Flexibility And Adaptability Of Technical Analysis

FLEXIBILITY AND ADAPTABILITY OF TECHNICAL ANALYSIS

One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension. There is no area of trading in either stocks or futures where these principles do not apply.

The chartist can easily follow as many markets as desired, which is generally not true of his or her fundamental counterpart. Because of the tremendous amount of data the latter must deal with, most fundamentalists tend to specialize. The advantages here should not be overlooked.

For one thing, markets go through active and dormant periods, trending and nontrending stages. The technician can concentrate his or her attention and resources in those markets that display strong trending tendencies and choose to ignore the rest. As a result, the chartist can rotate his or her attention and capital to take advantage of the rotational nature of the markets. At different times, certain markets become "hot" and experience important trends. Usually, those trending periods are followed by quiet and relatively trendless market conditions, while another market or group takes over. The technical trader is free to pick and choose. The fundamentalist, however, who tends to specialize in only one group, doesn't have that kind of flexibility. Even if he or she were free to switch groups, the fundamentalist would have a much more difficult time doing so than would the chartist.

Another advantage the technician has is the "big picture." By following all of the markets, he or she gets an excellent feel for what markets are doing in general, and avoids the "tunnel vision" that can result from following only one group of markets. Also, because so many of the markets have built-in economic relation­ships and react to similar economic factors, price action in one market or group may give valuable clues to the future direction of another market or group of markets.

TECHNICAL ANALYSIS APPLIED TO DIFFERENT TRADING MEDIUMS

The principles of chart analysis apply to both stocks and futures. Actually, technical analysis was first applied to the stock market and later adapted to futures. With the introduction of stock index futures, the dividing line between these two areas is rapidly disap­pearing. International stock markets are also charted and analyzed according to technical principles. (See Figure 1.2.)

Financial futures, including interest rate markets and foreign currencies, have become enormously popular over the past decade and have proven to be excellent subjects for chart analysis.

Technical principles play a role in options trading. Technical forecasting can also be used to great advantage in the hedging process.

Figure 1.2 The Japanese stock market charts very well as do most stock markets around the world.

TECHNICAL ANALYSIS APPLIED TO DIFFERENT TIME DIMENSIONS

Another strength of the charting approach is its ability to handle different time dimensions. Whether the user is trading the intra­day tic-by-tic changes for day trading purposes or trend trading the intermediate trend, the same principles apply. A time dimension often overlooked is longer range technical forecasting. The opinion expressed in some quarters that charting is useful only in the short term is simply not true. It has been suggested by some that fundamental analysis should be used for long term forecasting with technical factors limited to short term timing. The fact is that longer range forecasting, using weekly and monthly charts going back several years, has proven to be an extremely useful application of these techniques.

Once the technical principles discussed in this book are thor­oughly understood, they will provide the user with tremendous flex­ibility as to how they can be applied, both from the standpoint of the medium to be analyzed and the time dimension to be studied.

ECONOMIC FORECASTING

Technical analysis can play a role in economic forecasting. For example, the direction of commodity prices tells us something about the direction of inflation. They also give us clues about the strength or weakness of the economy. Rising commodity prices generally hint at a stronger economy and rising inflationary pres­sure. Falling commodity prices usually warn that the economy is slowing along with inflation. The direction of interest rates is affect­ed by the trend of commodities. As a result, charts of commodity markets like gold and oil, along with Treasury Bonds, can tell us a lot about the strength or weakness of the economy and inflation­ary expectations. The direction of the U.S. dollar and foreign cur­rency futures also provide early guidance about the strength or weakness of the respective global economies. Even more impressive is the fact that trends in these futures markets usually show up long before they are reflected in traditional economic indicators that are released on a monthly or quarterly basis, and usually tell us what has already happened. As their name implies, futures markets usu­ally give us insights into the future. The S&P 500 stock market index has long been counted as an official leading economic indi­cator. A book by one of the country's top experts on the business cycle, Leading Indicators for the 1990s (Moore), makes a compelling case for the importance of commodity, bond, and stock trends as economic indicators. All three markets can be studied employing technical analysis. We'll have more to say on this subject in Chapter 17, "The Link Between Stocks and Futures."

TECHNICIAN OR CHARTIST?

There are several different titles applied to practitioners of the technical approach: technical analyst, chartist, market analyst, and visual analyst. Up until recently, they all meant pretty much the same thing. However, with increased specialization in the field, it has become necessary to make some further distinctions and define the terms a bit more carefully. Because virtually all technical analysis was based on the use of charts up until the last decade, the terms "technician" and "chartist" meant the same thing. This is no longer necessarily true.

The broader area of technical analysis is being increas­ingly divided into two types of practitioners, the traditional chartist and, for want of a better term, statistical technicians. Admittedly, there is a lot of overlap here and most technicians combine both areas to some extent. As in the case of the tech­nician versus the fundamentalist, most seem to fall into one cat­egory or the other.

