WHEN nervous markets are jumping upon every single piece of economic data as an excuse to swing one way or the other, it can be extremely difficult for contracts for difference (CFDs) traders to concentrate on analysing the market movement.
But while traders should certainly not ignore the fundamentals, a blizzard of figures can hinder you in making level-headed trading decisions. Technical analysis certainly has both fervent followers and staunch sceptics but a judicious combination of the two approaches can be extremely profitable. It can help both beginners and experienced traders select precise entry and exit points, place stop losses and limit orders effectively and pick out patterns revealed by the charts.
But while inexperienced traders devour the technical analysis books, technicians need to appreciate the wider context, says Raghee Horner, chief market analyst at Autochartist, a provider of charting and pattern recognition solutions.
She says that technical traders often go wrong when they ignore the underlying market trend. For example, she says that triangle patterns are a much more meaningful continuation pattern when a market is consolidating, whereas channels and wedges are excellent in trending markets. “If you find a wedge pattern in a sideways-moving market, it is not the most powerful continuation indicator because there was no existing trend to be sustained,” she warns.
Equally, stochastic indicators are great tools for technical traders to use in a range-bound market because they signify when the market is seen as overbought or oversold. This happens regularly in a range-bound market as the market reverses on a more regular basis.
In contrast, moving averages lose a lot of their validity due to choppy price movements. To avoid this, choose a longer-term moving average which will give you an idea about the market’s overall direction.
Here are four key technical indicators that every trader should watch out for:
SUPPORT AND RESISTANCE LEVELS
SUPPORT and resistance levels are one of the most well-known and most frequently used technical indicators. A support is a level that the stock has historically had difficulty falling below, while resistance marks a level that the stock has struggled to surpass.
The market regularly tests these levels, that are then either reconfirmed (the stock bounces off them) or they are wiped out (the stock breaks through). Check the volume for the strength of the move.
For example, in the chart above, oil tested the $71 support level in early July before buyers re-entered the market and pushed it back up to $83. Concerns about growth caused oil to drop back to test support at $71. But the market seems to see value in this area so we have the start of a bounce, says David Jones, chief market strategist at IG Markets.
SIMPLE MOVING AVERAGES (SMA)
A simple moving average is calculated by adding the closing price of the security over a certain number of trading days and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying security, while long-term averages are slower to react.
A crossover is an important trading signal that occurs when either the price crosses the moving average or two moving averages (eg, the 20-day and the 50-day) cross. When a short-term average crosses above a longer-term average, this is seen as a buy signal and vice versa.
The chart shows the FTSE 100 and its 20 and 50-day SMAs. In July the 20-day SMA crossed above the 50-day SMA giving a buy signal from about 4,600. But the SMA’s power is weaker in choppy markets, making it a less useful indicator of late.
THIS is a common reversal pattern which signals that the security (in this case, sterling-yen) is likely to move against the existing trend.
There are two versions of this pattern: the head and shoulders top – usually formed at the peak of an uptrend – and the inverse pattern indicating that there is about to be a rebound.
In the standard head and shoulders top, the currency rises to an initial peak – the first shoulder – before dipping. The pair’s price then rises above the former peak and again declines, creating the head (H).
Finally, the pair rises again but fails to reach the heights of the middle peak and falls once more, breaking through the neckline (NL) and confirming the reversal of the security.
Traders would look to enter the market at the point where the price breaks through the neckline. But they should pay attention to volume as an indicator of the strength of the pattern.
In a head and shoulders top, volume in support of the initial trend should dissipate as the pattern works through.
FIBONACCI RETRACEMENT LEVELS
You either tend to be a follower or a sceptic but enough people take notice of these levels and trade accordingly so it is worth knowing where the key Fibonacci retracement levels are. Fibonacci analysis says that the key support levels will come in at 23.6 per cent retracement, 38.2 per cent, 50 per cent, 61.8 per cent and 76.4 per cent of the previous move.
Traders will look for the price to bounce off these levels – if it does so, then the correction was probably a blip. When prices break decisively through 38.2 per cent, the theory is that they are likely to fall all the way to the 61.8 per cent retracement.
The latest rally by sterling-dollar managed to slice through all the Fibonacci retracement levels (from the August 2009 to mid-May 2010 decline) with no problem. IG’s David Jones says: “The rally has run out of steam ahead of the 61.8 per cent retracement at $1.60. This is the last chance for the previous trend and a big one for the Fibsters – a failure to break here suggests that the downtrend from last year is still intact and this rally has been just a dead cat bounce.”