What is Technical Analysis (TA) and does it Work?
TA is a big subject and this text is intended to be a comprehensive introduction for new traders. Hence, this Sticky is on the long side! It starts at the beginning (generally a good place) with a brief history about the origins of TA. This is followed by examining what a chart is and, just as importantly, what it isn’t. Then it looks at the three main cornerstones of TA. Along the way it flags up key issues that new traders would do well to consider and pitfalls best avoided. Lastly, there is a 10 point plan designed to guide you through the murky depths of the TA pool. So, let’s get started . . .
A (very) Brief History of TA
Modern day TA has its roots in Dow Theory, which owes its name to Charles Henry Dow of Dow Jones fame (1851 – 1902). Check out the
Essentials Of Indices Sticky for more information about the late great Mr. Dow and why his indices – the Dow Jones Transportation Average and the Dow Jones Industrial Average – are still widely followed to this day. Dow devised his theory about how the markets behave over 100 years ago. You could be forgiven for thinking that a theory that old is no longer relevant to today’s high tech world of super fast computers, algorithmic trading and sophisticated analysis techniques. Some people would agree with that view, but disciples of Dow point out that what his theory and modern day TA does is to highlight the hopes, fears and expectations of the people who build the machines, write the software and perform the analysis. They’re just people after all and their hopes, fears and expectations are probably much the same today as they were 100 years ago. Or even 200 years ago come to that. Anyway, back the origins of Dow Theory.
It has six basic tenets:
1. The market has three movements
2. Market trends have three phases
3. The stock market discounts all news
4. Stock market averages must confirm each other
5. Trends are confirmed by volume
6. Trends exist until definitive signals prove that they have ended
In recent times, tenet No. 3 ‘the stock market discounts all news’ has been developed into a standalone theory called ‘Efficient Market Hypothesis’ (EMH). This argues that no one, be they technical analysts or fundamental analysts (check out this FAQ to compare and contrast the two:
What is Technical and Fundamental Analysis?) - can really profit from the markets because they always trade at fair value, incorporating all known information about the market as a whole. If, having researched EMH, (see links in post #3), you find yourself agreeing with it, then the answer to the second question posed in the title of this post will be an emphatic ‘no’. This Sticky will make the assumption that you do at least think it’s possible to make money out of the markets and that some form of TA may, possibly, be the key that unlocks the door to those profits. This leads us to the first question that you’ll need answering: ‘what is a chart?’
What is a Chart?
Everyone is aware of charts; doubtless you will have seen line charts of economic growth or of the FTSE or DOW on television or in newspapers etc. You may not be familiar with more exotic charts like Point & Figure charts or Ichimoku cloud charts, but they are mostly just variations on a theme. The first mistake made by many new traders when they look at a chart is to think that in some magical way it predicts the future. It doesn’t. No chart exists of any kind, with any type of indicator, of any instrument or in any timeframe that predicts the future. Period. Even if you don’t absorb any other idea from this Sticky, please read, mark, learn and inwardly digest that one!
A chart may contain clues that will help the trader to
‘forecast future price trends’ to use Murphy’s definition, but it doesn’t predict them. To avoid making this mistake, it might help if you replace the word ‘forecast’ with the word ‘probable’. Trading is all about probability. If you can work out
probable future price trends just 50% of the time
and you manage to make more money on the winning 50% than you lose on the other 50% - then you could be in business. Even so, it still begs the obvious question: if a chart isn’t a predictor of the future – even very roughly – then what is it?
A price chart is merely a visual record of transactions between buyers and sellers. Anything added to the chart, e.g. moving averages, other indicators and trendlines etc. are almost always derived from the data associated with these transactions, namely: price, volume and time. Any trades taken by traders are the result of the trader imposing his or her interpretation on what they see in the chart. In this respect, reading charts can be a bit like reading tea leaves and, often as not, no two traders will see the same thing.
In his influential book on swing trading
Marc Rivalland on Swing Trading, the author goes further with his definition of a chart, describing it as a
“pictorial representation of the forces of supply and demand”. It goes too far for some, if only because the forces of supply and demand are clear as day with the benefit of hindsight, but not so obvious in real time where price is currently trading. Historical turning points in supply and demand can provide the trader with some useful clues about the possible future movement of price but, all anyone can say for certain about the current price is that it is where buyer(s) and seller(s) have agreed to trade and where the most recent transactions have occurred.
