When you study past market data to predict future changes in the market it is referred to as technical analysis. It falls under the category of security analysis alongside fundamental analysis. In this article, we are going to discuss how technical analysis is utilized in day trading.
In This Article:
- Assumptions in Technical Analysis
- Market Cyclicality
- Price, Volume, and Volatility Run in Distinct Trends
- Analytical Approaches
- Types of Charts
- Open-High Low-Close
- Common Terms
- Technical Analysis Indicators
- Non-Chart Based
- Further Reading
Fundamental analysis can be applied to micro and macro economic levels, which often differs from technical analysis. Microeconomic fundamental analysis includes studying revenues, cost, earnings, assets and liabilities, capital structure, and “soft” elements such as the quality of the management team and competitive position in the market.
Macroeconomic fundamental analysis encompasses studying or forecasting economic growth, inflation, credit cycles, interest rate trends, capital flows between countries, labor and resource utilization and their cyclicality, demographic trends, central bank in relation to political policies and behavior, geopolitical issues, consumer and business trends, and “soft” data such as sentiment or confidence surveys.
Depending on the preference from each trader when making informed trading and investing decisions. Some traders might be more inclined to utilize one or the other and some may prefer using both.
The majority of large banks and brokerages have specialized teams in both fundamental and technical analysis. Ultimately, both forms of analysis are beneficial and effective when perfected and provide quality information to traders. When considering the different types of analysis, the more knowledge the better. The more quality information traders obtain to improve the odds of being right, the better their results will likely be in the end.
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Assumptions in Technical Analysis
Most traders tend to favor one type of analysis over the other, typically, or at least favor one type more heavily in making trading decision, but some traders and investors use both fundamental analysis and technical analysis equally.
The methodology that technical analysts rely on fall under two main beliefs. The first belief is that price histories tend to be more cyclical and the second belief is that prices, volume, and volatility of the market tend to have distinct trends.
Let’s take a look at each one more thoroughly:
Just as human nature shows commonly shared behavioral characteristics, market history also tends to repeat itself. Specific patterns of behaviors and sequences of events rarely repeat itself perfectly, they generally tend to be comparable. This also stands true for both long-term and short-term price behaviors.
Long-term behaviors in business cycles are inherently prone to repeating themselves, such as credit booms where debt escalates to an unmanageable level for a period of time and then eventually results in financial distress due to not enough cash being accessible to service these debts. When this happens, there tends to be slow progressive gains in the stock market and other “risk-on” trades (e.g., carry trending) during the upswing and a sharp decline when a recession strikes.
Technicians operate solely on the belief that market participants are likely to repeat the behavior of the past, due to the market’s collective and patterned nature. If this were true and behaviors were always more likely to repeat themselves, that would also imply that patterns could be recognized by looking at previous data regarding price and volume in the market and use this information to predict similar reoccurrences in the future. If traders were able to identify when and where a pattern or behavior is likely to be repeated, they would also be able to identify when different risk and/or rewards of trades were going to be in their favor.
Because this is true, there is also an ongoing assumption that a market’s price should discount all information that influences a particular market. If all of this information is subsequently reflected in asset prices immediately upon release, it would be just like fundamental events, such as news and economic data, and how they currently impact the financial market. Technical analysis would then switch it’s attention to identifying trends in the market prices and evaluate how market participants value specific information.
For example, if US CPI inflation data came in a tenth of a percent higher than what was being priced into the market originally, prior to any news releases, traders would be able to determine how vulnerable the market is to that information by monitoring asset prices and any trends that exist regarding how they react immediately following this event.
If US stock futures move down X%, the US dollar index increases Y%, and the 10-year US Treasury yield increase Z%, we can generally assume the economic inputs impact specific markets. If traders could predict how sensitive the market is at different times, that information would be invaluable to use for stress testing purposes in the form of risk management. For example, if inflations were on the rise unexpectedly and increase above 1%, data points could be used regarding unexpected inflation readings in order to determine how this might affect the portfolio.
Price, Volume, and Volatility Run in Distinct Trends
Another technical analysis assumption is that market price does not move around randomly without foreseeable or logical patterns. Generally, this is a belief amongst all securities in a broader sense as well. This assumption means that it is the general belief of technical analysis that there market prices move on a continuum where there are trends that are both explainable and predictable.
With his belief in mind, consider the graph below of EUR/USD amounts from 2013-2017. When looking at support and resistance within the contest of trends, we can see how technical analysis played a role. When the euro began depreciating compared to the US dollar as a result of a divergence in monetary policy in mid-2014, technical analysts might have taken short trades on a pullback to resistance levels within the downtrend, which is marked in the image below with arrows. Once this trend faded and consolidation was occurring in the market, a technician may have chosen to start taking longs at support to play the range, while simultaneously closing out any pre-existing short positions.
Technical analysis was originally a matter largely of “reading the tape” or interpretive the successive flow and magnitude of different data, such as price and volume, through something called a stock ticker. In the 1970s, when computers became more of a commonly used form of technology, data started being inputted into a chart that became the standard point of reference for technicians.
