Technical analysis guide: Lesson 1
Spy School Article | 12th April 08 | CFDSpy.com
| The following topics are covered in this lesson: 1. Picking a trading style to reflect your personality 2. What is fundamental analysis? What is technical analysis? 3. Technical analysis 101: Support and resistance lines. |
full size charts in article |
There are a million different ways to trade the financial markets. Maybe more. Swing traders, data players, Elliot Wave analysts, momentum traders, Gann theorists, spread traders, arbitrageurs – not to be confused with risk arbitrageurs – and correlation players all help to price and misprice assets. The music of the market reflects the instruments these traders use.
Yet any two traders using the same strategy could be taking wildly different trades – even taking opposites sides of the same trade. This is because, while sharing the same broad strokes, they could have different methods of analysis, different timeframes and different signals, leading to altogether different decisions.
Each person reflects his own personality in how he trades. No two traders, and therefore trading styles, are the same.
The choice of a trading strategy will depend in large part on two factors: your free time and your personality. Some strategies are more time-consuming than others. Some require a greater appetite for risk. But when you have made the decision of what your trading strategy will be, it should still be continually tweaked to fit your comfort level – and to reflect your own strengths and weaknesses.
Two types of analysis
Do you want to take a long-term view and stick to it – or do you want to buy and sell as the price moves up and down? Both of these strategies have strengths, and encapsulate the difference between the two main trading styles.
The smorgasbord of different strategies can loosely be separated into two categories: fundamental analysis and technical analysis.
Fundamental analysis considers the inherent financial health of a company, an economy or an industry.
In the stock market, you analyse company reports and pay careful attention to announcements and profit results; in the foreign exchange market, you watch data releases such as gross domestic product (GDP) growth, non-farms payrolls or interest rate releases; if you are buying an industry index or tracker you will look both at the individual companies within that industry and also macro factors (for instance, how are people in that industry affected by the price of oil?)
Technical analysis is based on the notion that prices move in trends – and that you can exploit these trends to make money.
You can either ignore the fundamental data entirely – as some brave chartists do – or you can absorb that data into your strategy, combining elements of both fundamental and technical analysis. The synthesis of the two styles is a strategy that many traders feel most comfortable with.
The technical analyst’s main tool is a price chart. By looking at this chart – seeing where the price has been before and seeing what happened when it got there – traders hope to predict where it will go next. The best way to learn technical analysis is by looking at a chart, so let’s have an example.
Support and resistance
In the chart below, every time the price has risen up to 48, it has fallen back down. Traders who bought the stock at a lower level close their positions here, and take profits; or new short sellers enter the market; or both. For whatever reason, the market is not comfortable with the price going above this level.
In other words: the price has found resistance at 48. This price is the resistance level.
We also see that when the price has fallen to 42, it has stopped and gone back up. Short-sellers close their positions; fresh buyers come in; or both. For whatever reason, the market is not comfortable with the price going below this level.
In other words: the price has found support at 42. This price is the support level.
Some technical analysis can get very technical indeed. But most of it remains based on these two simple concepts. Support and resistance are the foundation of technical analysis. They will be your most valuable tools.
Chart 1:
When we see the price trade between support and resistance like this, we wait (Chart 1). What we are looking for is a break-out to trade. When price does eventually break-out of its trading range and rises about the resistance level, we buy (Chart 2). Instead of taking a directional bias before watching the stock, we allow the movement of the stock to guide our decision.
Chart 2:
This is the essence of the break-out. Note that, with the same chart, we could have traded differently – we could have sold at resistance and bought at support, expecting the price to stay within the range.
The decision of whether to play the break-out or the continuation should be based on other factors: perhaps your fundamental analysis, perhaps the long-term technical analysis, perhaps indicators such as stochastics or Bollinger bands. We will examine these factors later in the series – but, again, these will come down to experience, and personal preference.
Technical analysis is worthwhile even if you don’t believe it
Many technical analysts believe that all the current information about a stock (or a currency, an index, a fund) is reflected in the price. This implies that inside trading is the only method of ‘fundamental analysis’ likely to yield results.
By using the chart, you are not looking at the information but what the market wants to do with that information. You don’t act, you react. Whether or not you agree with this principle, it is worth having a good knowledge of technical analysis – if only to know what everyone else is looking at.
Next time on Spy School: Chart formations
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