Another point that’s important to understand is that every transaction requires both a buyer
and a seller. You’ll often hear on forums comments along the lines of:
‘price went up because there are more buyers than sellers’. This is not quite right. By definition, for a trade to occur, the contracts or shares of buyers and sellers have to be evenly matched one to the other. If, for the sake of argument, sellers of ABC stock have between them 1,000 shares for sale at $20.00, and there are buyers who, between them, want to acquire 1,500 shares without paying more than $20.00, then one or more of those buyers is going to be disappointed. They will not be able to buy the 500 shares they want at $20.00. If they are willing to pay more than $20.00, then the buyers may secure their holding at a higher price, assuming there are sellers with 500 shares that they are willing to sell. So, in this example, price is pushed higher by
demand from buyers, as opposed to by the buyers themselves. The number of buyers and sellers is irrelevant. One buyer wanting to buy 1,000 shares is the same as ten buyers wanting to buy 100 shares each. They will only be able to buy if there is one or more seller(s) with 1,000 shares that they are willing to sell.
What is TA?
As stated in the opening post, TA involves using charts to study market action, i.e. price, time and volume, for the purpose of forecasting (probable) future price trends. Let’s examine this in a little more detail. In the next post, there are links to excellent resources which explain the various types of charts and their relative strengths and weaknesses. So, if you don’t know what a ‘candle’ in a candlestick chart represents or what the Xs and Os of a Point & Figure chart mean, don’t worry about it for now. What you need to decide is whether or not you buy into the basic premise upon which all TA of charts is based. It’s as well to understand what it attempts to do (which is often very different to what many traders imagine it should do), before deciding whether to invest a lot of time learning how to apply it.
The basic premise is that charts illustrate collective patterns of behaviour of all the people speculating in the market (or instrument that the chart represents). Every market participant is exactly the same as you in as much as they have to make the same decisions about when and where to enter a trade, when and where to bail out if it goes against them and when and where to realise their gains if it’s profitable. And, like you, they all hope to make money and are fearful about losing it. In this respect, the market is exactly the same today as it was back in Dow’s day; it is driven by the hopes, fears and expectations of the people who trade it. These patterns of behaviour have three main characteristics and can be seen in charts of yesteryear just as clearly as they can in charts of today. They are . . .
1. Market Action Discounts Everything
As mentioned above, this was the third of Charles Dow’s six tenets: ‘the stock market discounts all news’. Its principles are as relevant to modern day TA as they were when Dow first introduced it. It attempts to explain why markets don’t always fall on bad news or rise on good news. The notion is that the current price reflects all known information about the market or instrument being traded. For example, in the case of a stock, the current price has already factored in all the news about the company: its sales forecasts, projected growth, cash flow, Chairman’s report, broker’s upgrades and downgrades plus everything else besides. Naturally, fundamental investors don’t subscribe to this view and aim to find undervalued stocks that the market has somehow managed to overlook. Rumour has it that the ‘sage of Omaha’, a.k.a. Warren Buffet, has asked that when he’s on his death bed and about to draw his last breath, those closest to him whisper in his ear
‘market action discounts everything’. That way, he can be sure to die laughing.
So, the first of the three cornerstones to TA is hotly disputed and its veracity is something that you will have to decide for yourself. Your conclusions will be central to the way you view the markets, the way you believe they function and whether or not you can profit from them. The difference between followers of TA and those who subscribe to Efficient Market Hypothesis is that chartists believe this characteristic
aids their analysis of the markets and
increases their chances of profit. Why? Because it’s liberating; everything they need to evaluate is contained within the chart(s) in front of them. They don’t need to look at sales figures, projected growth, cash flow, Chairman’s reports and a myriad of other information. The chart says it all and, by skilful analysis utilizing the next two characteristics, they can forecast (probable) future price trends in order to make profitable trades.
2. Price Moves in Trends
This is also one of Dow’s six tenets and it’s one that’s easy to observe by looking at any chart that covers a reasonable time period. Price is more likely to continue in its current direction than it is to change. This gives rise to trends – up, down and sideways. Rising and falling trends are characterised by the typical staircase formation, indicating brief pauses where the market catches its breath. As in nature, nothing grows at a constant pace, resulting in periods of rest. This may include short lived counter-trend moves which – if you’re not careful - can easily be mistaken for a reversal in trend. Markets trending up or down are the result of an imbalance in supply and demand and, broadly speaking, price will continue to rise as long as demand outstrips supply, or fall as long as supply outstrips demand. When there is broad equilibrium between these opposing forces, markets will become range bound – i.e. trend sideways. This means that they may rise and fall, but usually within a fairly narrow band with clear upper and lower limits. Identifying whether a market is trending up or down, is range bound or in transition between these states, is central to the decision making process of most technical analysts.
