Chapter 3 - What is Technical Analysis?

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Technical analysis is the science (some may say art) of identifying patterns of demand and supply in financial markets. Originally used in the futures market, the charting of price and volume patterns has increasingly won favour in the stock market. With the advent of computers, the science of the market technician has found a following among individual investors. Its allure is the intuitive appeal of its basic tenets, which challenge traditional ways of looking at securities. There are three fundamental premises of technical analysis, on which Stock Trends is based:

1.      The market is transparent, meaning that every relevant fact about a company is already known to investors and used to determine a market price. Technical analysts focus entirely on the study of price and volume patterns. They believe all other factors - such as expectations of earnings growth, fluctuations in the business cycle and political instability - are already factored into the demand and supply for investments.

2.      Stock prices move in trends. They go up or down or remain stable, depending on the way investors feel about a company’s prospects. A stock that is trending up has earned the market’s favour and its rise is fueled by expectations of even better value (a euphemism for greed). A stock that is trending down has encountered resistance and, ultimately, fear. A stock that is moving within a trading range, apparently going nowhere, is the product of indifference and uncertainty. These primary emotions are what define trends in the market.

3.      Human psychology has identifiable patterns that repeat themselves. Two elucidating books for technical analysts are The Crowd: A Study of the Popular Mind by Gustave Le Bon and Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay. Both texts, written in the mid-19th century, deal with patterns of human behavior in situations where an individual’s action is determined by the group to which he or she belongs. Applying mass psychology to the stock market is what technical analysis is all about. Charting stock prices is a way to visualize the emotions of investors and quantify market sentiment.

Technical analysts are students of mass psychology, focusing on the perception of value in the marketplace. They do not worry about the intrinsic value of a stock - the strength of its balance sheet, the growth in sales and profits, or the potential of its product line. This is the concern of fundamental analysts and the fodder for reams of investment reports from brokerage houses. Technical analysts do not kick tires. Their interest in these matters is merely an adjunct of the evidence the market provides. In other words, since the market is all knowing, there is no need to understand its decisions - only to recognize when they are being made.

One of the fathers of technical analysis is Charles H. Dow, the founder of Dow Jones & Co., who formulated the principles of what is known as Dow Theory. Many technical analysts have added to this vocabulary, all of whom have expounded upon the potency of trading solely on the basis of the supply and demand for investment instruments. The important point for Stock Trends followers is that there are many approaches to understanding the market. Not all involve analyzing a company’s fundamentals.

Investment or speculation?

If value is determined by subjective evaluations in the marketplace - an assumption about exchange founded in the theories of Adam Smith, David Ricardo and even Karl Marx - then surely it makes sense to focus your investment analysis on these subjective evaluations, not on the intrinsic value of a given stock. The question to ask is not “what is the stock worth”, but “what does the market think the stock is worth?”

Financial markets are fueled by greed and fear. Learn to recognize what precipitates these emotions and you will become an investment genius. Why? Because greed and fear are an astute investor’s best ally and a poorly informed investor’s Pied Piper.

The demand and supply for stocks is a barometer of the market’s emotions. When you analyze the variance in stock prices - the highs and lows during a trading session or over longer periods, as well as the volume of trading - you record the buying and selling pressure on a stock. The best way to study these patterns is by charting the market data.

Charting

Technical analysts have an esoteric reputation in the investment business. It’s no wonder, considering the battery of mathematical weapons they use - bizarre-sounding indicators like stochastic oscillators, Bollinger bands, Fibonnacci fans, Andrews’ pitchforks, Fourier transforms, parabolic SARs, Herrick Payoff indexes, Japanese candlesticks and moving average convergence/divergence studies. The names alone are enough to scare many people away. But all these tools are just creative ways to interpret stock market data. Each indicator is designed to give buy and sell signals, and all are applied to various market situations.

Readers are advised to consult some of the reference texts listed at the back of this handbook. There are many different ways of quantifying investor psychology and identifying the hints the market gives about which stocks are in favour and which are not. Stock Trends is just one approach that falls under the category of trend analysis.

