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.
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.
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.
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.
- Support and Resistance
- Trend Lines
- Pattern Recognition
- Moving Averages
- Candlestick Patterns
Technical Indicators Popular Parameters
Standard moving averages seem to be most popular, although weighted moving averages are most sensitive to price changes:
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)
|Intra-day||60 minute or 120 minute (=1 hour or 2 hours)|
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|
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)|
(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|
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)