technical analysis. In fact, if spread betting has been the trading instrument phenomenon of the past few years, technical analysis, and in particular charting, has been the leading way to research the phenomenon in recent times. In some ways this was bound to happen, given that we have apparently finished a series of decades when the only direction for shares was up. Read on, and find out what makes charting so popular.
There are two good reasons why you should consider technical analysis.
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Brokers' buy notes and tips in the late 1990s were correct, not because of their analysis, but because of the up trend of the market. Now the trend has changed and the shortcomings of fundamental research is being revealed. Chartists are now credited with predicting the bear market - and how long it will last.
The problem that has been highlighted in a bear market is that much of the financial world is geared to markets going up and has a vested interest in them doing so. There are only two main groups that are not bothered whether this is happening or not: chartists and spread betters. Chartists are only really concerned with being seen to predict the markets correcting and spread betters are happy as long as it moves enough for them to trade quickly and successfully.
Technical analysis is the study of price action and behaviour that bases trading decisions purely on historical data. It works in all timeframes, from years to intra-day, giving rise to the growing band of day traders who trade minute-to-minute fluctuations. The widespread availability of software that specialises in allowing traders to chart and analyse price information as well as trawl markets for the best buy and sell opportunities in equities, indices and commodities is tailor-made for those who spread bet.
Unlike fundamental analysis, where hours may have to be spent reading and comparing differing opinions on a certain market, technical analysis can narrow choices into a few specific ideas within minutes, as well as provide stop loss and profit target points.
For an explanation of why technical analysis works on an index please refer to this article.
Charting is the visual part of technical analysis, where it is assumed that price trends and patterns can be relied upon to provide an insight into the future.
Trading software and financial websites have meant that almost everyone has access to charts of the share or markets that they are interested in. To the beginner, most charts resemble a random walk through time rather than anything that could provide any predictive clues. The trick, if there is one, is to identify trends and price formations to form a logical conclusion about what could happen next. The mistake that most beginners make is to not have decided before they put on a trade where their stop loss and target is. Charting is about tilting probability in your favour, but being prepared if prices turn against you.
Charts are a trading fingerprint. They include every buy and every sell traded in the market.
In the past couple of years Vodafone has fallen around 300p. In this time there have only been a handful of broker 'sell' recommendations, but tens of 'buys'. If you had followed fundamental research, you would have held on to the shares and would now be sitting on a big loss. But, given that the share has been in a downtrend for years, you would have been hard-pushed to find a chart that would have said buy.
You are able to manage risk by knowing what your maximum loss should be and your profit target should be before you take a position. Charting is ideal for this in that it provides a valid market level based on support levels and resistance levels.
You can display the price action of a chart in several different ways. A popular option is the bar chart, because it displays the greatest amount of information. As well as the open/high/low/close of the day/week/month, you can pinpoint support and resistance levels.
Let's take a look at the major chart types. The first three show Vodaphone's past performance.
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The simplest form of chart connecting end of day/time period closes.
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The open high, low and close of the day are represented in bar charts. This chart is used to determine the strength of price movement over the time period in question. The tick on the right side of the bar represents the close.
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A Japanese version of the bar chart, where a lower close than open on a day/time period is shaded dark and a higher close is left light.
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The most famous chart pattern of them all. Rising markets are generally characterised by up trends that demonstrate higher highs and higher lows. The term head and shoulders describes the pattern seen when a market fails to make a higher high. This is termed the right-hand shoulder of the formation. If, following this lower high a lower low also made, taking the price below the neckline, this is regarded by chartists as a sell signal.
The trend line is based on connecting at least two support or resistance points. The question is where? In fact, these can just about be any two points on a chart. It is best to regard them as your guess as to where the market is headed over any particular timeframe. It may sound strange, but it does not really matter, because if you get it wrong, the trend line will be broken and your particular theory of where the market is going will be proved wrong. Hence, the concept of the 'natural' stop loss, one that many a fundamentalist would love to have.
Surprisingly few shares are in an obvious trend and even when they are, you need to be able to identify the best buy/sell points so the position doesn't go against you as soon as you enter it. Draw trend lines and price channels that best fit the chart. Then use end-of-day closes below/above these lines as entry and exit points, even if they eventually prove to be only temporary.
In determining a trend you use price-action analysis.
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Support and resistance levels represent points where a market has temporarily formed a top or a bottom. For instance, with the FTSE 100 the autumn of 2002, this could be regarded as 3,600 in terms of the support area and 4,450 for the resistance. Spread betters and traders can use these levels as profit targets, depending on whether they are bullish or bearish.
Most shares occupy 'ranges', in the sense that statistically they spend over 80% of their time in such a state. Even if a share has bounced off support and resistance levels many times, you can make life simple for yourself by buying and selling these levels.
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In general, the more narrow the range the more powerful the breakout - for example, the FTSE 100 break below 5,000. Choose ranges where you can afford a stop loss below/above the width of the range. In the case of the Abbey chart, you see a trend line breakout where you would stop loss yourself out if the share price fell back below the trend line.
You can get live spread bet prices from all the major players. There are decent charts from spread betting firms Cantor, IG Index and City Index on their trading platforms. However, Deal4free's charting system beats them. Nevertheless, all the sites are still not good enough to rely on if you are serious about charting.
For these purposes, and for testing trading systems and ideas, you will still need to have a decent datafeed and charting software, especially if you are trading the index futures or foreign exchange. For UK and US shares, if you don't want to spend £100 a month or more for realtime data, you may want to look to ADVFN.com, Updata or Market Eye.
In terms of value, Esignal's datafeed is certainly on excellent option, on the basis of its automated Elliott Wave analysis. This is particularly handy for subscribers to Spread Trader, whose technical analysis is based on the Elliot Wave pattern. But it should be remembered that it is longer term traders who tend to win at the expense of the day traders. Daily charts that are available on all major financial websites should be enough for most people to start with if they need anything more than what is available on the spread betting websites themselves.
Well, by now you know all the basics of trading. And you also know how to choose your trades - by using both fundamental and technical analysis. But which spread betting company is the right one for you? Or should you choose even more than one firm to spread bet with? All will be revealed in the next course, where we evaluate the best spread betting companies in the UK.