Jack Haddad, January Guest Writing

Technical Analysis: the essentials of technical and market indicators
By: Jack Haddad, MD, CMT, DITA

Introduction:

Technical analysis has been around for as long as there has been organized markets in the form of exchanges. But, it was not long ago (late 70s to early 80s) when Wall Street, major funds, and financial institutions accepted technical analysis as a viable tool for making money. Before then, technical analysis was regarded as a form of mystical hocus-pocus. Now, however, with the scandalous rise of corporate dishonesty, shenanigan business practices, the purely fundamental analyst is virtually extinct. Why the change? What cause this dramatic shift (fundamental to technical) in perspective? According to the Market Technicians Associations (MTA), more than 30 US colleges and universities are currently offering accredited courses in technical analysis (see appendix A). The MTA, an organization founded in 1993, defines our professional code of ethics and promotes the development of technical analysis. Through the effort of the MTA, a third program has emerged that leads to chartered Market Technician (CMT) and a diploma in technical analysis (DITA). If you have an interest in earning a CMT or DITA, the best place to start is by contacting the MTA.

Technical versus fundamental analysis:

To aid in the comprehension of how technical analysis works, one needs to know that a finite number of traders participate in the markets on any given day. These individuals interact with each other on the trading floor and form collective behavior patterns. These patterns are not only observable and quantifiable, but also repeat themselves with statistical reliability; that said, technical analysis is a method that organizes these collective behavior patterns that give clear indications of when there is a greater probability of one thing occurring over another. Fundamental analysis attempts to take into consideration mathematical models that weigh the significance of a variety of variables (corporate earnings and revenues, price-to earnings ratio, gross margins, valuations, etc..) that could effect the relative balance or imbalance between the supply and demand of a particular stock, commodity, or financial instrument. The trouble is that this economic equation that defines the laws of supply and demand does not have an exponential variable to quantify fear or greed. Fear or greed is an element of human nature which is called market sentiment or behavioral analysis, and fundamental analysis gives it no consideration. It's people who express their beliefs and expectations about the future that make prices move and not fundamental models. The fact that a fundamental model makes a logical and reasonable projection is not much value if traders who are responsible for most of the trading volume are not aware of the model or simply don't believe in it. Bob Prechter, a famous practitioner of technical analysis once commented that, "... the main problem with fundamental analysis is that its indicators are removed from the market itself. The analyst assumes causality between external events and market movements, a concept which is almost certainly false. But, just as important, and less recognized, is that fundamental analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. The analyst is then forced to take a second step in coming to a conclusion about how those forecasted events will affect the markets! Technicians only have one step to take, which gives them an edge right off the bat. Their main advantage is that they don't have to forecast their indicators."

Main difference between the two types of analysis:

Fundamental analysis - Focuses on what ought to happen in a market
Technical analysis - Focuses on what actually happens in a market

Factors involved in price analysis:
1. Supply and demand
2. Seasonal cycles
3. Weather
4. Government policy
5. Is a medley of Science & art. No algebraic / empiricalformulae.
6. Involves study of price charts and oscillators derived thereon.
7. Study regards price as the ultimate factor, which factors in fundamental factors as well. Does not subscribe to the random walk theory.
8. Signals generated by market action on prices.
9. Chances of multiple interpretations are higher.
10. Will generate more signals, works for catching MOST price movements.
11. Will generally generate signals in advance.
12. Involves built-in capital / risk management techniques.

Charts are based on market action involving:
1. Price
2. Volume
3. Open interest (futures only)
4. Is a pure science form, involves pre-set parameters for investment decision support systems. 5. Involves study of Balance Sheets, P & L accounts.
6.Study regards price moves as a random phenomena, caused by market forces.
7. Signals generated by corporate actions.
8. Chances of multiple interpretations are lower.
9. Will generate fewer signals, works better for catching major moves.
10. Will generally generate delayed signals.
11. Involves NO risk / capital management techniques.

Charting:

The time frame used for forming a chart depends on the compression of the data: intraday, daily, weekly, monthly, quarterly, or annual data. Traders usually concentrate on charts made up of daily and intraday data to forecast shorterm price movements. The shorter the time frame and the less compressed data is, the more detail that is available. While long on detail, short term charts can be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can effect volatility, which can distort the overall picture. Long term charts care good for analyzing the large picture to get a broad perspective of the historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months. Four of the most popular methods of displaying price data are by the following charts: line bar, candlestick, and point & figure. The line chart is one of the simplest charts. It is formed by plotting one price point, usually the close. For that matter, I don't favor them because I personally consider the open, low, and high to be as important as the close in technical analysis. However, at times, only closing data are available for certain indices, thinly traded stocks and intraday prices. Bar charts are perhaps the most popular charting method. The high, low, and close are required to form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar. On a daily chart, each bar represents the high, low, and close for a particular day. Weekly charts would have a bar for each week based on Friday's close and the high and low for that week. Bar charts can be effective for displaying a large amount of data. Using candlesticks, 200 data points can take up a lot of room and look cluttered. Line charts show less clutter, but do not offer as much detail (no high-low range). The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars before the chart gets cluttered. If you're not interested in the opening price, bar charts are an ideal method for analyzing the close relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker. If you're interested in the opening price, candlestick charts probably offer a better alternative. The beauty of Point & Figure charts is their simplicity. Little or no price movement is deemed irrelevant and therefore not duplicated on the chart. Only price movements that exceed specified levels are recorded. This focus on price movement makes it easier to identify support and resistance levels, bullish breakouts and bearish breakdowns. Contrary to this methodology, Point & Figure charts are based solely on price movement and do not take time into consideration. The topic on candlestick charting is broad and beyond the scope of this article. This method of charting originated in Japan over 300 years ago, and have become quite popular in recent years. For a candlestick chart, the open, high, low, and close are all required. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range, and Friday's close.