3. History Repeats Itself
Adherents to TA believe that charts are visual records of transactions between buyers and sellers, i.e. people. People (or machines operated by people), exhibit patterns of behaviour which tend be repeated. That’s human nature. These patterns of behaviour are then reflected in the movement of price. Ergo: history repeats itself. The basic concept may be sound and, on the face of it, uncontroversial. However, it’s given rise to endless arguments about the efficacy of TA. As such, it warrants a section of the Sticky all to itself . . .
History Repeats Itself
John Murphy detailed many chart patterns in his ‘bible’ - Technical Analysis of the Financial Markets. Steve Nison took it a stage further with his book
Japanese Candlestick Charting Techniques which highlighted individual candlestick patterns and how to interpret them. Both books are held in high regard and, arguably, have contributed greatly to chartists’ analysis of the markets. Additionally, there are eminent works by Wyckoff, Edwards & Magee, Bulkowski and others, along with endless debate about why some patterns repeat more often than others and why some of them are more reliable than others.
The unfortunate consequence of all of this is that trading has been reduced to spotting a few simple patterns or shapes such as ‘Ascending Triangles’, ‘Bull / Bear Flags’ and ‘Head & Shoulders’ (H&S) etc. - and entering trades when price breaches the perimeter of the pattern or shape. The same criticism applies to overlays such as moving averages or indicators such as RSI and MACD. Blindly entering trades based purely on a breach of a simple pattern - or an alert from an indicator - is hit ‘n miss at best. It’s akin to phoning the police and reaching for the baseball bat stowed under your bed when the exterior security light comes on in the dead of night. Sure, a burglar or ne’er-do-well could have triggered the light. So too could a bat, insect, cat or leaf on the breeze.
A novice trader can go from looking at a chart in complete bewilderment to confidently spotting numerous patterns - to which they attribute all sorts of fancy meanings - in a matter of days. It’s fun, it’s easy and it’s highly seductive, not least because the patterns they think they see and they think have meaning, often appear to ‘work’. Until they don’t work that is, at which point the trader is confused and doesn’t understand why the pattern has failed. They get frustrated and look for another pattern or indicator – a better one. Then the same thing happens and after a few more attempts they conclude that TA doesn’t work and that all patterns and indicators are useless. Applying simple formulas to the market along the lines of
‘there’s ABC pattern, therefore the market will do XYZ’ will almost certainly fail over the medium to long haul. It’s ‘TA by numbers’ for want of a better term. It is not how the work of Murphy, Nison & Co should be utilised, and those who adopt this simplistic approach will, almost certainly, be disappointed. The next obvious question is: if TA by numbers isn’t going to cut it when trading live, what will?
Meaningful Patterns of Behaviour
Sexy, superficial patterns are a smokescreen. You must look beyond them to see what’s created them to shine a light on what your fellow speculators have done in the past and, based on that, what they
might do in the future. Again, note the emphasis on ‘might’. Remember, you’re dealing in probability, not predictive certainty. Support & Resistance (S&R) is an example of a true pattern of behaviour and lies at the heart of the ‘history repeats itself’ characteristic. Buyers and sellers repeatedly enter and exit the market at levels where they have entered and exited in the past. These levels are where other traders like you have taken fright and sold as fast as they could, or put up a fight and piled in for all they’re worth. To quote the famous line from ‘All the President’s Men’ - the film based on the Watergate scandal - “follow the money!” Chartists have a variation of this quote which is to ‘follow the
smart money’.
