Module 1 – Technical Analysis and the Dow Theory

Introduction

Welcome to the first module of this comprehensive course in technical analysis. By the time you graduate, you will be able to analyze any markets, and should be able to trade successfully in all financial products.

Technical analysis is the basic tool used by all successful traders to help them know where and how to trade. In this module we discuss just what makes up technical analysis and what its capabilities are, together with an outline of why it works, and why mastery of it is the key to successful trading in a multitude of markets.

In this course I will often refer to stocks and shares when talking about technical analysis of trading. This is just so I do not need to keep repeating ‘futures, options, financial instruments’ and other names. The basics of technical analysis apply across all markets, and in later modules we will get to any differences, such as which tools work best in different circumstances. The nuts and bolts that you learn here are what you need regardless of which way you want to take your trading career in the future.

 

Market Action

There are a number of basic concepts which must be grasped in order to build upon them. One of these is the idea of ‘market action’, which represents all that we may know about the performance of a trading market, such as the stock market. Market action reflects the two basic facts that are available from observation of most markets, namely ‘how much’ and ‘how many’. How much is the price at which a trade happens, and how many is the quantity of shares or contracts which were bought and sold at that price, otherwise known as the volume. If you trade the Forex market, which happens around the world with no central marketplace or counting house, the movement of the price may be all you know on which to base your trades.

It doesn’t seem like much information when you think of it in those terms – just two numbers. But when you consider that there may be hundreds of trades in a day, each of them involving a different number of shares and perhaps a different price, you can see that just this basic information can build up into a picture of what the participants in the market are thinking, sometimes called the ‘market sentiment’, and how it changes over time.

A third value can be added when you trade futures or options, and that is called the ‘open interest’. When you trade futures, you are trading a promise to buy or sell something at a future date at a certain price. You don’t have to own that something right now, even if you are contracting to sell it. With options, there’s even less commitment, as the contract to buy or sell in the future may never be ‘exercised’, or taken up, and won’t be unless the buyer of the option can make a profit from it.

As futures and options don’t involve buying and selling actual shares or goods, but only a promise or possibility for future buying and selling, the number or value of contracts traded isn’t limited to the existing supply. You are free to promise as many thousands of the shares as you want to, and the number that has been promised is the open interest. I’ll go into that in more detail later.

What is Technical Analysis?

Technical analysis comprises the study and interpretation of ‘market action’ to try and project future price trends. In summary, all the information we have comes from the past, and with it we use technical analysis to try to predict the future so that we can trade profitably. In this respect technical analysis is about recognising past price patterns. You are looking for particular patterns that in the past triggered a certain outcome and these can be patterns not just in price but also in momentum.

If this seems like a difficult thing, you should take comfort in the fact that technical analysis has evolved and continues evolving thanks to the work of thousands of experts. We are not having to reinvent any wheels, but can stand on the shoulders of those who came before and made a lot of the observations which have resulted in practical tools that we can apply straight away to improve our trading.

Why use Technical Analysis to Trade?

Technical Charts

Technical Charts(also called as Stock Charts) are the heart and soul of technical analysis. For this reason, technical analysts are also known as ‘chartists’.

It is rightly said that a picture is worth a thousand words. A chart of a stock / commodity / forex price tells much about the probable trend of the price – if it is likely to move up, move down, or if it is moving sideways.

Most of the times, technical charts have the price on the Y-axis and the time on the X-axis. Technical analysts then apply various indicators to this chart to arrive at a buy / sell / hold strategy.

Normally, technical charts are based on the closing price of the day’s session; some indicators may require other prices (open, high, low).

Many exchanges today (stock exchanges / commodity exchanges / Forex exchanges) provide online access to the traded data on a daily basis. This enables technical analysts to construe stock charts real time.

Stock charts are one of the easiest ways to get a visual clue regarding the price of a share. And the more data you have, the more accurately you can predict the price movement. Serious stocks investing people tpically look at the long term trend of the stock chart; day traders prefer to take a look at the technical charts for a very short time span (typically 3 months or less)

Japanese candlesticks also use technical charts to predict the price movement. These patterns take cognizance of all the prices for the day’s trading session. Predictions are then made depending upon the patterns that emerge from the prices.

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