Trendlines:

Trendlines are an important tool in technical analysis for both trend identification and confirmation. The general rule in technical analysis is that it takes two points to draw a trendline and the third point confirms the validity. An up trendline is formed by connecting two of more low points. The second low must be higher than the first for the line to have a positive slope. Up trendlines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A downtrend is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Down trendlines act as a resistance and indicate that net-supply is increasing even as the price declines.

Types of technical chart patterns:

When looking for patterns, it's important to keep in mind that they're more of an art than science. Pattern interpretations should be fairly specific, but not overly exacting as to obstruct the spirit of the pattern. A pattern may not fit the exact description, but that should not distract from its robustness. Below are patterns which I have found to be particularly useful and enriching in my personal experience as a professional trader.

A. Bump and Run Reversal: This pattern was developed by Thomas Bulkowski, and introduced in the June-97 issue of Technical Analysis of Stocks and Commodities. As the name implies, the Bump and Run Reversal (BARR) is a reversal pattern that forms after excessive speculation drives up too far, too fast. The pattern can be applied to daily, weekly, and monthly charts. Bulkowski identified three phases to the pattern: lead-in, bump, and run. The lead-in phase can last 1 to 3 months and forms the basis from which to draw the trendline. During this phase, prices advance in an orderly manner and there is no excess speculation. The trendline should be moderately steep. If it is too steep, then the ensuing bump is unlikely to be significant enough. Bulkowski advises that an angle of 30 to 45 degrees is preferable. As the stock advances during the lead-in phase, volume is usually average and low. When the speculative advance begins to form the left side of the bump, volume expands as the advance accelerates. The bump phase forms with a sharp advance, and prices move further away from the lead-in trendline. Ideally, the angle of the trendline from the bump's advance should be about 50% greater than the angle of the trendline extending up from the lead-in phase. Roughly speaking, this would call for an angle between 45 and 60 degrees. The distance from highest high of the bump to the lead-in trendline should be at least twice the distance from the highest high in the lead-in phase to the lead-in trendline. These distances can be measured by drawing a vertical line from the highest highs to the lead-in trendline. The run phase begins when the pattern breaks support from the lead-in trendline. Prices will sometimes hesitate or bounce off the trendline before breaking through. Once the break occurs, the run phase takes over and the declines continue.

B. Top Head and Shoulders Reversal: This pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. The slope of the neckline will affect the pattern's degree of bearishness. A downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form a neckline. It is important to establish the existence of a prior uptrend for this to be a reversal pattern. While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trendline, keeping the uptrend intact. From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The advance from the low of the head forms the right shoulder. This peak is lower than the head, and usually in line with the high of the left shoulder. The head and shoulder pattern is not complete and uptrend is not reversed until neckline support.

C. Bottom Head and Shoulder Reversal: The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form a neckline. After breaking the neckline resistance, the projected advance is found by measuring the distance from the neckline to reach a price target.

D. Double Top Reversal: The pattern is made up to two consecutive peaks that are roughly equal, with a moderate trough in between. With any reversal pattern, there must be an existing trend to reverse. In the case of the double top, a significant uptrend of several months should be established. The first peak should mark the highest point of the current trend. After the first peak, a decline takes place that typically ranges from 10% to 20%. Volume on the decline from the first peak is usually inconsequential. The advance off the lows usually occurs with low volume and meets resistance from the previous high. The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline show that the forces of demand are weaker than supply and that a support test is imminent. Breaking support from the lowest point between the peaks completes the double top.

E. Cup With Handle: The pattern was developed by William O'Neil and introduced in his 1988 book, "How to Make Money in Stocks". There are two parts to the pattern: the cup and the handle. The cup forms after an advance and looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side, and the handle is formed. A prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation or the less upside potential. The cup should be "U" shaped and resemble a bowl or rounding bottom. A "V" shaped bottom would be considered too sharp of a reversal to qualify. The softer "U" shape ensures that the cup is a consolidation pattern with valid support at the bottom of the "U". Ideally, the depth of the cup should retrace 1/3 or less of the previous advance. However, with volatile markets and over-reactions, the maximum retracement could be 2/3. After the high forms on the right side of the cup, there is a pullback that forms the handle. Sometimes this handle resembles a flag or pennant that slopes downward, other times just a short pullback. The handle represents the final consolidation/pullback before the big breakout and can retrace up to 1/3 of the cup's advance, but usually not more. The smaller the retracement is, the more bullish the formation and significant the breakout. Sometimes it is prudent to wait for a break above the resistance line established by the highs of the cup. The cup can extend 1 to 6 months, sometimes longer on weekly charts. The handle can be from 1 to many weeks, and ideally completes within 1 to 4 weeks. F. Ascending Triangle: The ascending triangle is a bullish formation that usually forms during an up trend as a continuation pattern. Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more equal highs form a horizontal line at the top. Two or more rising troughs form an ascending trendline that converges on the horizontal line as it rises. At least two reaction highs are required to form the top horizontal line. The highs do not have to be exact, but should be within reasonable proximity of each other. There should be some distance between the highs, and a reaction low between them. At least two reaction lows are required to form the lower ascending trendline. These reaction lows should be successfully higher and there should be some distance between the lows. If a more recent reaction low is equal to or less than the previous reaction low, then the ascending triangle is not valid.

Final thoughts:

While technical analysis can be a great help in trading the market, no technical indicator is infallible. Further, technical analysis is only as good as its interpreter. Finally, a significant of time must be spent in learning the principles of technical analysis, and in how to properly interpret the various charts and other technical indicators.In practice, many market players use technical analysis in conjunction with fundamental analysis to determine their strategy. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments, whereas the fundamental analyst needs to know a particular market intimately.