In the previous chapter we took a look at the two kinds of analysis briefly, and discussed the various advantages and problems associated with making use of them. In this chapter we’ll examine technical analysis in greater detail.
If you’re dismayed by your inability to correctly interpret price movements in light of technical data, you may find the information in this article invaluable. If you’re a beginner, remember that each indicator has a particular configuration in which it generates the most reliable signals. Just like we cannot use a spade in a task better suited to a screwdriver, it is wrong to use the RSI for analyzing a trend which is better analyzed by a combination of moving averages.
Two important rules of technical analysis are to keep it simple, and to be strict and disciplined with money management and risk controls. Technical tools are not infallible, and their greatest use is in identifying and acting on the scenarios which offer the best risk/reward potential for the trader. In the absence of certainty, even the most capable technical trader will be in danger of seeing his account wiped out, if he doesn’t take the necessary steps for ensuring that he is properly controlling his risk allocation. Once those steps are taken, we are cleared to go on our journey to riches and prosperity.
Let’s take a look at the various tools used by the technical analyst in evaluating and understanding the price action.
Oscillators
Price action has no limits. The price of a currency pair can theoretically move anywhere between zero and infinite on the charts, and while in practice there is always an upper limit, it is extremely difficult to estimate where it should be. For example, based on today’s prices in EURUSD at around 1.35, we would regard 1.50 a very high price. But while this is true, how about 1.45, or 1.55? Since all those prices are “high” on an arbitrary definition, we would have great difficulty in placing a stop loss or take profit order anywhere on the charts. It is clear that we need to confine the price action into a more practical range within which we can interpret the developments more conveniently.
This lack of precision in defining a high or low price for a currency pair within a specific time frame is overcome by the usage of oscillators. There are a large number of oscillators developed through the past decades each of which depends on a different formula, but all of them aim at rearranging the price data mathematically in a way that will facilitate the designation of oversold or overbought levels. An oversold value indicates that the price is too low in comparison to where it has been in the past. Conversely, an overbought reading indicates that traders have driven the quote too high in their excitement. Both cases suggest that a contrarian trade may be profitable.
Oscillators fluctuate between a predefined upper and lower value, beyond which an oversold and overbought level is defined. As the price moves to the overbought level, the trader will contemplate a sell order. When the indicator signals an oversold price, the trader will consider placing a buy order. Oscillators are defined according to the price pattern where they function best. Some are used best in a trending market, while others are suited better to ranging or periodic markets. Examples of those that function best in a ranging environment are the RSI and Stochastics indicators. In contrast, the Williams oscillator and the MACD are thought to emit their most useful signals in a trending market.
Many experienced traders are skeptical of the validity of overbought and oversold readings on an oscillator even under the best of circumstances. It is important to remember that oscillators reduce the arbitrariness in defining what a high or low price is, but do not eliminate it altogether. For example, while an RSI reading at 80 is regarded as an overbought value, the price in many cases ignores this contention and keeps charging on, reaching 85-90, even 95 without looking back.
In order to avoid this problem, many make use of the concept of divergence/convergence between price and the indicator. As the divergence/convergence phenomenon is rarer in practice, greater significance is attached to its occurrence. A bearish divergence is the situation where the oscillator registers lower highs, while the price is making higher highs. In this case it is thought that the uptrend is running out of power. A bullish convergence occurs when successive lower lows of the price are coupled to successive higher lows of the oscillator. This is thought to signal that the downtrend is losing momentum. In both cases, a contrarian trade is advisable.
The RSI, Stochastics, Average True Range, Williams Oscillator, MACD, Force Index are a few of the indicators that are in common use among currency traders.
Moving Averages and Trend Indicators
Oscillators find the greatest use in ranging markets. But while ranges offer many profitable trades to those who like to concentrate on them, it is a fact that many of the greatest traders in history were trend followers. Trends can be overwhelmingly profitable for those who can capture them in time and possess the tools necessary for understanding and exploiting them. The fundamental analyst has his economic theory, his statistical tools, and analytical skills to depend on while studying trends, while the technical analyst makes use of certain indicators tailor-made for trend analysis.