Whether or not the traditional chartist uses quantitative work to supplement his or her analysis, charts remain the prima­ry working tool. Everything else is secondary. Charting, of neces­sity, remains somewhat subjective. The success of the approach depends, for the most part, on the skill of the individual chartist. The term "art charting" has been applied to this approach because chart reading is largely an art.

By contrast, the statistical, or quantitative, analyst takes these subjective principles, quantifies, tests, and optimizes them for the purpose of developing mechanical trading systems. These systems, or trading models, are then programmed into a com­puter that generates mechanical "buy" and "sell" signals. These systems range from the simple to the very complex. However, the intent is to reduce or completely eliminate the subjective human element in trading, to make it more scientific. These statisticians may or may not use price charts in their work, but they are con­sidered technicians as long as their work is limited to the study of market action.

Even computer technicians can be subdivided further into those who favor mechanical systems, or the "black box" approach, and those who use computer technology to develop better technical indicators. The latter group maintains control over the interpretation of those indicators and also the decision making process.

One way of distinguishing between the chartist and the statistician is to say that all chartists are technicians, but not all technicians are chartists. Although these terms are used inter­changeably throughout this book, it should be remembered that charting represents only one area in the broader subject of tech­nical analysis.

A BRIEF COMPARISON OF TECHNICAL ANALYSIS IN STOCKS AND FUTURES

A question often asked is whether technical analysis as applied to futures is the same as the stock market. The answer is both yes and no. The basic principles are the same, but there are some significant differences. The principles of technical analysis were first applied to stock market forecasting and only later adapted to futures. Most of the basic tools—bar charts, point and figure charts, price patterns, volume, trendlines, moving averages, and oscillators, for example— are used in both areas. Anyone who has learned these concepts in either stocks or futures wouldn't have too much trouble making the adjustment to the other side. However, there are some general areas of difference having more to do with the different nature of stocks and futures than with the actual tools themselves.

Pricing Structure

The pricing structure in futures is much more complicated than in stocks. Each commodity is quoted in different units and incre­ments. Grain markets, for example, are quoted in cents per bushel, livestock markets in cents per pound, gold and silver in dollars per ounce, and interest rates in basis points. The trader must learn the contract details of each market: which exchange it is traded on, how each contract is quoted, what the minimum and maximum price increments are, and what these price increments are worth.

Limited Life Span

Unlike stocks, futures contracts have expiration dates. A March 1999 Treasury Bond contract, for example, expires in March of 1999. The typical futures contract trades for about a year and a half before expiration. Therefore, at any one time, at least a half dozen different contract months are trading in the same com­modity at the same time. The trader must know which contracts to trade and which ones to avoid. (This is explained later in this book.) This limited life feature causes some problems for longer range price forecasting. It necessitates the continuing need for obtaining new charts once old contracts stop trading. The chart of an expired contract isn't of much use. New charts must be obtained for the newer contracts along with their own technical indicators. This constant rotation makes the maintenance of an ongoing chart library a good deal more difficult. For computer users, it also entails greater time and expense by making it neces­sary to be constantly obtaining new historical data as old con­tracts expire.

Lower Margin Requirements

This is probably the most important difference between stocks and futures. All futures are traded on margin, which is usually less than 10% of the value of the contract. The result of these low mar­gin requirements is tremendous leverage. Relatively small price moves in either direction tend to become magnified in their impact on overall trading results. For this reason, it is possible to make or lose large sums of money very quickly in futures. Because a trader puts up only 10% of the value of the contract as margin, then a 10% move in either direction will either double the trad­er's money or wipe it out. By magnifying the impact of even minor market moves, the high leverage factor sometimes makes the futures markets seem more volatile than they actually are. When someone says, for example, that he or she was "wiped out" in the futures market, remember that he or she only committed 10% in the first place.

From the standpoint of technical analysis, the high leverage factor makes timing in the futures markets much more critical than it is in stocks. The correct timing of entry and exit points is crucial in futures trading and much more difficult and frustrating than market analysis. Largely for this reason, technical trading skills become indispensable to a successful futures trading program.

Time Frame Is Much Shorter

Because of the high leverage factor and the need for close moni­toring of market positions, the time horizon of the commodity trader is much shorter of necessity. Stock market technicians tend to look more at the longer range picture and talk in time frames that are beyond the concern of the average commodity trader. Stock technicians may talk about where the market will be in three or six months. Futures traders want to know where prices will be next week, tomorrow, or maybe even later this afternoon. This has necessitated the refinement of very short term timing tools. One example is the moving average. The most commonly watched averages in stocks are 50 and 200 days. In commodities, most moving averages are under 40 days. A popular moving aver­age combination in futures, for example, is 4, 9, and 18 days.

Greater Reliance on Timing

Timing is everything in futures trading. Determining the correct direction of the market only solves a portion of the trading prob­lem. If the timing of the entry point is off by a day, or sometimes even minutes, it can mean the difference between a winner or a loser. It's bad enough to be on the wrong side of the market and lose money. Being on the right side of the market and still losing money is one of the most frustrating and unnerving aspects of futures trading. It goes without saying that timing is almost pure­ly technical in nature, because the fundamentals rarely change on a day-to-day basis.