Study Guide to Technical Analysis of the Financial Markets

1. Technical Analysis: Understanding Market Psychology

Market action discounts everything.

Market reflects collective behavior. Technical analysis operates on the premise that all factors influencing a market, including fundamental data, news, and psychological biases, are ultimately reflected in price movements. It's not about why prices move, but how they move, revealing the collective psychology of market participants.

Technical vs. Fundamental: Unlike fundamental analysis, which focuses on intrinsic value, technical analysis studies price charts, volume, and other market data to identify patterns and predict future price trends. It assumes that history tends to repeat itself, and that these patterns can provide clues about future market behavior.

• Technical analysis is about when to trade, while fundamental analysis is about what to trade.
• Technical analysis is more about timing, while fundamental analysis is more about value.
• Technical analysis is more about psychology, while fundamental analysis is more about economics.

Focus on price action: Technicians believe that price action is the most important indicator, as it reflects the combined impact of all market forces. They use charts to identify trends, support and resistance levels, and other patterns that can help them make informed trading decisions.

2. Charting: Visualizing Price Action

The daily bar chart is by far the most commonly employed.

Charts as a visual language: Charts are the primary tool of technical analysis, providing a visual representation of price movements over time. They allow technicians to identify patterns, trends, and other important market signals that might be difficult to discern from raw price data.

Types of charts:

• Bar charts: Display the high, low, open, and close prices for a given period.
• Line charts: Connect closing prices with a line, showing the overall trend.
• Point and figure charts: Focus on price movements, ignoring time.
• Candlestick charts: Originated in Japan, they display the open, high, low, and close prices, with a "body" and "wicks" that provide additional information about price action.

Importance of scale: The choice of scale (arithmetic or logarithmic) can significantly impact the appearance of a chart. Arithmetic scales are best for short-term analysis, while logarithmic scales are better for long-term analysis, as they show percentage changes more accurately.

3. Trends: Identifying Market Direction

A trend is a pattern of successively rising or dropping peaks and troughs.

Trends are the foundation: Identifying trends is a fundamental aspect of technical analysis. A trend is a general direction in which something is developing or changing. Trends can be upward (uptrend), downward (downtrend), or sideways (trading range).

Types of trends:

• Primary trends: Long-term trends lasting from several months to years.
• Secondary trends: Intermediate-term trends that are corrections within primary trends.
• Minor trends: Short-term trends lasting a few days or weeks.

Trendlines and channels: Trendlines are lines drawn connecting a series of highs or lows, helping to visualize the direction of a trend. Channel lines are parallel lines drawn above and below the trendline, defining the range within which prices are likely to move.

• Trendlines act as support in uptrends and resistance in downtrends.
• Penetration of a trendline can signal a potential trend reversal.

4. Patterns: Recognizing Reversal and Continuation Signals

The head and shoulders top is the best known major reversal pattern.

Patterns reveal market psychology: Chart patterns are specific formations that appear on price charts, reflecting the collective psychology of market participants. They can be classified as either reversal patterns, which signal a change in trend, or continuation patterns, which suggest that the current trend is likely to continue.

Reversal patterns:

• Head and shoulders: A pattern with three peaks, the middle one being the highest, signaling a potential trend reversal.
• Double tops and bottoms: Two peaks or troughs at similar price levels, indicating a potential trend reversal.
• Saucers: Gradual, rounded patterns that signal a slow change in trend.

Continuation patterns:

• Triangles: Symmetrical, ascending, or descending patterns that suggest a pause in the current trend before it continues.
• Flags and pennants: Short-term patterns that appear after a sharp price move, indicating a brief consolidation before the trend resumes.
• Rectangles: Sideways price movements between two parallel horizontal lines, suggesting a pause in the trend.

5. Volume and Open Interest: Gauging Market Strength

Volume precedes price.

Volume confirms price action: Volume, the number of shares or contracts traded in a given period, is a crucial secondary indicator that confirms the strength of price movements. High volume during a price move suggests strong conviction, while low volume suggests a lack of conviction.

Open interest in futures: Open interest, the total number of outstanding contracts in a futures market, provides insights into the flow of money and the level of market participation.

• Rising open interest in an uptrend is bullish, while rising open interest in a downtrend is bearish.
• Declining open interest in an uptrend is bearish, while declining open interest in a downtrend is bullish.

On Balance Volume (OBV): OBV is a cumulative volume indicator that adds volume on up days and subtracts volume on down days, helping to identify buying and selling pressure. It is a simple line indicator used to measure the volume pressure direction.

6. Moving Averages: Smoothing Price Data

The moving average is used primarily as a trend-following device.

Moving averages filter noise: Moving averages are a technical indicator that smooths out price data by calculating the average price over a specific period. They help to identify the underlying trend by filtering out short-term price fluctuations.

Types of moving averages:

• Simple moving average (SMA): Calculates the average price over a specific period, giving equal weight to each price.
• Linearly weighted moving average (LWMA): Gives more weight to recent prices, making it more responsive to changes in price action.
• Exponential moving average (EMA): Similar to LWMA, but gives even more weight to recent prices.

Using moving averages:

• Crossovers of moving averages can generate buy and sell signals.
• Prices moving above a moving average can signal an uptrend, while prices moving below a moving average can signal a downtrend.
• Moving averages can also act as support and resistance levels.

7. Oscillators: Spotting Overbought and Oversold Conditions

Oscillators are especially valuable toward the end of market moves.

Oscillators identify extremes: Oscillators are technical indicators that fluctuate between upper and lower boundaries, helping to identify overbought and oversold market conditions. They are particularly useful in sideways markets or when prices are reaching extremes.

Types of oscillators:

• Relative Strength Index (RSI): Measures the speed and change of price movements, ranging from 0 to 100.
• Stochastic Oscillator: Compares a security's closing price to its price range over a given period.
• Moving Average Convergence Divergence (MACD): Uses two moving averages to identify trend changes and momentum.

Divergence: A key concept in oscillator analysis is divergence, which occurs when the oscillator and price action move in opposite directions, signaling a potential trend reversal.

• Bearish divergence occurs when prices make higher highs, but the oscillator makes lower highs.
• Bullish divergence occurs when prices make lower lows, but the oscillator makes higher lows.

8. Point and Figure & Candlesticks: Alternative Charting Methods

Point and figure charts provide the technician with specific entry and exit points.

Point and figure charts: These charts focus solely on price movements, ignoring time. They use X's to represent rising prices and O's to represent falling prices, with a specific box size and reversal criterion.

• They are useful for identifying support and resistance levels, as well as price objectives.
• They are less sensitive to short-term price fluctuations than bar charts.

Japanese candlesticks: These charts display the open, high, low, and close prices, with a "body" and "wicks" that provide additional information about price action.

• They are useful for identifying reversal patterns, such as the "hammer," "shooting star," and "engulfing patterns."
• They provide a more nuanced view of price action than bar charts.

Combining techniques: Technical analysts often combine different charting methods and indicators to confirm their trading signals and increase the probability of success.

Last updated: January 25, 2025