Introduction to Technical Analysis

Traders are constantly searching for different trading systems, refreshing ideas, and new innovations to better refine their trading plans. By investigating the works of the forefathers of technical analysis, Traders can gain an immense knowledge of the workings of the financial markets. Technical analysis is based on three basic premises. First, the market is a discounting mechanism, which means that every fact or information pertaining to the market is already been discounted in the price since there are individuals and groups with large interests and pockets, who are armed with the latest research and findings, and who can afford to stay on top of the latest developments in the market. Second, technical analysis involves the study of mass psychology and the repetition of price patterns or formations. Since crowds behave similarly, price patterns will repeat again and again. Third, markets are either consolidating or trending. When the market is trending, the odds are that the market will continue to trend. The forefathers of technical analysis wrote extensively about technical set ups relating to the markets and noted their own observation pertaining to the mental and psychological aspects of trading as well. Having the trading plan and technical set ups account for nearly ten percent of your success as a trader. Your ability to make timely trade executions and to stay head and shoulders above the crowd accounts for about 90 percent of your success as a trader. Charles Dow, a prolific author and a journalist pioneered the art of technical analysis. He wrote his own observations in a series of editorials and articles in the Wall Street Journal around 1901-1903. Robert Rhea, William Hamilton, and Samuel A. Nelson compiled and formalized Dow work into a body of theories. Each of these authors wrote books in his turn. Samuel Nilson wrote ABC of stock speculation. For example, among the basic tenets of the Dow Theory is that there will always be three different price fluctuations in the market. The primary, the secondary, and the minor trend, which is respectively synonymous to saying daily, weekly, and yearly fluctuations. Successful traders include more than one time frame in their analyses to have a full picture of the whole structure of the market. The hourly chart can be used in conjunction with the daily chart. The daily chart can be used in conjunction with the weekly chart. Equally, Charles Baucker, Richard Wyckoff, Ralph Nelson Elliott made significant contributions to the art of technical analysis. Richard Schabacker, The father of the art of technical analysis in principle, pioneered the concept of chart patterns. He introduced terms such as head and shoulders, triangles, flags. He is also the first individual to use trendlines to define support and resistance levels. Richard Wyckoff coined the concept of testing, and examined meticulously market actions and reactions. He observed and looked for nuances in chart patterns to analyze how a specific price pattern may emerge. For instance, he looked at how the market shook bulls (buyers) before a major rally. Elliott is credited with the concept of waves and that, not only charts, but also waves form patterns, which will repeat themselves again and again. For instance, he introduced the concept of impulse wave which tend to happen in the direction of the trend.

MOMENTUM INDICATORS

Momentum indicators, also called oscillators, are used in technical analysis to measure the velocity of price changes (momentum) both up and down. Every momentum indicator is an oscillator as it oscillates between two extreme levels. These extremes are commonly known as overbought and oversold levels. When an oscillator reaches the upper extreme level, it is said to be overbought. When an oscillator reaches the lower extreme level, this condition is known as oversold. The horizontal line in between these extremes is referred to as the equilibrium line. The Relative Strength Index (RSI), the moving average convergence/divergence (MACD), and the stochastic index are widely used momentum indicators.

RELATIVE STRENGTH INDEX (RSI)

Momentum oscillator developed by J.Welles Wilder in the late 1970s and discussed in his book, New Concepts in Technical Trading Systems. RSI measures the relative strength of the present price movement as increasing from 0 to 100. There are many variations of RSI in use today although Wilder emphasized using a 14 period and setting the significant levels of RSI at 30 for oversold (signaling upturn) and 70 for overbought (signaling downturn). The averages of up days and down days for 14 day periods are plotted. If the financial instrument makes a new high but the RSI does not move beyond its previous high, this divergence suggests reversal. When RSI bounces down and falls below its most recent trough that signals a price reversal.

STOCHASTIC INDEX

Oscillator which measures overbought and oversold conditions in a financial instrument based on moving averages and relative strength concepts. In its simplest form, the stochastic index is expressed as a percentage of the difference between the low and the high price of a financial instrument during the stochastic chosen period. For instance, if the stochastic period is 14days and the high in that period was 50 and the low 40, the difference would be 10. If the price at the time of the calculation of the stochastic index was 40, the stochastic reading would zero. At a price of 50, the stochastic would be 100. At 45, the stochastic would be 50. The stochastic index normally plots a 5 day moving average of the stochastic. Lines representing the 25 percent and 75 percent levels refer to oversold and overbought conditions respectively. If the stochastic index falls below the 25 percent line, that suggests an oversold condition. When the stochastic index rises above the 75 percent line that indicates an overbought condition. An upward reversal through the 25 percent line is a positive breakout and a downward reversal through the 75 percent line is a negative breakout, indicating new uptrend and downtrends respectively.

MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)

Oscillator developed by Gerald Appel which measures overbought and oversold conditions. MACD, pronounced MACD, makes use of three exponential moving averages a short one, a long one, and a third, which is the moving average of the difference between the other two and represents a signal line on the MACD graph. (MACD is typically shown as a histogram, which plots the difference between the signal line and the MACD line. Trend reversals are signaled by the convergence and divergence of these moving averages. When the histogram crosses the zero line upward, that suggests a positive breakout (a buy signal). If the histogram crosses the zero (equilibrium line downward (a sell signal), that indicates a negative breakout. One of the most popular MACD indicators in use is the 8/17/9 MACD. On a daily MACD, the short moving average would be 8 days, the long one 17 days, and signal line 9 days. On a weekly MACD, the same applies but those same numbers would refer to weeks rather than days. Again, we suggest you to trade with virtual money for as long as possible, before trading your own funds. We will continue this practice of sending educational e-mails in order to help you obtain further knowledge about various financial markets.