An Introduction to Technical Analysis: Keep It Simple

[MadMarketScientist 11]

I have never understood the great divide between fundamental analysis and technical analysis. It is true that there are those who have made money trading by isolating and mastering one type of these analyses. Rather than specialize in either, I use a holistic approach: The fundamental allows the formation of a bias for future market action, while the technical paints an objective picture of the market as it is here and now.

 

Many people have a difficult time understanding the point of technical analysis. How can a bunch of math and seemingly arbitrary lines on a chart displaying prices over time help one pick points which represent opportunities to buy low and sell high (or buy high and sell higher)? The real benefit of technical analysis is that it keeps the trader objective. That is, he is merely reading the story that price action is dictating. He does not impart his own desires, opinions, and/or emotions into the analysis, as he might while analyzing the same market fundamentally.

 

Mind you, just as with any other type of financial analysis used for trading, most using it are unsuccessful. Indeed, many have had experiences using technical analysis to overcomplicate often simple situations and impart their own emotions into the charts, even though this is exactly what technical analysis should be used to avoid. This is because there are near-infinite ways to use technical analysis; and more are being created every day. It has been my experience that keeping it as simple as it can be (but no simpler) is the key to being a great technical chartist. Let me impart my personal techniques, discovered by a painful but priceless process of trial, error, and observation.

 

The most essential part of technical analysis is often the most overlooked by novices who jump headfirst into stochastics and MACD signals - the trendline. The trendline is significant and useful because it represents a simple and powerful concept: who is still making money in the current market move, and who needs to exit his position because the market is changing. When a trendline is violated, buying higher lows or selling lower highs is suddenly less profitable than it has been in the recent past. This will at the very least cause market participants to take pause and reconsider market conditions and at most create a reversal in the trend; this understanding creates opportunity and provides a signal to exit a position and reevaluate. Being aware that a trendline exists and comparing the trendline to current price and time gives one a sense of the state of the market.

 

To create an uptrend, find an extreme low on whichever timeframe chart you are using and connect it to the next-higher low with a line. For a downtrend, find a high and connect it to the next-lower high.

 

 

If we maintain the uptrend, buying dips is the strategy of choice. If the uptrend is violated, it does not necessarily mean that one should begin selling rallies, but one must be aware that buying dips is not as profitable as it had been. When an uptrend is breached, it is often most prudent to exit the long and watch to see if the market conditions have changed. This sounds too simple for most people, but it works because one is merely considering the objective facts: Buying dips is no longer as profitable as it once was, and indeed those who bought the latest dip may be losing money and quick to exit their long.

 

The other piece of technical analysis that I find extremely useful and overlooked is volume. Many would not consider volume to be technical analysis, but in my eyes it is the only way to keep track of where the major money is changing hands and the time and location that most participants find important. Often, volume is quite complex to analyze, but following it closely and using patterns in volume to judge market conditions can be extremely valuable.

 

Often on major highs or lows, you will see a relative spike in volume which indicates that a higher-than-usual amount of trading has just taken place. This is often a place where long-term stops have been placed, and positions have been exhausted.

 

 

Being aware of volume spikes can keep one away from the herd mentality. If everyone is involved at the same scary low spike, it is not prudent to sell into that spike. By the same token, if one is short into that spike low, it may be best to cover some or all of one's position and take a breather, as most participants have just used most of their trading ammunition.

 

It is apparent to me that these are the two most important forms of analysis because they work the same way for any timeframe of a chart, mirroring the market's fractal nature. What works on a one-minute chart will work on a monthly chart, simply because they reflect human nature. What day traders do within a day is the same general behavior that longer-term traders and money managers exhibit. The day traders are usually trading with each other, and the money managers do the same with their peers. The trends and areas of high market interest appear regardless of the timeframe of chart one looks at. Indeed, being aware of trends occurring in other timeframes often proves valuable in analyzing the "story" of the market thus far.

 

Both trendlines and volume require attention and observation in order to become profitable. They are not black and white, and should never be treated as such. They are important in order to gain perspective as to what the market has done so far, who is winning, and where traders are most likely to exit or enter positions. If observed closely and combined with personal experience and patience, they often reveal where market participants have shown their hands, so to speak. They provide an objective framework for a trader to put market conditions into perspective, realize who is winning, and jump on board or get out before the exits become crowded. Combining these with an understanding of market fundamentals provides a trader with the basis to at least protect himself from ugly surprises... and with time become a keen member of the "smart money."

 

Syndicated from the Casey Report

[peterjerome 10]

Agree...a simple strategy based on trendline breaks can reliably identify both entry & exit opportunities. i prefer using TLBs on indicators vs. price.

 

daily chart for HAL shows TLB exit 07/27/11. (vertical blue line).

.confirmation next day

[joshdance 10]

Thanks for the article MMS. Always good to get back to the basics of what the market is telling us -- trends in price, and volume.