Technical Analysis Explained
Technical analysis assumes that the market knows all the key fundamental information about a company which is factored into the current price. The focus of technical analysis then, is the price and volume and this information is best reflected in a chart. Technical analysts apply tools to their charts to give themselves an 'edge'. With an edge and proper money management and position sizing strategies, investors believe they will be profitable over a large number of investments.
If you are going to use technical analysis as part of your investment approach, then you should become familiar with the pros and cons of using technical analysis as well as the main types of price charts that are commonly used. There are four common price chart formats. These are explained in a little more detail below and examples of the charts are provided.
- Pros & cons
- Price & volume
- Line chart
- Bar chart
- Candlestick chart
- Point and figure chart
A good definition of technical analysis comes from Investopedia. They define technical analysis as:
A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
For further reading and an online vide from Investopedia go to their technical analysis page.
Pros & cons
Technical analysis is a robust tool for timing purchases and sales but unlike fundamental analysis it is not much use for estimating the real value of a stock.
Let's explore the advantages of technical analysis:
Because technical analysis focuses on price movement the charts provide a clear picture of market action. This information can be quickly gained from just looking at a chart.
Uses price and volume data which is objective data.
Prices are ultimately governed by human emotions so technical analysis takes into account market sentiment.
Patterns are easily identifiable on a chart. Technical analysts can use patterns to guide their buy and sell decisions.
Computers have allowed access to charts that can either be free or relatively inexpensive. Technical analysis also frees up an analysts time.
Now let's look at some of the disadvantages of technical analysis
Too many indicators
A technical analyst can apply too many indicators to their chart resulting in underlying price action being overlooked and too many differing signals from the competing indicators which could result in 'analysis paralysis'.
Technical analysis does not take into account the underlying fundamentals of a company which for longer timeframes may be a risk that needs to be considered.
Price & volume
For any period that a stock trades there are five important pieces of information that a technical analyst can consider and that form the basis for all other technical analysis tools.
These pieces of information are the:
The open, high, low and close form the bar or candle in a price chart and volume is usually plotted in a separate graph below the price chart.
Any timeframe may be plotted on a chart. For example, for a day's trading, the open, high, low, close and volume can be plotted on a daily chart. Alternatively, after a week of trading, the entire 5 day's trading activity can be captured with the open at the beginning of the week, the close at the end of the week, and the high and low (whenever they occured during the week) plotted to represent the week's activity.
It will depend on the investing timeframe of the individual as to which timeframe they consider. A long term investor might consider weekly charts for their analysis and use daily charts to fine tune their entries and exits. A trader, may use daily charts for their analysis and an hourly chart to fine tune their entries and exits.
No matter what timeframe is used, the market is considered to be fractal, that is, the same patterns are repeated on all timeframes.
The most basic chart type is the line chart which only plots one of the four price points, usually the close price, to form a simple line. One of the major advantages is that this chart is simple; it removes the ‘noise’ that you may encounter with other chart types and often you can get a clearer picture of market activity.
Bar charts are probably the most widely used method of plotting the price of a stock. For each period of time, this type of chart plots the open, high, low and close price. Each bar consists of a single vertical line with two marks on either side of the line. The top of the bar indicates the high price of the day, the bottom of the bar indicates the lowest price of the day, the mark or tab on the left indicates the opening price and the mark or tab on the right indicates the closing price. Often these types of charts will be called OHLC charts. To the left is a screen shot of the same price data as shown above but in bar chart format.
The candlestick chart uses the same four pieces of information, the open, high, low and close prices, but plots them in a slightly different way to a bar chart. Instead of just using a single line to represent the range of the day, a wider coloured 'candle' is used to represent the opening and closing prices with the colour of the candle determining whether the close was higher than the open (a bullish day) or the close was lower than the open (a bearish day). If the close is higher than the open the candle is green and if the close is lower than the open, the candle is red. Let’s take a look at two examples
In the candlestick example to the right, the stock closed higher than it opened so the candle is coloured green. In other words, the stock opened at $44.25, at some stage during the day, traded as low as $44.12 and as high as $44.75 but at the end of the day closed at $44.59.
In the example on the left from the same chart, the stock closed lower than it opened, so the candle is coloured red. The stock opened at $44.70 and at some stage during the day traded up near $45 and as low as $44.00 but at the end of the day closed at $44.14.
Here is a candle chart of the same price action that we saw in the line and bar charts above.
Candlestick charts were developed and used by the Japanese since the sixteenth century and proponents of candlestick charts today use translated Japanese terms to describe common patterns such as doji, hammer and dark cloud cover. The interpretation of candlestick charts is a broad subject and there are excellent websites where you can learn more:
- The ASX website has some great tutorials
- Incredible Charts is always a sound source of technical analysis information.
- Stockcharts has some basic information.
- Steve Nison is credited with introducing Candlesticks to the western world. He has a website and free resources including a free candlestick charting glossary.
Point and Figure Chart
Point and Figure charts are significantly different to other forms of charts. In the other forms both price and time are plotted, however, in Point and Figure charts only price action is displayed and reference to time is disregarded.
Price data is represented by a series of X’s and O’s (or in the example to the right from Incredible Charts, by blue and red marks) that indicate only when the price rises or falls by more than a certain specified amount. Each column can contain either X’s or O’s but can never contain both. Before a new column can be made the price must move by the reversal amount.
If you are interested in this type of charting, visit the incredible charts website for a detailed explanation and examples of patterns or the ASX website has a page on point and figure charts that is worthwhile reading.