From the August 01, 2008 issue of Futures Magazine • Subscribe!

Technical analysis best practices

Price is everything. Whether you are buying or selling, employing market neutral strategies, or even sitting in cash, price has a fundamental effect on your fortunes — realized, missed or forgotten.

Technical analysis, at its core, is all about price, studying changes in price to forecast future changes, or a lack thereof. Technical analysts, or technicians, believe that past prices contain all the information necessary to predict future prices. Indeed, the most zealous contend this is the only proper way to analyze the markets. Price, they argue, absorbs and reflects all current relevant supply and demand information faster than any human analyst or computer possibly could.

To that end, technicians employ specific techniques to retrieve that information in a meaningful way. Over this and the next four articles, we will describe the most common techniques, what they purport to do and how they work with other measures.

These discussions will assume the reader is familiar with a basic open, high, low, close bar chart (see “Bars in charge”). Although other chart types play a significant role in technical analysis, to stay on topic, examples in this introductory series will be based on bar charts only. For consistency’s sake, daily data will be used, although most technicians believe their techniques apply equally to all but the shortest and longest time frames.

WHAT ARE INDICATORS?

Technical indicators and techniques are the rules that technicians employ to analyze past price for purposes of forecasting future price direction. A technical indicator can be subjective, such as a visual analysis of formations depicted on a price chart, or objective, such as the result of a mathematical calculation applied to past prices.

Technical indicators fall into various categories. Some are used to identify price trends, or extended moves in one direction. Some are intended to pinpoint price turning points, also known as tops and bottoms. Still others seek to detect market states — more obscure attributes, such as distribution, accumulation or equilibrium. For a breakdown of some popular technical indicators and techniques see “Tools of the trade.”

The types of indicators and techniques are vast. Volumes have been used to describe them in excruciating detail. We will provide an overview of price patterns, trendlines, moving averages and momentum indicators.

BEYOND PRICE

OK, price really isn’t everything.

In addition to price, the analysis of other market statistics generally falls under the umbrella of technical analysis. These statistics include volume, open interest and volatility.

Volume is the number of transactions that have taken place within a specified time period, typically a day. It is a measure of buying and selling activity in a particular contract or stock. On a chart, volume is conventionally displayed as vertical bars beneath price, often in conjunction with open interest.

Open interest applies to futures and options, and refers to the number of outstanding contracts for a particular market and contract month. Open interest reflects a snapshot, typically taken at the end of a trading day. On a chart, open interest is conventionally displayed as a line beneath price, often in conjunction with volume.

Open interest increases when a new long position in a futures contract is offset by a new sale. If a new long position is matched by the sale of an existing contract, open interest does not change. Likewise, open interest decreases when an existing position is sold to an existing buyer. If an existing position is sold to a new buyer, open interest does not change.

Although both volume and open interest play specific roles when considered alongside different technical indicators, in general, rising volume and open interest tend to indicate strength in the current trend. If the current trend is accompanied by falling or flat volume and open interest, many technicians consider that trend weak and vulnerable to change.

Volatility is another field of study altogether. It describes how quickly prices are changing. There are two general types of volatility, implied and historical. Implied volatility is derived by plugging market data into a volatility model. Historical volatility is calculated by applying statistical methods to past data. Although important, volatility is generally beyond the scope of this series and will not be addressed in an analytical sense.

PROS & CONS

There are many reasons to consider technical analysis, and there are also many reasons to consider it with a grain of salt.

While technical analysis can become quite complex, one of its most appealing benefits is its inherent simplicity. At its most basic level, technical analysis requires just past price. There is no need to pour over reams of fundamental data, to decipher the words of supply/demand analysts, to subscribe to fundamental reports or to make your own conclusions about the extent overseas geopolitical tensions could impact domestic commodity prices.

Most technicians also subscribe, at least to some degree, to the notion that markets are largely fractal mechanisms. That is, the dynamics behind price changes are considered equally valid across time frames. They can range from intraday 10-minute charts to monthly data. Most analysts, particularly those just getting started in trading, trade off of daily data, with perhaps an eye on weekly charts to help gauge broader price trends.

Of course, technical analysis has its detractors (see “Funny-mentals,” page 62). One popular criticism is that because so many traders follow popular technical signals, the indicators are priced into the market before any regular trader could exploit them. This argument is countered by the observation that rarely do all technical signals agree. Because techniques deliver different signals to buy or sell, markets are continuously pulled in different directions. In liquid markets with countless competing interests of all sizes, there is ample disagreement and opportunity for even the most popular techniques to have a difference of opinion.

One of the most damning arguments against technical analysis is only one step removed from what many consider the source of its validity — that is, that market price itself is the best measure of all fundamental price drivers. This belief also relates to the efficient market hypothesis, which holds that as the most efficient reflection of supply and demand, it is impossible for an active trading program to consistently outperform a passive investment.

Fortunately for technicians, empirical evidence is on their side, with years, even decades, of better-than-benchmark performance by professional money managers, many who use technical methods. Efficient market proponents counter that a few traders are bound to get lucky, regardless of how they trade.

Who you believe probably depends on your last trade and how you came about it, but history suggests that technical traders can prevail and that price, despite its role as the ultimate arbiter of supply and demand, offers many time frames for potential profit, not all of which are affected equally by all data.

FINDING FOCUS

The sheer number and variety of technical indicators available are mesmerizing, as is the lure of developing your own twists on existing methods. Whatever you rely on for your signals, don’t overdo it. Remember, techniques rarely agree. If you try to follow too many, you’ll quickly fall victim to what traders call “paralysis by analysis.”

However, there is also good reason to expand your technical toolbox beyond just one or two indicators. The idea is to select a few tools that compliment each other; that typically means striving to find indicators that measure different aspects of the market.

Many technical traders find this easier to do using a filtering approach. For example, a long-term trend-measuring indicator might be used to filter those markets that are showing a strong bias in one direction or the other. Then, a shorter-term timing indicator might be employed to determine precisely when to place a trade.

In general, technicians should maintain an open mind. All traders should also take some time to assess their natural predilections. For example, a math-minded individual may work best with clear-cut calculations, while a more visual thinker might be more successful with subjective, somewhat more esoteric, pattern-based techniques.

CAVEAT EMPTOR

In the mid-1980s, author, trader and analyst Jack Schwager wrote a series of articles for Futures that warned against allowing yourself to be tricked by the “well-chosen example” (see “Why You Should Beware of the Well-Chosen Example,” Futures, September 1984). The phrase refers to “extrapolating probable future performance on the basis of an isolated and well-chosen example from the past,” Schwager wrote.

Although there are many ways to fall victim to this expensive mistake, one of the most common is to apply an indicator over a short period of past price action, recognize isolated profitable signals then assume identical application will work equally well going forward.

One solution to the well-chosen example, systematic trading and historical performance validation, warrants a series all its own. For the beginning trader who is getting in touch with these techniques, the best defense is a thorough understanding of time-tested rules, a simplified approach that avoids complexity and includes emotional restraint and plenty of practice. Next month, we’ll start with what many consider the purest form of technical analysis, price patterns and chart reading.

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