Technical analysis tenants
Many traders use technical analysis when making trading and investing decisions.
Technical analysis is the basic belief that all information, no matter how well guarded, is already factored into price. As an example and ignoring the ethical issues, someone with knowledge of information that could affect the share price of a stock would be expected to trade that stock in order to make a personal gain. As such, the news would already be priced into the market.
If we believe that all news and information is already factored into price and take that one step further, then many technicians believe that the only reliable gauge of a market is its price. Many technicians use chart analysis and patterns, or indicators derived from price to determine potential future price movements.
Fundamental analysis alternatively is the more commonly held idea of trading, based on news, events and in the case of broader markets, data. Technicians play down this form of trading as;
• News and events can arrive at inopportune times to trade
• Data will only move markets if it is a surprise
Technicians feel that this information is already reflected in price anyway, or else, if it isn’t, the market simply reacts to it in the same way, removing the benefit of trading “fundamentally.”
Technical analysis benefits
Exact price levels
The major benefit of technical analysis is that it is more exact than fundamental analysis. As such, “levels” of price action can be identified, which gives a trader a specific price to buy or sell at, and to place profit and stop levels.
This is based on the premise that technical analysis actually works off of the price itself and not some intangible idea of “value.” By working with the end product (price) technicians can be much more exact about their entry and exit levels, which in turn allows a trader to buy in lower, or sell short higher, increasing the chances of profit on a trade.
Removes data “interpretation”
Technical analysis also reduces the risk that the market may “misinterpret” data, as technical traders prefer to trade with the price action itself and not the news item.
Effectively, the market doesn’t move on the data release itself, but on the “market’s reaction to the data.” This is a very important distinction, as the market’s reaction to data that the trader thought was bullish may in fact be negative, or visa versa.
Quick and easy
Finally, technical trading is much easier and quicker than gathering and keeping up to date with the plethora of fundamental factors. If a trader wished to trade the AUD/USD using fundamental analysis, he or she would need a deep understanding of all economic data and trends and major political happens in the Australian and American economies.
This style of trading becomes more time intensive if the trader wanted to trade in more markets.
A technical analyst on the other hand simply needs to turn on a computer, add the chart and indicators and can be trading in less than two minutes.
Technical analysis styles
There are two major styles to technical trading; chart patterns and indicators.
Chart patterns are what many would call “old fashioned” schools of technical analysis. This style of analysis includes trend lines and channels and patterns themselves, such as the well known “head and shoulders” pattern.
A trend is defined as constant movement in a single direction; a bullish trend is intact when price moves higher, while a bearish persists when price moves lower. Technical analysts quite often draw lines from the lows (bullish trend) or highs (bearish trend) to pictorially define the trend as shown in the diagram below:
A chart pattern is a confluence of price action that forms a pattern that has repeated in the past and prompted a regular or repeatable result. The most well known technical chart pattern is the “head and shoulders top,” which quite often indicators a bearish break. The pattern is determined by a first peak (left shoulder) a higher second peak (head) and a third peak similar to the first (right shoulder). A head and shoulders top is shown in the diagram below:
Indicators are a mathematical interpretation of data, which then provides buy and sell signals independently of the price action itself.
Broadly, indicators can either be “trend indicators” or “momentum indicators.” Obviously, trend indicators confirm the appearance and often the direction of a trend. These indicators include:
• Moving averages
Momentum oscillators on the other hand simply indicate the appearance of overbought or oversold conditions in a market. If the market is overbought, a technician would expect price to fall slightly, while if the market is oversold, a rise in price would be expected. The most commonly used momentum oscillators include:
• Williams %R
Technical analysis is commonly combined with Money Management techniques in order remove the emotion around basic trading necessities. Money Management generally covers:
• Trade size
• Risk to reward
Trade size is the strategy that manages how much of a trader’s account is allocated to each individual trade. Many traders limit each trade size to a maximum of 5% of their account. This ensures that a single bad trade won’t wipe out the account and that a long string (20) of consecutive bad trades is required before the account is reduced to zero.
Risk to reward is the ratio that is to be calculated on each individual trade. Basically, it is the ratio of how much is to be risked (where a trader places his stop) to how much is the expected reward or payoff (profit target).
Most traders aim for a risk: reward ratio of 1:2, meaning that they expect to make double per trade that they are willing to lose. Interestingly, a trader with a 1:2 risk: reward ratio will only need to get slightly more than half of their trades right to make money in the market.
The lock-out is the final safety mechanism that many money management systems contain. Essentially, after a certain amount of consecutive losses on a day or a week, the trader will stop trading for that period.
If the lock out is “three for the day,” three consecutive losses will cause the trader to stop trading for the rest of that day.