Markets are technical
Technical analysis uses previous market price action to predict future outcomes. It offers a trader an excellent way to manage risk. Its popularity grew exponentially with the explosion in IT during the past 25 years. Easy access to market data has allowed more traders to build technical strategies.
Another appeal of technical analysis is that it is a more structured approach compared to fundamental analysis. A fundamental approach has a logical appeal. Imbalances in supply and demand can often be glaringly obvious. The major problem is that markets can move quickly and by the time one can determine shifts in supply or demand, it can be too late. This makes it difficult to know when one’s position is wrong and to exit the trade before it becomes a catastrophic loss. Technical analysis does not rule out fundamentals, it just assumes they are worked into the price.
The technical makeup of any market is best represented by price charts. It is important to remember that a price chart is not the market; rather a graphical representation of it. All the bars, oscillators, trend lines, moving averages, etc., are analytical representations of the market. However, markets take on a living, breathing life of their own. They are composed of numerous participants with vastly different strategies and objectives. As a result, the markets themselves become alive.
Quite often when we ask why a particular market went up we get the flippant remark that there were more buyers than sellers. While this seems logical enough, it really is not true because there always has to be a seller for every buyer. A more appropriate response would be that the buyers were more motivated than the sellers. Which brings up a very key aspect of trading: Collective psychology is what moves markets in the short-term; not overall supply and demand fundamentals. In their most basic form, price charts are a graphical image of this collective psychology.
The bar chart is a common way to graphically display price data. Each bar represents a specific period and can range from one minute to one month. It consists of a vertical line connecting the high and low, with a small horizontal mark placed on the left for the open and the right for the close.
It is also standard to manipulate the basic chart data (open, high, low, close) into formulas called indicators and studies. These mathematical representations are then plotted over the chart or below it in a separate window.
Price fluctuation in a specific direction and time frame is equivalent to a single unbroken price change called a swing. As price rises, the bars on a chart will make higher highs and higher lows. At some point the move up will end and price will reverse lower. In its simplest form, a swing high represents a high bar surrounded by lower highs on either side. Just the opposite applies for a low. Below is a simple swing high.
Bar charts have a hierarchy of swings, which define trends, corrections and reversals. For example, a swing high is more significant if it is higher than the previous and following swing highs. Below is a simple wing hierarchy.
In the swing hierarchy example the high at (d) is more significant as it has lower swing highs on either side of it (b, f). Another absolute of the swing hierarchy concept is that after every swing high there must be an offsetting swing low before there is another swing high (and vice versa). Sometimes the offset is not apparent. In that case one needs to drill down to a shorter
time frame to find it.
Volume & open interest
Volume and open interest are valuable technical metrics. The significance of volume is probably easier to understand because it is a direct reflection of the urgency that market players feel. High volume tends to occur at market tops and bottoms and often occurs when market participants are in a rush to get in or out. Once these over-anxious traders have bought or sold, there is no one overly motivated to adjust their market position and thus a market extreme is made.
Low volume, on the other hand, suggests that market players are disinterested and that price action is not creating any sense of urgency. Price moves on these type of days/bars tend to suggest that the market will soon proceed in its original direction. Also, a technical signal is less valid if made as a result of low volume exaggerating the importance of a move.
Open interest can be an even better metric than volume when analyzing the market, but deciphering its meaning can be tricky. Open interest is the existing number of exchange contracts between buyers and sellers at any moment in time. It represents what market participants are doing as prices fluctuate.
In theory a price move on rising open interest represents new speculators entering the market, and a continuation of the trend can be expected.
“Shorts take control,” (below) is an example of how this phenomenon manifested itself in May 2012 during the currency crisis. If a predominant price trend reverses itself on falling open interest, it suggests speculators are liquidating their positions and want out. Once they are finished, the price move will have exhausted itself and the market should probably reverse.
In “Get out of Dodge!” (below) we see how open interest fell precipitously as panicked shorts exited the market in droves during mid-May in response to global weather concerns. This marked a significant high. Also note how volume surged, reflecting the urgency that traders felt in exiting their positions.
Open interest is a great way to see the big picture of what is occurring in the market. One caveat, however, is that contract expiration can cause large cyclical distortions (see dips at end of February and April in “Get out of Dodge!”). A trader needs to be aware of expiration time frames to distinguish potential signals from normal cyclical movement.