Technical analysis: a broader approach
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There is more to technical analysis than merely the study of lines on the page. The technical analyst will take into consideration such factors as intermarket analysis, comparative analysis, psychology, and seasonal and cyclical factors. These are combined with technical analysis to form what can be described as market analysis, and it is the study of these which gives rise to an opinion on the likely direction of future prices.
A very brief description of these forms of analysis follows.
This takes into account such things as price patterns, volume, momentum, and support and resistance levels. In reality, these simply represent the mood of the market. Price is not merely a reflection of news or events, but the human reaction to these events. If we think about trendlines and support and resistance levels, they simply reflect the balance of supply and demand. Trend reversal occurs when the balance of supply and demand tips the other way.
Those who do not believe in technical analysis will take great delight in deriding names such as tops and bottoms, double tops, flags, or rising wedges. But in reality, these patterns merely reflect the human behaviours of fear, greed and indecision. There is nothing extraordinary about these chart formations - they are simply a representation of the prevailing mood of market participants.
Years ago, before the advent of the computer, analysts plotted the price action by hand each day. Chartists would identify particular patterns and trendlines, and use these to determine the outlook for a stock, index, commodity or currency. The problem here was that patterns were open to individual interpretation.
This led to the use of indicators. This was viewed as an attempt to turn charting from an art into a science. With the proliferation of computers, indicators could be computed quickly. These are now widespread and easily accessible. It must be remembered, though, that there is a subjective element to these indicators as well. And, most importantly, their reliability is dependent upon determining the trend or lack thereof.
Indicators fall into different categories, but the most common indicators that most technical analysts use are a measure of momentum.
Momentum indicators, as the name suggests, measure the momentum behind the move. Just as a car will struggle to move forward without a foot on the accelerator, so too will a market struggle to move higher if momentum begins to falter. On the downside, once downward momentum begins to abate, the odds of stability and a renewed advance begin to improve.
Momentum indicators fall into two broad categories: trend following and oscillators. Before applying any of the indicators, the technical analyst needs to firstly identify the current state of the market - is it ranging or trending? This needs to be determined because oscillators are ineffective in trending markets, and similarly, trend following indicators are misleading in ranging markets.
Oscillators register overbought and oversold levels, and the problem with using them in trending markets is that they will move to overbought or oversold levels and stay there for quite some time. This will cause the trader to exit or enter prematurely. Conversely, trend following indicators will "whipsaw" traders in a ranging market.