The Art Of Technical Analysis

Foreword from ShareInvestor

This article “The Art Of Technical Analysis” by Mindy Tan was first published in The Business Times on 14 May 2012 and is reproduced in this blog in its entirety.

It involves studying the formation of stock prices into exotically named patterns and basing investment decisions on them.

A hammer, harami cross, shooting star, hanging man, and dark cloud cover – these are just some of the more colourful terms a technical analyst may use.

Assumptions Behind Technical Analysis

The company’s fundamentals, broader economic factors and market psychology are all priced into the stock, removing the need to consider these factors separately. Therefore, a technical analyst does not need to know the fundamentals of a company or the news that is affecting the stock price, because if the price is going up, the fundamentals must be improving.

After a trend has been established, future price movement is unlikely to waver from the trend. The concept that history tends to repeat itself is particularly prevalent in their analysis of price movement.

The repetitive nature of price movements is attributed to market psychology (that is, market participants tend to react in the same way to similar market stimuli over time).

Spotting Patterns And Reversals

That being said, technical analysts are particularly attuned to market reversals.

Says Wang Tao, president of the Technical Analysts Society Singapore (TASS): “Technicians have developed many types of signals to spot the reversal of an individual stock. For instance, they may study the candlesticks pattern of the stock: if there is a hammer, a bullish engulfing or a harami cross, they probably conclude a bullish reversal; if they spot a shooting star, a hanging man, or a dark cloud cover, they may decide there has been a bearish reversal.”

“Other simple techniques, such as a break above a descending trendline could be good in detecting a bullish reversal,” adds Mr Wang.

The candlesticks technique, which is pattern analysis in nature, involves the study of candle patterns to forecast price movement.

A candlestick consists of four prices of a specific duration – open, high, low, and close. When the “close price” is above the “open price”, it is called a white candle, and is normally bullish. Conversely, when the “close price” is below the “open price”, it is black, and normally bearish.

While a commonly used tool, the technique is not perfect, notes TASS: “The weakness is, it is too sensitive, thus making quite a lot of false signals. When applying it, traders need to combine other techniques to filter the false signals.”

Another commonly used basic pattern is the “head-and-shoulders formation”.

In this case, a share’s price may rise, forming the “left shoulder”, before more buyers enter the market to push the prices to a new peak, forming the “head”.

The market then undergoes a correction before the second wave of buyers push the prices to another lower peak, forming the “right shoulder”.

In the case of the “head-and-shoulders formation”, the technical analyst will draw a line across the two previous lows to form a “neckline”. Once the share price cuts below this neckline, it is a signal that you should sell your shares and take profits.

Other typical patterns that appear within pattern theory include double tops, double bottoms, and flags.

“Patterns normally signal continuation or reversal of the trend. They can be applied on trend forecasting which goes according to the breakout point, and price forecasting which goes according to the magnitude of the patterns,” says Mr Wang.

According to him, other commonly used tools are moving averages, relative strength index (RSI), moving average convergence divergence (MACD), stochastics, directional movement index (DMI), Bollinger band, volume, classical patterns, support, or resistance.

He notes: “Each technique has its own strengths and weaknesses. For example, moving average works well in a strong trend, but works poorly in a sideways market.”

Momentum Investing

An example of an investment strategy based on technical analysis is “momentum investing”, which aims to capitalise on the continuance of existing trends in the market.

Thus, to participate in momentum investing, a trader will take a long position in an asset which has shown an upward trending price, or short-sell a security that has been in a downtrend.

That being said, the investment style is not for the faint-hearted, and it is particularly difficult for an individual to pursue, as trading costs can easily eat up profits.

DMACO

Traders may also use the dual moving average crossover (DMACO) rule, which is based on two moving averages: the short-term moving average (STMA), and the long-term moving average (LTMA) of the security’s price.

The LTMA will move in the same direction as the STMA, but at a slower rate and, because it is averaged over a longer window, the LTMA will also be less volatile.

So when the STMA is above the LTMA, it signals that security prices in more recent times are higher than what would have been suggested by longer-term trends. This is suggestive of an upward trend, and constitutes a buy signal.

Mr Wang concludes: “No matter which tool you use (whether technical analysis or fundamental analysis), the most important thing is that you have to be an expert in that tool. A poor technical analyst or a poor fundamental analyst will seldom make accurate predictions.”