Technical Analysis

Traders in the know are increasingly turning to technical analysis. They realise that prices of equities, commodities, futures, derivatives, fixed income and currencies do not move randomly, rather they move in repeating and identifiable patterns.

They use this information to gain an edge on other investors and make money in the markets. They make decisions based on proven technical analysis techniques.

Trading Computers Technical Analysis

Principles of Dow Theory

No introduction to technical analysis is complete without an explanation of Dow Theory. Dow used the price behaviour in the stock market as a barometer of economic business conditions. Note that he didn’t actually use the behaviour to actually forecast future stock price moves.

Dow Theory is a method of identifying major trends in the stock market. Dow Theory is only concerned with market direction, it has no forecasting value in terms of the potential size or duration of a trend.

He left it to others to compile his ‘theory’ from his many scattered writings about averages – a handful of tenets that act as the underpinning of modern technical analysis.

Using the rules below, Dow summarised that directional trends will continue until there is a definite signal of a reversal. Easier said than done. Identifying this reversal is perhaps the hardest part to get right when it comes to technical analysis.

The 6 tenets of Dow Theory:

  1. The averages discount everything except acts of God

    1. This is a basic principle of technical analysis, anything and everything that CAN affect the price is already reflected and discounted in the price.
  2. There are three types of trend

    1. Major – Major trends last for more than a year and often many years.
    2. Secondary – Secondary trends may endure for several weeks to several months. They are also called corrections because they’re regarded as interruptions in the major trend. They may trace from one-third to two-thirds of the price trend but only temporarily.
    3. Minor – Minor corrections last up to a few weeks and there may be two or three of them within an intermediate trend.
  3. Major trends go through 3 phases – Accumulation, Trending & Distribution

    1. Accumulation phase is when price levels are relatively low, astute investors start buying or accumulating new positions.
    2. As more buyers join the buying price advances rapidly and economic conditions are strong and healthy. This is the second phase of the market otherwise known as the trending phase.
    3. At some point a buying climax occurs. More buyers are caught up in the buying enthusiasm, often less astute investors and speculators. By this time the trend has likely been going up for months and suddenly the prices seem too high and the market becomes overpriced. This is when the sensible investors begin to sell off, the third phase, the distribution phase.
  4. Volume should confirm the trend

    1. The movements in the direction of the major trend were usually accompanied by heavy or increasing volume. Any market movements, whether up or down are considered to be stronger if increased volume goes along with it. Volume can be seen as a signal of market aggression.
  5. Price action determines the trend

    1. A bullish trend is defined by a series of higher highs and higher lows in the price action. A bearish trend is the opposite and can be described as lower highs and lower lows. Whilst this is accurate, technical analysis is not a science and so you are unlikely to see perfect trends.
  6. The averages must confirm each other

    1. This is one of the most important principles of Dow Theory. To confirm the potential future strength of the economy, the share prices of companies that make goods should rise, but also the share price of companies that distribute (i.e. transport) these goods must also rise. Although Dow referring to the transportation and industrial averages, he was touching on the much broader and more significant principles of confirmation and divergence. No one indicator in technical analysis can be regarded as the one-and-only signal, signals must confirm each other for the buy or sell signal to be considered valid.

As you can see, Dow Theory acts as the theoretical foundation for technical analysis.

Modern Technical Analysis

Technical analysis has really taken off with the improvements of technology. The emergence of computers available to the masses also means that anyone can access the markets and use technical indicators to analyse it.

Trading Computers

Technical analysis can be defined as simply the study of securities based on market action. Technicians record historical price and volume activity (usually in chart form) and deduce from that pictured history the probably future trend of prices.

Most technicians now use charting software’s and platforms to conduct their analysis on. Charts will show the price of a market against time and can be portrayed in various different types; line charts, bar charts, candlestick charts.

There is a huge amount technical indicators you should be aware of.


Technical Indicators Popular Parameters

Moving Averages

Standard moving averages seem to be most popular, although weighted moving averages are most sensitive to price changes:

Long-term 13, 21, 34 & 55 days

(Fibonacci Numbers, with 21 = 1 monthly cycle)

5, 10, 20 & 40 days (=1 week, 2 weeks, etc)

200 days (or 200 weeks for very long-term)

Medium-term 18 hours
Intra-day 60 minute or 120 minute (=1 hour or 2 hours)

Bollinger Bands

John Bollinger, in his book “Bollinger on Bollinger Bands” suggests:

  • 20-day simple moving average
  • 2 standard deviations of the moving average

Relative Strength Index (RSI)

J Welles Wilder, in his book “New Concepts in Technical Trading Systems”, used the RSI:

Long-term 14 (= One half moon cycle), 9 or even 5 days
Very long-term 21 weeks
Long-term 21 days (1 month)

10 days (2 weeks), or 9 days (reacts a bit faster)

Medium-term 24 hours (or 22 hours)
Intra-day 15 minutes or 25 minutes (for non-volatile markets)

Stochastics

(Note that slow stochastics are far more popular than normal stochastics)

Lane devised his own stochastic parameters:

Chart Type 1st Number 2nd Number 3rd Number
Long-term (Daily bars) %K = 5 %D = 3 %Dn = 3
or %K = 10 %D = 6 %Dn = 6
or %K = 15 etc %D = 9 etc %Dn = 9 etc
Medium-term (hourly bars) %K = 22 %D = 15 %Dn = 15
or %K = 15 %D = 14 %Dn = 14
or %K = 8 %D = 5 %Dn = 5
Short-term (10-min bars) %K = 15 %D = 9 %Dn = 9

On-Balance Volume

No parameters required

Moving Average Convergence/Divergence (MACD)

Gerald Appel devised his parameters using an optimisation on the Silver market:

Long-term = 12, 26 and 9 days

Some variations of Appels values are also popular for MACD

Long-term = 10, 20 and 10 days, (i.e. 2 weeks, 4 weeks, 2 weeks), or 10, 20 and 9 days (which gives slightly earlier signals)