Perhaps the most useful of all trend following indicators is the moving average. This indicator adds up the closing prices of a predefined period (like five minutes, two hundred hours, or ten days), and divides them by the moving average period, reaching at the indicator’s present value. The main reason of using the moving average is determining a mean value around which the price action fluctuates. The difference between an ordinary numerical average and a moving average is that the value of the moving average is constantly updated: as the price registers new highs or lows, the moving average also follows it, but at a slower pace.
There are two kinds of moving averages. The simple moving average (SMA) is the one that we have described in the previous paragraph where the prices of each period receive the same weighting in the calculation of the moving average. In other words, the price of five minutes ago is of the same value as the price of five days ago in determining the value of the moving average. The other kind, the exponential moving average, is a little different in that it gives the prices of the latest period a higher weighting, that is, the indicator is much more sensitive to price changes in the latest period than it is to the values registered weeks or months ago. The exponential moving average is not that useful when used in conjunction with the price action itself. Many traders choose to use the exponential moving average together with a simple moving average of about the same period, and interpret the crossover or divergence/convergence between those two trend indicators as entry or exit points.
Apart from the moving average, an important indicator favored by many technical analysts is the Bollinger Band. This indicator can be used, in combination with others, for predicting the breakdown of a range pattern, but it is also useful for determining entry or exit points in trading trends. During the course of a trend there are many periods where the trend calms down, and price settles into a consolidation pattern. The Bollinger bands are used to predict the end of these patterns, and to open positions as the consolidation phase concludes.
There are many other kinds of indicators which can be used in combination with others to generate trade signals for trend patterns. Once could even write his own indicator with a little bit of practice and understanding of market dynamics. The predictive power of the indicators, while valuable, are most fruitful when they are coupled to prudent money management methods which we’ll discuss a while later.
Price Patterns
Both in trending and ranging markets, it is possible to break down the price action into various smaller scale patterns where the market consolidates and prepares the next phase of the movement. Similar to the concept of tension and resolution in both music and literature, prices move as tension is created during the consolidation phase, and resolution of the tension draws the market forward as the consolidation pattern breaks down.
There are many kinds of price patterns. During the development of a trend, triangles of all kinds are ubiquitous. In a range pattern, consolidations occur at the support and resistance levels of the price action, but the breakout fails to breach those levels. It is also possible to recognize many short-term range patterns developing during the course of a major trend: the successive legs of the trend follows the breakdown of those range patterns in succession.
Technical analysts divide price patterns into reversal patterns and continuation or consolidation patterns, but as we discussed shortly before, as branches of a main trend break down, reversal patterns can be found in the course of a trend too. A continuation or consolidation pattern (such as triangles) signals that the trend is ongoing, but is going through a phase of rearrangement, as market participants reevaluate their strategies, and readjust their positions. A reversal pattern signifies that the underlying price action is losing its power: the present dynamics behind the market action may soon be invalidated by market developments.
The use of price patterns in technical analysis is widespread, but it must be born in mind that in many cases the formations discussed by the technical analyst is obvious and actionable in hindsight only.
Conclusion
There are a vast number of tools available to the technical trader. While this richness can be useful for identifying and evaluating different scenarios, it can also be confusing for the novice and experienced trader alike. The power of technical analysis lies in the precise nature of its predictions, but there’s nothing precise about setting up the correct configuration of indicators which will generate the most useful predictions.
In spite of these facts, technical analysis is the most widespread method for the study of the market action. It is used by millions of traders all over the world, and consequently, its predictions possess a kind of power that is often thought to be unique to religions: as its dictates are confirmed by the collective behavior of vast numbers of technical traders, only the reckless will deny the value of technical studies.
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