What the ‘smart money’ is doing is of primary interest to the chartist. Smart money refers to the big investment banks, proprietary trading houses and hedge funds. The sheer scale of their transactions is what moves the markets and, as a rule of thumb, it’s generally better to be in their slip stream than it is to be standing in their way. A trader who is able to spot the intentions of these major players by looking at a chart is well placed to speculate on the probable direction of the instrument they’re trading. For example, take our imaginary ABC stock priced at $20.00. Having studied the stock’s chart, you surmise that the ‘smart money’ certainly isn’t trying to accumulate the stock and may even hold stock already that they now want to sell. In other words, there’s a lot of available supply and little evidence of any demand. Traders who are able to interpret this from the chart wouldn’t buy ABC at $20.00. If anything, they would look to sell it short. The rationale being that in all probability, price will slip below $20.00 in order to attract buyers. Why? Because price seeks equilibrium and will tend to fall if supply outstrips demand and rise if demand outstrips supply. If few buyers are forthcoming, sellers might panic and seek to offload their holdings in an attempt to secure the best price they can, as near as possible to $20.00. When the market is flooded with supply, it can tank very fast. In a falling market, given a choice of fight (buy) or flight (sell), most traders will sell and run. This is because markets are predicated on human emotions, primarily fear and greed.
If the ‘smart money’ is looking to offload their holding, they’ll want to sell at or as near to $20.00 as possible, but will try to cover their tracks to hide their intentions from you. To do that, they’ll sell in stages to avoid swamping demand with supply which, in turn, could easily cause price to waterfall. They may even buy back more stock at lower price levels in order to attract other buyers. Why? To create buying pressure which will help to push prices back up, so they can then offload more stock close to $20.00. Smart money acting on behalf of a major pension fund with millions of shares to offload could repeat this process many times. This is one reason why history appears to repeat itself and areas of resistance (in this example) are created. The same principle applies when smart money accumulates a stock and areas of support are created. It has nothing at all to do with simple shapes and patterns that can be spotted in most price charts.
Price patterns are the consequence of the ever changing market dynamic: not the cause of it. They no more signify an imminent price move any more than an apparition of Gene Kelly in a cloud formation signifies an imminent downpour.
A simple but useful little trick when looking at a chart is to imagine how you’d feel and what you’d do if you were already long or short the market. If you can get inside the heads of your fellow speculators and feel their joy and feel their pain, it will help to shine a light on what they might do in the future. Some years ago on T2W, a new member asked a long standing member and experienced trader - which of the following subjects he should study in order to become a trader: computer science, physics, maths, economics or politics.
“None of the above,” replied the old hand
“instead, get yourself a degree in psychology.”
Psychology
Hopefully, being the astute reader that you are, you will have cottoned on by now to the fact that price charts can provide insights into the hopes, fears and aspirations of the people speculating in the markets, as opposed to any great insight into the company itself (in the case of a stock chart). This is the unique value of TA and it’s something that fundamental investors can’t get from studying company reports, balance sheets, PE ratios and mountains of other data. The trader who goes short ABC as it drops below $20.00 does so because of their perception of what other speculators will do when they see price drifting lower. Their actions have absolutely nothing to do with whether or not ABC is a profitable and well run company. This disconnect is one that frequently frustrates fundamental investors as they can’t fathom out why ABC’s share price doesn’t shoot to the moon, based on the fact that it’s a great company, well managed, good cash flow, no debt, full order book – blah, blah, blah! In the longer term, i.e. months, ABC’s price may well rise if its fundamentals remain strong. But, in the short term, i.e. intra-day to a few weeks, price could literally go anywhere, based on the people trading it,
not on the company itself.
Using TA as a means to assess the sentiment of the market – is the ‘art’ part of the game. It’s far from easy, obviously, and it will take time just to get comfortable with the basics. Certainly, it can’t be reduced to a few simple patterns and indicators that are easily learned. However, if you buy into the premise that TA can expose the hopes, fears and aspirations of other speculators – and you’re able to utilise it - then you’ll have a market edge that could pay you handsomely. To research the psychological aspects of TA further, start with the
Essentials Of Trader Psychology Sticky. As with this Sticky, it provides an overview of the topic with some useful links for further study. The ‘science’ part of TA is a little more straightforward in some respects but, even then, it has some serious pitfalls. We’ll look at these next.
