Technical Market Indicators and their Workings

Q. What is technical analysis and who are chartists?


A: You will often hear of chartists and technical analysis in the business of spread betting and trading. Technical analysis utilises charts, as opposed to fundamental or quantitative research, to reach investment conclusions. Chartists are persons who study charts that track the performance of a particular index or share and try to identify patterns and trends which can be used to influence future trading decisions. Technical analysts in practice believe that the price action on the chart provides a snapshot of human behaviour and that there are circumstances when this behaviour is predictable. For instance if a market has fallen to a certain price level on a number of different times during a specific period of time and has bounced back every time, then there is a logic rationale that such price level is likely to attract buyers and a trader may be able to use this knowledge to his advantage.

Technical analysis involves the application of methods designed to measure the changes in the net mood or psychology of the market and then return a prediction pf the possible consequences of that interplay. By analyzing chart patterns, chartists are looking for a compelling reason to initiate a trade or to exit an existing one.

How does technical analysis work?

Markets are monitored for subtle shifts in the basic supply-demand equation, and once an 'initial condition' is found that indicates a spot where there is a probable edge, the job simply becomes a matter of setting up an entry trigger, defining initial risk and then learning how to manage a trade properly in response to the market's actions. They typically identify support and resistance levels - a support level being a price which a stock is unlikely to fall into, however should it rupture this level they will sell on the belief that having breached the support level, the stock will continue falling until it reaches the next support point.

Technical analysts (another word for chartists) are less interested in fundamentals like management changes or a company's quarter announcement - they just focus on the price and on how it moves since they believe that prices follow simple patterns and believe that history tends to repeat itself meaning that key price levels of the past may effect how the share price moves in future.

Why does technical analysis work?

Technical analysis is based on two simple concepts -:
  1. A number of investors are earlier than others to recognise value or overvalued assets.
  2. The early investors back their judgements accordingly, ahead of the bulk of investors and in the process create momentum and volume patterns that can be analysed so as to acquire predictive insight.

Technical analysis trading works because you're assessing the supply/demand through price. Speculators and hedgers are entering/exiting the market, all of which are watching price to make decisions. That's why it works. Whether you agree or not on whether charting and technical analysis is important is irrelevant - the fact remains that 80% of the market does. So if you know that most market participants are checking charts, you should keep an eye on them as well, if anything to know how the herd is thinking. Important factors to watch out for are when major support or resistance chart levels are breached, 50 or 200 day-moving averages and price breakouts from key highs or lows. Note that technical analysis is taught all over the world and has several professional bodies, The Society of Technical Analysts and the International Federation of Technical Analysts, to name the leading ones.

Q. Is technical analysis the holy grail that will make the difference?

A: Technical analysis can be very effective in helping traders plan a trade. It is basically another way to help limit risk and identify sound opportunities, and that's the only real way to make net profit through trading I think. No method is perfect and none works all the time but a decent technician can find a trade that you might take and give you the plan for success or failure of that trade.

Note, however that technical signals still average about 50% win: lose (Warwick University have done a lot of study on this) or it would be a license for us all to connect to a simple trading program, leverage to the sky and rake in our fortunes. The investment banks make sure that can't happen. They have the best mathematicians and algorithm programmers on their side to stop us from winning. Think of technical analysis as a way of skewing risk-reward in your favour. If it helps you identify entry and exit trade levels, for instance by risking 20 points to make a 40-point gain, in the long run you tend to come ahead.

What makes technical analysis work is that it assists us with a disciplined process whereby we can enter and exit trades with the ability to keep the 50% losers smaller than the 50% winners. For instance technical analysis helps me to wean me off the emotional attachment to bad positions, which in fact I find incredibly liberating - it is amazing how much poor timing and then dwelling on a bad result can wear you down each day. It feels great to let go of a bad position...

To further improve on this we trade with positive company fundamentals and main market direction. Although I would add that fundamentals will get you into a trade, but by the time the fundamentals change the opportunity to leave a trade is normally long gone, for which we need charts.

Combine all three and :-)))

As such technical indicators have their uses. I traded Bund futures using nothing but charts for a while, a technical analysis guru did the analysis and I did the trading. We didn't make enough money to cover expenses, so we pulled the plug on it. I just wish I had a penny for each time I read a technical analysis piece that, edited to cut out the fluff, said "A few days ago I noticed in the charts, and today happened, therefore proving the charts right." You never hear of all the things that weren't noticed, or all the things that were noticed but didn't happen, and it always happened a few days ago.

One expert trader I know can draw a distinction between this and a fundamentalist saying the market did today because of news yesterday, or because news came out today, is what will happen to the market tomorrow. He's a better man than I.

But this experienced trader is right about one thing. We never stop looking for an edge. If you do stop, it may be time to quit the markets...

 ...Continues here - Resistance and Support Levels

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