Chart patterns and bar, or candlestick, analysis’ became more widely recognized as the most common forms of analysis, followed by regression analysis, moving averages, and price correlations. Today, the technical indicators have increased exponentially. Any person with adequate knowledge of coding that is relevant to this software program has the ability to transform price or volume data into any specific indicator of interest.
Technical analysis is extremely useful in identifying trends, behavioral proclivities, and potential errors in supply and demand where trading opportunities are likely to appear, however, it cannot solely or flawlessly predict the future.
The easiest way to approach technical analysis is a basic candlestick price chart, which shows price history as well as the buying and selling dynamics of the price within a particular period.
Another way technical analysis could be conducted is by employing a price chart with technical indicators or by using specialized forms of technical analysis, such as Elliott Wave Theory or Harmonics, to formulate concepts in trading. Traders must resist “information overload” or cluttering the charts with too many indicators and lines, which starts to have an adverse impact on the readability of the chart.
Some traders may utilize subjective judgment in trading calls to avoid trade based on restrictive rules, depending on each unique situation. Other traders may enter into trades only when there are uniformed rules, in order to increase objectivity in their trades and prevent emotional biases from having an impact on how effective their trading methods are.
Types of Charts
Candlestick charts are the most common form of charting utilized today through this software. Vertical candles are used on this chart in green, or somewhat white, when current price is higher than the opening price and red, or sometimes black, for bearish candles when the current price is lower than the opening price.
Candlestick charts have the ability to show the distance between opening and closing prices compared to the total daily range, as seen below where the body of the candle signifies the prices and the length of the wick signifies the daily range.
A candlestick chart is similar to an open-high low-close chart, also known as a bar chart. But instead of the body of the candle showing the difference between the open and close price, these levels are represented by horizontal tick marks. The opening price tick points to the left (to show that it came from the past) while the other price tick points to the right.
Open-high low-close charts, also known as bar charts, are similar to candlestick charts. The difference is, instead of the body of the candle signifying the difference between the open and close price, it is represented horizontally using tick marks. The opening price tick points start on the left and progress towards the right where the close price tick can be seen, instead of the body of the candle representing the difference between the open and close price. The opening price tick points are shown from left to right to signify the left being the past and all updated price tick points will appear as it progresses forward to the right.
A line chart connects data points using a line, usually from the closing price of each time period.
Area charts and line charts are relatively the same, except the area underneath is shaded. The purpose of this is to be able to more easily visualize the price movement in relation to the line chart.
Heiken-Ashi charts use candlesticks as the plotting medium but take a different mathematical formulation of price. Instead of the standard use of candles interpreted from basic open-high low-close criteria, prices are smoothed in order to be able to predict trending price action more accurately according to this formula:
- Open = (Open of previous bar + Close of previous bar) / 2
- Close = (Open + High + Low + Close) / 4
- High = Highest of High, Open, or Close
- Low = Lowest of Low, Open, or Close
Average true range – The range over a certain time period, usually daily.
Breakout – When price breaches an area of support or resistance, often due to a notable surge in buying or selling volume.
Cycle – Periods where price action is expected to follow a certain pattern.
Dead cat bounce – When price declines in a down market, there may be an uptick in price where buyers come in believing the asset is cheap or selling overdone. However, when sellers force the market down further, the temporary buying spell comes to be known as a dead cat bounce.
Dow theory – Studies the relationship between the Dow Jones Industrial Average (an index comprised of 30 US multinational conglomerates) and Dow Jones Transportation Average. Proponents of the theory state that once one of them trends in a certain direction, the other is likely to follow. Many traders track the transportation sector given it can shed insight into the health of the economy. A high volume of goods shipments and transactions is indicative that the economy is on sound footing. A similar indicator is the Baltic Dry Index.
Doji – A candle type characterized by little or no change between the open and close price, showing indecision in the market.
Elliott wave theory – Elliott wave theory suggests that markets run through cyclical periods of optimism and pessimism that can be predicted and thus ripe for trading opportunities.
Fibonacci ratios – Numbers used as a guide to determine support and resistance.
Harmonics – Harmonic trading is based on the idea that price patterns repeat themselves and turning points in the market can be identified through Fibonacci sequences.
Momentum – The rate of change of price with respect to time.
Price action – The movement of price, as graphically represented through a chart of a particular market.
Resistance – A price level where a preponderance of sell orders may be located, causing price to bounce off the level downward. Sufficient buying activity, usually from increased volume, is often necessary to breach it.
Retracement – A reversal in the direction of the prevailing trend, expected to be temporary, often to a level of support or resistance.
Support – A price level where a higher magnitude of buy orders may be placed, causing price to bounce off the level upward. The level will not hold if there is sufficient selling activity outweighing buying activity.
Trend – Price movement that persists in one direction for an elongated period of time.
Technical Analysis Indicators
Technical indicators involve some statistical or arithmetical transformation of price and/or volume data to provide mathematical descriptions of up/down movement, support and resistance levels, momentum, trend, deviations from a central tendency, ratio(s), correlation(s), among other delineations. Some indicators also describe sentiment, such as short interest, implied volatility, put/call ratios, “fear” or “greed”, and so forth.