Indicators and the Mechanics of TA
Many traders think that applying TA to get inside the collective heads of their fellow speculators is a grey art and very hit ‘n miss at best. They prefer a more mechanical, scientific approach, based on crunching numbers that doesn’t rely on tenuous things like perception, interpretation and supposition. Welcome to the world of technical indicators. As has been mentioned already, indicators are one of the many tools in the technical analyst’s box of tricks, but they must be utilised with care and understanding. There are hundreds of them which can be applied to charts to tell you pretty much anything you might want to know. Everything that is, apart from when and where to enter and exit your trades. Just as charts don’t predict future price movement, indicators don’t provide signals of when to get in and out of the market. This is the second most important thing to learn from this Sticky. Tens of thousands of hours have been wasted by traders who go from one indicator to the next, endlessly tweaking the settings of each one, as if they were trying to find the combination to open a safe. It’s a holy grail that doesn’t exist: don’t waste a minute of your time looking for it. Does this mean all indicators are worthless? To be far, there are some experienced traders on T2W who would answer that question with an emphatic ‘yes’. Equally, there are those who would say no. In spite of these conflicting views, there are aspects of indicators about which, broadly speaking, both camps would agree.
These days, in the TA world, indicators get a bad rap. They’re akin to traffic wardens and estate agents. Accusations abound along the lines of ‘they’re a waste of space’, ‘they tell lies’ and ‘they don’t work’. Is all the bad press justified? Well, not really. The problems lie more with the traders using them, than they do with the indicators themselves.
There are three problems in particular:
1. The trader doesn't understand what the indicator does.
2. The trader doesn't understand how the indicator works and what its limitations are.
3. The trader doesn't understand when to apply - or not apply – whatever it is s/he thinks the indicator is indicating.
All three can be summed up in the pejorative catchall phrase ‘TA by numbers’. The trader who does understand points 1 through 3 may well be able to use their chosen indicator to great effect. All three points apply equally well to all other TA tools, such as S&R levels, trendlines and the aforementioned patterns: Ascending Triangles, Bull / Bear Flags and H&S etc. They are all useless in the hands of the trader who misuses them or blindly follows them without thinking about how they are created (don’t worry about the ‘why’) – and any information they may impart. In a nutshell, if you decide to use indicators, it’s essential that you learn what they do, how they work and how to use them properly and then, likely as not, they’ll do what you want them to do. But remember, if what you want them to do is to provide you with a simple cookie cutter solution that enables you to milk the markets day in and day out - for little or no work - then you’re going to be disappointed. Bitterly disappointed. At least you can’t complain that you haven’t been warned.
So, does TA Work or Not?
The answer to this question very much depends on how you define ‘work’. As an infallible predictor of where price is going to go next –
NO it doesn’t work! As a useful aid to enable you to forecast (probable) future price trends –
YES it can work. Whether or not it will work for you will depend on whether or not you’re prepared to put in the effort required to master it. TA is a tool like any other and using it well will take time and effort. Those who claim it doesn’t work tend not to bother. They apply
TA by numbers and buy when the blue line crosses the red line (of XYZ indicator), or sell when price breaches the neckline of an H&S pattern etc.
Some critics who maintain that TA doesn’t work are academics who provide impressive mathematical studies to support their claims. A recent example of this is a paper entitled
Technical Analysis from Around the World by Ben Marshall, Rochester Cahan and Jared Cahan. The authors of many papers like this one are intellectual heavyweights, but they are rarely traders and, therefore, have no practical experience or understanding of the subject. Additionally, none of them can actually prove that TA doesn’t work or, even, that XYZ indicator doesn’t work. Here’s why . . .
You’ll probably be familiar with the popular myth that bumblebees can’t fly. Everyone knows that they can, but scientists have struggled to explain how and, even, supposedly ‘proved’ that they can’t. Actually, they haven’t done that at all. What they have done is to demonstrate that relatively simple mathematical models fail to explain something as complex as the flight of a bumblebee. They’ve struggled to model the way the insect moves, the way its wings bend and twist and the number of strokes they have and how their angles change etc. And so it is with academic studies about TA: because the mathematical models fail to take the
trader into account. They invariably look at chart patterns or indicators in isolation. It’s akin to saying cars don’t work when there isn’t someone in the driver’s seat. You don’t say! Chart patterns, indicators and TA in general are just tools to aid the trader. As with any tool, how well it works (or not) is dictated by the knowledge, skill and experience of the person using it. Consequently, academic studies about the effectiveness (or otherwise) of TA tend to be as flawed as mathematical models which supposedly ‘prove’ that bumblebees can’t fly.
