A technical analyst is in some ways like a doctor, taking the “pulse” of the financial instrument, conducting other tests, comparing the data to data obtained at different times from that or other financial instruments and drawing conclusions about the “health” of the financial instrument. Technical analysis is based on a series of assumptions about market behaviour which include the following:
1) Price action discounts fundamental data – in other words price action should reflect the shifts in supply and demand for an instrument which are based on fundamentals.
2) Prices move in trends – despite some academic debate suggesting most price movement is random.
3) History repeating itself – this is partly because human reactions to price movement tend to be constant.
Investors and traders are prone to making incorrect decisions due to the impact of emotions such as fear and greed. They tend to cycle from euphoria to capitulation and back on all timeframes. Their buying and selling behaviour while riding this emotional roller coaster leaves tracks on the price charts. Technical analysis, as well as identifying which of those tracks have predictive value, can also help define simple guidelines and algorithms to avoid falling prey to the impact of such emotions.
Various published research documents looking at trading off daily charts suggest that there is an edge in respecting the location of price versus the 200 day exponential moving average: not going long if price is below it, not going short if price is above it. A simple algorithm such as that can prevent panic selling after a pullback in a bull market or greedy buying in the middle of a bear market.
TOOLS OF THE TRADE
The tools available to the technical analyst are many and varied, and an experienced analyst will tend to focus on quite a small number that match their trading objectives and style. For instance, for trades held more than one day a strategy I like is momentum based, which means I use various technical analysis filters to help identify instruments which are trending and outperforming (for longs) or underperforming (for shorts) a benchmark index. For day trading I like approaches which have a proven statistical edge, for instance the tendency for US indices to come back to touch yesterday’s close after opening away from it.
IT’S ALL ABOUT TIMING
Traders and investors have a choice as to how much they use technical analysis, from a lot to a little. Clearly I am at one extreme of the scale. But even long only fund managers who have their own bespoke methods of searching for value using fundamental analysis are quite likely to consult a chart these days before embarking on a buy programme. Why buy now if the instrument is in a powerful downtrend? Yes, you can time the market!
For those who are interested in exploring these areas more, here are some routes in. For the investor, a great introductory book is The Visual Investor by John Murphy. For the more active trader, excellent start points are Trading for a Living by Alexander Elder, and How Markets Really Work by Larry Connors, Conor Sen and Connors Research Group. For those interested in obtaining a professional qualification in technical analysis visit www.sta-uk.org.
Malcolm Pryor is a qualified technical analyst, a trading coach and an author. Visit www.sparkdales.co.uk and www.spreadbettingcentral.co.uk. Follow Malcolm on Twitter: @pryormalcolm