Technical indicators fall into a few main categories, including price-based, volume-based, breadth, overlays, and non-chart based.
Average Directional Index (ADX) – Measures trend strength on an absolute value basis.
Average Directional Movement Rating (ADXR) – Measures the rate of change in a trend.
Commodity Channel Index (CCI) – Identifies new trends or cyclical conditions.
Coppock Curve – Momentum indicator, initially intended to identify bottoms in stock indices as part of a long-term trading approach.
MACD – Plots the relationship between two separate moving averages; designed as a momentum-following indicator.
Momentum – The rate of change in price with respect to time.
Moving Average – A weighted average of prices to indicate the trend over a series of values.
Relative Strength Index (RSI) – Momentum oscillator standardized to a 0-100 scale designed to determine the rate of change over a specified time period.
Stochastic Oscillator – Shows the current price of the security or index relative to the high and low prices from a user-defined range. Used to determine overbought and oversold market conditions.
Trix – Combines to show trend and momentum.
Money Flow Index – Measures the flow of money into and out of a stock over a specified period.
Negative Volume Index – Designed to understand when the “smart money” is active, under the assumption that the smart money is most active on low-volume days and not as active on high-volume days. Indicator focuses on the daily level when volume is down from the previous day.
On-Balance Volume – Uses volume to predict subsequent changes in price. Proponents of the indicator place credence into the idea that if volume changes with a weak reaction in the stock, the price move is likely to follow.
Positive Volume Index – Typically used alongside the negative volume index, the indicator is designed to show when institutional investors are most active under the premise they’re most likely to buy or sell when volume is low. Focuses on days when volume is up from the previous day.
Williams Accumulation/Distribution – Looks at divergences between security (or index) price and volume flow. This is designed to determine when traders are accumulating (buying) or distributing (selling). For example, when price makes a new low and the indicator fails to also make a new low, this might be taken as an indication that accumulation (buying) is occurring.
Breadth indicators determine how strong or shallow a market move is.
Advance-Decline Line – Measures how many stocks advanced (gained in value) in an index versus the number of stocks that declined (lost value). If an index has gained in value but only 30% of the stocks are up but 70% are down or neutral, that’s an indication that the buying is very likely only occurring in certain sectors rather than being positive toward the entire market.
If 98% of the stocks are up but only 2% are down or neutral at the open of the market, it’s an indication that the market might be more trendless and “reversion to the mean” day trading strategies could be more effective. However, if a lopsided advance/decline persists, it could mean that the market could be trending.
Arms Index (aka TRIN) – Combines the number of stocks advancing or declining with their volume according to the formula:
(# of advancing stocks / # of declining stocks) / (volume of advancing stocks / volume of declining stocks)
A value below 1 is considered bullish; a value above 1 is considered bearish. Volume is measured in the number of shares traded and not the dollar amounts, which is a central flaw in the indicator (favors lower price-per-share stocks, which can trade in higher volume). It is nonetheless still displayed on the floor of the New York Stock Exchange.
McClellan Oscillator – Takes a ratio of the stocks advancing minus the stocks declining in an index and uses two separate weighted averages to arrive at the value. Best used when price and the oscillator are diverging. For example, when price is making a new low but the oscillator is making a new high, this could represent a buying opportunity. Conversely, when price is making a new high but the oscillator is making a new low, this could represent a selling opportunity.
Overlay indicators are placed over the original price chart.
Bollinger Bands – Uses a simple moving average and plots two lines two standard deviations above and below it to form a range. Often used by traders using a mean reversion strategy where price moving above or below the bands is “stretched” and potentially expected to revert back inside the bands.
Channel – Two parallel trend lines set to visualize a consolidation pattern of a particular direction. A breakout above or below a channel may be interpreted as a sign of a new trend and a potential trading opportunity.
Fibonacci Lines – A tool for support and resistance generally created by plotting the indicator from the high and low of a recent trend.
Ichimoku Cloud – Designed to be an “all-in-one” indicator that gives support and resistance, momentum, trend, and generates trading signals.
Moving Average – A trend line that changes based on new price inputs. For example, a 50-day simple moving average would represent the average price of the past 50 trading days. Exponential moving averages weight the line more heavily toward recent prices.
Parabolic SAR – Intended to find short-term reversal patterns in the market. Generally only recommended for trending markets.
Pivot Points – Levels of support and resistance determined from yesterday’s open, high, low and close. Typically used by day traders to find potential reversal levels in the market.
Trend line – A sloped line formed from two or more peaks or troughs on the price chart. A break above or below a trend line might be indicative of a breakout.
Although it is widely used, charting and arithmetical transformations of price are not exclusively used in technical analysis. Sometimes sentiment-based surveys are utilized from consumers and businesses to predict where the price might be headed.
If the investor sentiment is weighing heavily one way or the other, surveys may be deployed as a contrarian indicator. If the market is extremely bullish, it would indicate that most people are fully invested, and few buyers remain on the sidelines to create an increase in prices. When this happens, prices are more likely to trend down than trend up. The risk that is associated with being a buyer is much higher in this situation than if sentiment was slanted in the other direction.