Technical analysis has undergone a renaissance of sorts over the last few years. Whereas technical analysts were once seen as little more than soothsayers trying to divine information from charts, modern traders now are looking to charts to find any edge they can get.
The expansion of more short-term, day and intraday strategies have made technical analysis a more efficient way to analyze the markets. Add to that the very size of the traders who utilize this approach, and every trader needs to understand the technicals because its practitioners have grown to a size where they can become a fundamental that needs to be watched.
"With the changing dynamics of regulation and fundamental data coming out of the blue as it does these days, traders are looking for an edge in the one thing that does not change, human nature," says Craig Russell, director of active trader products at Interactive Data Desktop Solutions. "At the core, technical analysis is a read on the human nature of those participating in the market. Those participants broadcast their opinions through their actions."
Charts are useful because they quickly can transmit large amounts of information visually that would otherwise be unwieldy to absorb or analyze in other formats. To that end, Barbara Rockefeller, founder of Rockefeller Treasury Services and author of "Technical Analysis for Dummies," says, "The written chart is more powerful than the written word." Additionally, because of the systematic nature of technical analysis, she says it instills discipline in a way that fundamental trading cannot.
Although technical analysis has gained acceptance, getting started still can be a confusing ordeal. Here we attempt to unveil some of the mystery and explain some of the basics of reading a chart.
There is no one standard chart, but there are a number of standard options for a price chart. "As far as reading charts goes, it’s important to remember that the chart makes the analysis. In other words, the symbol in the chart, the bar interval, bar style and the data in the chart all make up the environment that goes into the analyses," says Michael Burke, vice president of client training and education at TradeStation.
Most charts today are comprised of a series of vertical lines in either bar chart format or candlestick format. Both show open and close prices as well as highs and lows for the bar, the difference being what each emphasizes. "A typical bar chart shows the magnitude of volatility in a single bar in relation to the other bars. The primary focus is on the high, low, and where the bar opened and closed," Burke says. "With candlestick charts, the focus is on the relationship between the open and the close, and the high and low are secondary. There is a whole science of unique patterns related to candlestick charts."
Digging deeper, each individual bar or candlestick represents a set amount of time that can be adjusted by the trader depending on what information is needed at the time and the trading timeframe desired. Most charting packages give options for bar durations ranging from as long as a month to as short as one minute.
Your trading horizon plays a large part in determining which bar duration is best for you. "There is no ‘one size fits all’ answer, there is no best timeframe; there is only what is best for you and your own personality/trading. Is a five-minute chart better than a daily? No, they are just different," Russell says.
If you are looking to enter a position and stay in it for an extended period, then a longer bar duration is probably better. But, if you are a day trader, then a shorter bar duration probably will suit you better. It’s important to find what bar length you are comfortable with in making trading decisions.
Even if you are a longer-term trader, there may be times you will want to look at a shorter timeframe. "Events don’t follow a 24-hour calendar. Events come out at specific times of day and in order to judge the importance of those events, you really want to see something intraday. A perfect example is payrolls," Rockefeller says.
It usually is necessary to look at multiple timeframes to get a read on a market. Often a trader picks a direction with a longer-term chart and then pinpoints an entry with a shorter-term chart.
Pattern recognition
Charts can be a powerful analytical tool because they can make it easier to identify long- and short-term trends, or the lack of a trend. Further, historic data allows you to identify levels of support and resistance, areas of price consolidation and areas of high volatility.
Charts excel at making trends recognizable both because the human brain naturally shines at picking out patterns and because a number of simple indicators have been developed to assist in this area (see "The trend(line) is your friend," below). "Charts provide a visual representation of trading activity and trendlines can be added to charts to see them more clearly," Russell says.
One of the simplest ways of visualizing this is hand-drawn trendlines. Burke says that although hand drawing trendlines is pretty simple, if you asked 10 traders, each probably would have a slightly different approach. Nonetheless, he recommends looking for small retracements against the current trend and drawing your trendline between those retracement points.
Drawing a trendline is easy. Simply begin by drawing a line connecting two or more market tops or market bottoms. The more times a market touches that line, the more significant that level is as either support or resistance. Basic trendlines can serve as a building block for a range trade or breakout trade.
In addition to hand-drawn trendlines, most charting packages include a number of indicators to help you define trends. One of the simplest and easiest to understand is moving averages. These are a lagging indicator that display average prices from a previous given number of bars. These help show the strength of the trend, eliminate some of the noise in the market and often are used as a signal for entering or exiting a trade. Technical traders often will use two moving averages of different durations. A simple strategy signals an entry when the faster (shorter-term) moving average crosses the slower (longer-term) moving average. A trade is signaled in the direction of the cross. "The trend(line) is your friend" shows how the 10-day moving average crossing the 20-day moving average would have signaled, albeit a little tardy, several successful trades. This approach usually is used with additional filters to improve results.
Traders like to experiment with different time intervals but the concept is the same; the faster moving average crossing the slower moving average is an indication of momentum. The time horizon of your trades should determine what time intervals you look at. If you are trying to determine changes in a long-term trend, you might look at 50- and 100-day moving averages. In choppy market conditions there could be many crosses of 10 and 20-period moving average (see "A matter of time," below). There are different types of moving averages. Our examples show simple moving averages, but some traders prefer to use exponential or volume-weighted moving averages. An exponential moving average gives more weight to recent data in calculating the average.
Besides identifying trends, charts also make finding support and resistance levels more accessible. Like identifying trends, detecting support and resistance also can be done from a visual standpoint or with the help of indicators. "Past highs and lows, especially when they occur around a round number, become magnets or targets," Rockefeller says.
In addition to significant highs or lows, Burke says a number of chart patterns can help identify support or resistance levels and says his favorite confirming pattern is a double-top or double-bottom in which price visits a specific level two times and reverses at the same level each time (see "Double the fun" below). Once a top (or bottom) is made, that level serves as resistance (or support in case of a bottom). If that top is tested and fails, creating a double top, that resistance is stronger.
Also like trendlines, a number of indicators are available to help in finding support or resistance levels. Some work by calculating a price band, such as Bollinger Bands, that show possible support and resistance levels, while others work as momentum indicators showing the degree of conviction in the market in a particular move, such as the Relative Strength Index (RSI). RSI is used mainly to signal overbought or oversold conditions and usually is used in tandem with other indicators. "A matter of time," shows how the RSI in corn moved into overbought territory (above 80) shortly before reversing at the end of August.
There are a plethora of indicator options offered with most modern charting packages and it may be tempting to just throw them all onto one chart. Not only would that virtually bury the original price bars, but it would be impossible to make any sort of trading decisions. Burke says that the type of market can help you decide what types of indicators to use at any given time. "Moving averages normally work best when the market has lower volatility and is trending. In volatile, sideways markets, support/resistance indicators like Stochastics can be a better tool for identifying market direction and reversals," he says.
One of the beauties of technical analysis, though, is that multiple indicators can be used to confirm trading signals. "I take the confirmation approach — one indicator is good, but two are better," Rockefeller says. "You always want to use at least two and preferably more indicators, as long as they don’t confuse you. When they start to confuse you, get rid of the ones that are excess baggage."
As a beginner at reading charts it is best to start out simple and move forward incrementally. Begin by determining trend and then add additional indicators to serve as confirmation or filters for entries and exits. Be careful though, just as too many cooks can spoil the broth, too many indicators can spoil profits and lead to paralysis by analysis. A good rule is to know what every indicator is telling you; if you are not sure, it’s best to eliminate it.