A Ten Point TA Plan
If, having read this far, you’re keener than ever to explore TA further and are wondering how best to go about it – you’re in luck. What follows is a ten point plan which is designed to help you in two ways:
• It will help you decide whether or not TA is something that makes sense to you in principle and warrants further research and study.
• Thereafter, it will help you to focus on the elements that matter so that you can get up to speed as quickly as possible. TA is a huge topic that is riddled with cul-de-sacs and if you’re not careful you can spend months, years even, looking at charts that won’t aid your understanding of the markets or help you to trade them.
1. The First Step
Consider the main characteristics upon which TA is based: 1) Market action discounts everything, 2) Price moves in trends and 3) History repeats itself. If you don’t subscribe to these three patterns of behaviour or, even, subscribe to Efficient Market Hypothesis (EMH), then a TA approach to trading and investing is not for you. So, before going any further, it will pay you to research the subject some more. If and when you’re ready to sign up to the three cornerstones upon which it’s based, you’ll want to . . .
2. Study, Study and Study some More!
Be prepared to spend many, many hours looking at charts until the repeating patterns of behaviour start to make sense to you. We’re not talking about simple ‘TA by numbers’ type shapes that your software will highlight for you. We’re talking about uncovering the footprints left by the ‘smart money’; spotting where there’s an inequality in the supply and demand dynamic, along with price floors and ceilings in the form of S&R. That’s what will shine a light on the most probable future movement of price at the far right hand edge of the chart. This requires work – and lots of it. If you’ve stumbled upon TA and think it’s a short cut to riches – stop right now. Read no further. Nothing could be further from the truth.
3. Timeframe
Charts can display a combination of three basic elements: price, volume and time. Charts that display price over fixed time periods (e.g. bar or candlestick charts) can be extremely useful; many traders would say they are vital and that they couldn’t trade without them. However, they can muddy the waters for those starting out. If you’ve ever learnt to juggle, you’ll know it’s much easier to start with one ball, then to add a second and, finally, a third. And so it is with trading, so consider removing time from the equation – at least to start with. Better still, dispense with volume too and only look at price. Time and volume have their place, but they add complexity and neither one compares to price in terms of importance. Price rules! This leads to . . .
4. Types of Chart
There are lots of types of chart but, as recommended above, the ones best suited to novice technical analysts are ones that do not plot fixed time periods. Of these, either
Renko charts or
Point & Figure charts (P&F) are good starting points. The latter are a little more complicated but well worth the effort. The value of these charts is that they hide many of the ‘TA by numbers’ shapes and patterns which, generally, don’t help the novice trader. More importantly, the things that really matter will jump out at you; most notably trend, areas of S&R (if you’ve been paying attention you’ll know that S&R stands for Support and Resistance!) and the supply and demand dynamic between buyers and sellers. This is down to their method of construction. Unlike time based charts, they only update when the market moves and they only ‘speak’ when the market has something to say. They filter out extraneous ‘noise’ which will help you to ‘hear’ what the market is telling you.
5. Intra-Day Charts
If you can’t resist the seductive good looks of time based charts – try to keep to a daily or weekly timeframe. The markets (e.g. stock market), have one open, one high, one low and one close each day. The open, high, low and close (OHLC) on hourly, 15 minute and 1 minute bar and candlestick charts (plus the numerous other time intervals) are artificial constructs created by your TA software. The market doesn’t actually open and close at those intra-day intervals. Trading these timeframes can add an additional layer of complexity for novice traders. So, keep it simple while you’re learning by sticking to daily charts.
6. Indicators
This Sticky defends indicators on the grounds that their poor reputation isn’t really justified. However, for the new trader, they spell danger as they deflect from the hard work of studying price movement. They are next to impossible to resist and appear to offer a quick and simple solution about when and where to get in and out of the market. They do no such thing – that’s just an illusion. If you do decide to use them, learn what they may be telling you about price, and ask yourself whether price itself is already telling you that anyway. Many indicators lag price, so if you can do without them and glean the information you want from price alone, you’ll steal a march on the trader who can’t.
If you must use them, heed the warnings about them listed in the section above entitled:
‘Indicators and the Mechanics of TA’ and try to restrict yourself to one or two at most. In the hands of a novice trader, indicators are much like fonts are to a graphic designer; they must be used sparingly, judiciously and with purpose. Otherwise the results will be ugly. Above all, remember that all any indicator does is to
indicate a market state, i.e. that the market is range bound, trending, running out of momentum or building up a head of steam etc. It’s all too easy for the novice trader to misinterpret this information - or to ignore it completely - and use indicators as a means to jump to conclusions about when and where to enter and exit trades.