TREND ANALYSIS

One of the basic charting techniques is trend-line analysis. A trend line is simply a line drawn on a chart of a stock’s price history. It is drawn parallel to the perceived direction of the stock price, generally connecting points of support or resistance, depending upon the direction of the stock. Chartists look for a stock’s price to penetrate a trend line and move in the opposite direction, a situation that alerts them to buy and sell signals. Again, the assumption is that stocks move in trends and repeat patterns of trending in three possible directions.

•  Bullish or rising trend

This, of course, is the trend all “long” traders hope to harness. A stock with a rising price trend is a market favourite.

• Bearish or falling trend

Falling prices generally come fast and hard, but once a bearish trend is in place investors take considerable risk in taking a contrarian view. A stock with a falling price trend enjoys little support in the market.

• Trading range or flat trend

Stocks that trade in a volatile or sedentary fashion within a price range are stocks about which the market feels uncertain or indifferent. This type of flat trend in price is the fodder of aggressive short-term traders who attempt to make small but frequent profits off this trading pattern. However, this is a very dangerous trend for investors or traders who wish to take longer-term positions.

If we accept the assumption that stock prices trend, and that there are only three possible trend directions, then an attempt to categorize and define a price trend for any stock (or index) will generate possible changes in trend. Obviously, “long-traders” (traders who buy stock, to sell later at a profit) will look for trend changes from a bearish or flat trend to a bullish trend.

What is a moving average?

The traditional way of drawing a trend line can involve a variety of approaches, but moving averages follow a strict definition. They are defined by the period of time you focus on - short-term, intermediate-term or long-term. Depending on your trading patterns, your desired time period may be different from another trader’s. For the purposes of our analysis we assume an intermediate-term trading horizon, where the holding period of stocks is measured in weeks. The principle concept in trend analysis is to define primary and secondary trend lines. The primary trend is the long-term price trend and is of principle concern for long-term investors. The secondary trend line is an intermediate trend that reveals the character of more recent price movement, often foreshadowing changes in the primary trend.

The graph above shows linear regression trend lines, illustrating the difference in perspective a long-term primary trend line gives on the secondary intermediate-term trend line. However, the precise application of a trend line can vary according to the method from which it is derived. Stock Trends uses the most generally accepted method of calculating and applying trend lines: the moving average.

Stock Trends defines the long-term as 40 weeks, and the intermediate-term as 13 weeks. The Stock Trends analysis is designed for the long-term trader who is looking for signals that identify changes in the long-term direction of a stock. Moving averages are used to establish trend lines, and are the central parameter of analysis in Stock Trends. A trend is defined by relating the current price of a stock to its historical price - as represented by a 13-week and a 40-week moving average price.

How is a moving average calculated?

To get a 13-week moving average, you add together the closing prices of the previous 12 weeks plus the current week, and then divide by 13. This is a simple moving average, which gives equal weighting to all weeks. Some technical analysts have other ways of calculating averages, such as the weighted and exponential moving averages, that give more weight to recent price movements.

The following table shows the calculation of the 13-week and 40-week moving average for a stock:

The graph below shows us an example of moving averages at work. The 40-week moving average represents the primary trend, while the 13-week moving average represents the secondary trend. These lines are derived from the average prices of the stock over the period defined. Both lines smooth price data and provide a clearer picture of how the stock price is changing over time.

The most important aspect of the trend lines presented is the divergence of trend between the primary and secondary trends. There are periods where the secondary trend has moved in a different direction than the primary trend. This period of divergence is often graphically shown when the secondary trend line crosses or intersects the primary trend line.

Stock Trends focuses on these changes in trend, using the 40 and 13-week moving averages to define the points at which a trend changes. The Stock Trends definitions of Bullish and Bearish are determined by this relationship. A Bullish trend is defined when the 13-week moving average is above the 40-week moving average. A Bearish trend is defined when the 13-week moving average is below the 40-week moving average.

Next > Chapter 4 - Guide to Stock Trends Symbols and Indicators

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