Module 4

Trading - The Technical Analyst Approach

 The Philosophy
of
Technical Analysis
Technical Analysis Foundation

Technical Analysis is based on 3 principles:

1. Market Action (prices) Discounts Everything

2. Prices Move in Trends

3. History Repeats itself

Market Action Discounts Everything

 All fundamental, political and economic information available to

the market is reflected in the price.

 Furthermore it includes hidden fundamentals.

 If prices are rising, demand is more than supply meaning the

fundamentals are good. If prices fall, supply is more than demand,
meaning the fundamentals must be bad.
Prices Move in Trends

 Charles Dow developed the Dow Theory based on his empirical

observation of trends more than a century ago.

 This state’s prices move in Zigzags not as straight lines.

History Repeats Itself

 Basic human nature does not change and the market, reflecting
the sum of all participants actions, behaves in identifiable
patterns.

 So, if we see, say a Head and Shoulders after a rising market,

chances are that the market will go down afterwards.

 Like weather forecasting.

Technical vs. Fundamental

 The Fundamental approach:

 Examines all of the relevant

factors that affect a market
(inflation, interest rates,
management, company accounts)
+
in order to determine the intrinsic
value of that market. EUR/USD 1.30 (intrinsic)

 If this intrinsic value is under the current market price, then the
stock is overpriced and should be sold and vice versa.
 +

EUR/USD 1.30 (intrinsic)

Technical vs. Fundamental

 Is at critical turning points where the two approaches disagree.

 Fundamentalists cannot explain the market movement at the

beginning of important market moves.

 Price tends to lead the known fundamentals.

 Major bull and bear markets in history have begun with little or no
change in the fundamentals.
Technical vs. Fundamental

 The technical approach includes the fundamental approach.

 Since the fundamentals are reflected in the price then the study of
fundamentals is unnecessary.

 Thus, chart reading is a shortcut of fundamental analysis.

 However, fundamental analysis does not include a study of price

action.

 Even if fundamental analysis has been employed, the timing has

to rely on Technical principles.
Advantages of Technical Analysis

 Flexibility and Adaptability.

 Technical Analysis applies to different trading mediums.

 Technical Analysis applies to different time dimensions.

 Technical Analysis can play a role in Economic Forecasting.

Flexibility and Adaptability

 The chartist can easily follow as many markets as desired, which

is generally not true of the fundamentalists who tend to specialize
in one group.

 The chartist can rotate attention and capital to take advantage of

the rotational nature of the markets.

 After a market has been trending it is followed by a trendless

period while at the same time another market or group of
instruments is experiencing a major trend.
Different Trading Mediums

Technical principles apply to ALL the markets:

 Bonds
 Equities(Stock Market)
 Futures
 Interest rates
 Foreign Exchange
 Derivatives
Different Time Dimensions

The Technical Analysis principles apply to:

 Short term – Hourly charts

 Medium term – Daily Charts
 Long Term – Weekly Charts
 Very Long term – Monthly Charts

The opinion that Technical Analysis should be used only in the short
term is NOT true.
Economic Forecasting

 The charts of commodities hint the strength or weakness of the

economy as well as the direction of inflation.
 Rising commodity prices suggest stronger economy and rising
inflation.
 Falling commodity prices warn for a slowing economy and
inflation.
 Interest rates are generally positively correlated with commodity
prices and inflation.
 Interest rates are inversely correlated with bonds.
 U.S dollar and foreign currency futures also provide early
guidance about the strength or weakness of the respective
economy.
Criticism of Technical Analysis

 Self-Fulfilling Prophecy.

 The past cannot predict the future.

 Efficient Market Hypothesis.

 Random Walk Theory.

Self-Fulfilling Prophecy

 The use of most patterns (i.e. Head and Shoulders) has been
widely publicized in the last several years.

 Many traders are quite familiar with these patterns and often act
on them in concert.

 This creates a “Self – Fulfilling Prophecy”, as waves of buying or

selling are created in response to “bullish” or “bearish” patterns…
Self-Fulfilling Prophecy
Head We do not do
anything until
Right Shoulder prices break
Left Shoulder the Neckline –
Neck Line So its not us
creating the
formation

How many people use Technical analysis 30%?

How about the remaining 70%?
Can the Past Be Used to Predict the Future?

 Critics of Technical Analysis often raise this question.

 In every statistical analysis, they use the past to predict the

future. This is true for economic and fundamental analysis,
weather forecasting and technical analysis forecasting.

 We can only estimate the future by projecting past experiences

into the future.

 The use of past price data to predict the future is based on sound
statistical concepts(descriptive and inductive statistics)
Efficient Market Hypothesis

 Efficient Market Hypothesis holds that prices fluctuate randomly

about their intrinsic value.

 It also holds that the best market strategy to follow would be a

simple “buy and hold” strategy as opposed to any attempt to
“beat the market”.

 Efficient Market Hypothesis assumes the news, the information

and the data comes to everyone at the same time that’s why no
one can take advantage of it.

 The basis of technical forecasting is that important market

information is discounted in the market price long before it
becomes known.
Random Walk Theory

 It claims that price changes are “serially independent” and that

price history is not a reliable indicator of future price direction.

 Price movement is random and unpredictable.

 It is based on Efficient Market Hypothesis.

 All markets exhibit a certain amount of randomness or “noise” but

to believe that all price movement is random, is unrealistic. Price
movement appears random to those who have not taken the time
to study the rules of market behavior.

 Empirical observation shows that prices DO trend.

 Dow
Theory
 Daily
Hourly

Weekly
 Distribution Phase (to non
professionals)

Accumulation Phase
Public participation Phase
(Smart money, Insurance (a) (trend followers,
funds) Professionals first then
rest)
Psychology – Investor behavior
Conviction
Enthusiasm

Greed
Confidence Hope
Growing recognition Disbelief

Caution Apprehension
Skepticism
Shock & fear

Contempt Surrender
Disgust
The Averages discount Everything

The market reflects every possible knowable factor that affects

overall supply and demand.
No important bull or bear market signal could take place unless all
averages gave the same signal, thus confirming each other.
 Volume Increases in the Direction of the trend

at the end of the

downtrend the
volume dries ou t,
they don ’t want to
sell anymore

In an up trend, volume should In a downtrend, volume should

increase as prices move higher, increase as prices fall, and
and decrease as prices fall decrease as prices rise
A Trend Is Assumed to Be in Effect Until It Gives Definite Signals
That It Has Reversed.

Hence the sayings:

“The trend is your friend”

“Never go against the trend”