7. Market Observations
Hopefully, the results of your studies will be a series of observations about price: the way it moves, how far, how fast, whether the movement is clean and smooth or nervous and jittery etc. From there, you can start to formulate a basic hypothesis along the lines of ‘price tends to be range bound here’ or ‘enter a trending phase there’ or ‘reverses there’ etc. Keep it very simple and remember you’re just observing what price does; you’re not trying to figure out
why it does what it does. Your broker won’t pay you extra on your winning trades or refund losses on your losing ones for being able to explain why the market did what it did!
8. Turning Observations into Opportunities
Next, you’ll need to work out how you can profit from your observations by formulating a simple trading strategy or system. On the face of it, this sounds impossibly difficult, but there’s lots of help and examples from other members to inspire you. Most retail traders utilising TA build a strategy based on one of three basic styles: reversals, breakouts and retracements. These are explained in this FAQ:
Is There a Strategy or System that I should Use and where Can I Find it? Select just one of your observations – preferably the one that lends itself best to one of the three basic trading styles. Focus on that. Try to resist the temptation to jump from pillar to post - trying a little bit of everything - as if you were in a restaurant on an all inclusive holiday.
9. Test, Test, Test!
Having made your observations and formulated a simple trading methodology around them, you then need to test it. Depending upon the strategy and your computer/techie skills, this will either be done manually or mechanically. To do this effectively, you’ll need to decide exactly when and where to enter and exit your trades, how big your positions should be and where to place your stops. The results should indicate that your methodology has a positive expectancy. (All of this is explained in detail in the
Essentials Of 'Risk & Money Management' Sticky.) If the results are encouraging, then the next step is to trade the methodology with real money using a live account. To start with, keep the amounts involved as small as possible and only increase them if the live results match the test results.
10. And Finally . . .
It’s not right to have a lengthy document about TA without a single chart in sight. So, to inspire you, here’s a Renko chart of the $INDU, often referred to simply as the DOW, Charles Dow’s industrial average. The blue diagonal lines show the trend which is clearly up, but the angle is dropping off which indicates that the trend isn’t as strong as it was when the move started in October 2011. In other words, demand to own shares in the top 30 U.S. blue chips is showing signs of waning. The horizontal lines show where the demand and supply dynamic reversed in the past and
may become support (green) and resistance (red) zones in the future. Note how price has found support no less than four times around the 12,500 mark since June. If it tests this level for a 5th time (it may not, of course), the third blue trend line will be breached and many observers will be looking at the next possible area of support just above 12,000. (The ‘higher swing low’ created in June.) Could price drop back down to this level?
Who knows - who cares. What we do know and care about is that, as things stand, the chart remains bullish, although the recent reversal creating a ‘lower swing high’ just below 14,000 is ominous and another sign that buying pressure is easing off. If price falls back down and breaches support just above 12,500 then, according to standard Dow Theory, the primary trend will have switched from being bullish to bearish.
Adopting basic principles such as trading with the trend would have enabled the chartist to be on the right side of the market – i.e. the long side – from late Nov’ 2011 when price made a ‘higher swing low’ at 11,250. Just by looking at this one chart, in one timeframe, following one golden principle (trading with the trend), you can see that 2,250 points were up for grabs. In these dismal economic times, that’s pretty exciting and more than enough reason to take this TA malarkey seriously.
‘This time next year Rodney . . .’
The Bottom Line
Hopefully, the resounding message of this Sticky has hit home. Namely, that whether or not TA works is the wrong question. The right question is whether or not it will work
for you and the answer to that starts with your beliefs about the markets and how they function. If you can look at a chart and spot an imbalance in supply and demand or a ‘fight or flight’ response from fellow speculators in a timely manner (it’s easy in hindsight!), then you’ll have the basis for trading with the trend or and / or spotting when an existing trend is running out of steam. This will put you way ahead of most other retail traders and investors. Hopefully, the other important message has also hit home. Namely, that although many of the basic principles of TA are just that – basic – applying them well on a consistent basis to make profitable trades is far from easy. It will take time, effort and practice to learn. The road ahead offers no short cuts, no holy grails, just lots of hard work. Enjoy the journey!
