Introduction: Prices Move in Trends

INTRODUCTION

Before beginning a study of the actual techniques and tools used in technical analysis, it is necessary first to define what technical analysis is, to discuss the philosophical premises on which it is based, to draw some clear distinctions between technical and fun­damental analysis and, finally, to address a couple of criticisms fre­quently raised against the technical approach.

The author's strong belief is that a full appreciation of the technical approach must begin with a clear understanding of what technical analysis claims to be able to do and, maybe even more importantly, the philosophy or rationale on which it bases those claims.

First, let's define the subject. Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. The term "market action" includes the three principal sources of information available to the techni­cian—price, volume, and open interest. (Open interest is used only in futures and options.) The term "price action," which is often used, seems too narrow because most technicians include volume and open interest as an integral part of their market analysis. With this distinction made, the terms "price action" and "market action" are used interchangeably throughout the remain­der of this discussion.

PHILOSOPHY OR RATIONALE

There are three premises on which the technical approach is based:

• Market action discounts everything.
• Prices move in trends.
• History repeats itself.
• Market Action Discounts Everything

The statement "market action discounts everything" forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possibly affect the price—funda­mentally, politically, psychologically, or otherwise—is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning.

All the technician is really claiming is that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and funda­mental forecasting. The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever the specific reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamen­tals must be bearish. If this last comment about fundamentals seems surprising in the context of a discussion of technical analysis, it shouldn't. After all, the technician is indirectly studying fundamentals. Most technicians would probably agree that it is the underlying forces of supply and demand, the eco­nomic fundamentals of a market, that cause bull and bear mar­kets. The charts do not in themselves cause markets to move up or down. They simply reflect the bullish or bearish psychology of the marketplace.

As a rule, chartists do not concern themselves with the rea­sons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way. While the tech­nical approach may sometimes seem overly simplistic in its claims, the logic behind this first premise—that markets discount everything—becomes more compelling the more market experi­ence one gains. It follows then that if everything that affects mar­ket price is ultimately reflected in market price, then the study of that market price is all that is necessary. By studying price charts and a host of supporting technical indicators, the chartist in effect lets the market tell him or her which way it is most likely to go. The chartist does not necessarily try to outsmart or outguess the market. All of the technical tools discussed later on are simply techniques used to aid the chartist in the process of studying mar­ket action. The chartist knows there are reasons why markets go up or down. He or she just doesn't believe that knowing what those reasons are is necessary in the forecasting process.

Prices Move in Trends

The concept of trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there's no point in reading any further. The whole purpose of charting the price action of a market is to iden­tify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the tech­niques used in this approach are trend-following in nature, mean­ing that their intent is to identify and follow existing trends. (See Figure 1.1.)

Figure 1.1 Example of an uptrend. Technical analysis is based on the premise that markets trend and that those trends tend to persist.

There is a corollary to the premise that prices move in trends—a trend in motion is more likely to continue than to reverse. This corollary is, of course, an adaptation of Newton's first law of motion. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses. This is another one of those technical claims that seems almost circu­lar. But the entire trend-following approach is predicated on rid­ing an existing trend until it shows signs of reversing.

History Repeats Itself

Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart pat­terns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change. Another way of saying this last premise—that history repeats itself—is that the key to under­standing the future lies in a study of the past, or that the future is just a repetition of the past.

TECHNICAL VERSUS FUNDAMENTAL FORECASTING

While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that cause prices to move higher, lower, or stay the same. The fundamental approach examines all of the rel­evant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the cur­rent market price, then the market is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought.

Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions. The fundamentalist studies the cause of market movement, while the technician studies the effect. The technician, of course, believes that the effect is all that he or she wants or needs to know and that the reasons, or the causes, are unnecessary. The funda­mentalist always has to know why.

Most traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap. Many funda­mentalists have a working knowledge of the basic tenets of chart analysis. At the same time, many technicians have at least a pass­ing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually they come back into sync at some point, but often too late for the trader to act.

One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment. While the known funda­mentals have already been discounted and are already "in the mar­ket," prices are now reacting to the unknown fundamentals. Some of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.

After a while, the technician develops increased confidence in his or her ability to read the charts. The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom. A technician begins to enjoy being in the minority. He or she knows that eventually the reasons for market action will become common knowledge. It is just that the technician isn't willing to wait for that added confirmation.

In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the funda­mentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the tech­nical. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial markets using just the technical approach. It is doubtful that any­one could trade off the fundamentals alone with no consideration of the technical side of the market.

ANALYSIS VERSUS TIMING

This last point is made clearer if the decision making process is broken down into two separate stages—analysis and timing.

Because of the high leverage factor in the futures markets, timing is especially crucial in that arena. It is quite possible to be correct on the general trend of the market and still lose money. Because margin requirements are so low in futures trading (usually less than 10%), a relatively small price move in the wrong direction can force the trader out of the market with the resulting loss of all or most of that margin. In stock market trading, by contrast, a trader who finds him or herself on the wrong side of the market can simply decide to hold onto the stock, hoping that it will stage a comeback at some point.

Futures traders don't have that luxury. A "buy and hold" strategy doesn't apply to the futures arena. Both the technical and the fundamental approach can be used in the first phase—the forecasting process. However, the question of timing, of deter­mining specific entry and exit points, is almost purely technical. Therefore, considering the steps the trader must go through before making a market commitment, it can be seen that the correct application of technical principles becomes indispensable at some point in the process, even if fundamental analysis was applied in the earlier stages of the decision. Timing is also important in indi­vidual stock selection and in the buying and selling of stock mar­ket sector and industry groups.