Technical Analysis for Dummies

1. Technical Analysis: Price is King

The price neatly cuts through all the clutter of words and is the one piece of hard information you can trust.

Price as Primary Data: Technical analysis prioritizes the study of price movements over fundamental factors. It assumes that all known information, including news, opinions, and emotions, is already reflected in the price of a security. This approach allows traders to focus on what the market is actually doing rather than what it should be doing.

• Technical analysis is not about the "value" of a security, but about the trade.
• It's about timing your sales as much as your purchases.
• The price chart is the primary workspace of technical analysis.

Technical vs. Fundamental: While fundamental analysis focuses on a security's intrinsic value, technical analysis focuses on price behavior. Technical traders believe that price action reveals the collective psychology of market participants, offering clues about future price movements. Many traders use both forms of analysis, using fundamentals to select securities and technicals to time entries and exits.

• Technical analysis is not antithetical to fundamental analysis.
• Many analysts choose to trade only the highest-quality securities on a fundamental basis, but time purchases and sales according to technical criteria.
• Technical analysis levels the playing field for the individual and allows him to compete with the professionals having far greater resources.

The Technical Mindset: Technical analysis requires a specific mindset: independent thinking, responsibility for actions, and acting on observation rather than conventional wisdom. It's about cutting losses and letting winning trades run, a concept that often goes against traditional buy-and-hold strategies.

• Technical trading means to trade with a plan that identifies the potential gain and the potential loss of every trade ahead of time.
• The technical trader devises rules for dealing with price developments as they occur in order to realize the plan.
• Using rules is the key feature of lasting success in trading.

2. Crowd Behavior: The Auction Dynamic

In securities trading, the pricing process is more like the pricing process in an auction.

Auction vs. Traditional Economics: Unlike traditional economics where demand decreases as price rises, in securities trading, demand often increases as price rises, similar to an auction. This is because traders are often motivated by the perception that others also want the security.

• Securities are not regular goods, and to apply orthodox supply-and-demand economics to securities trading can result in some silly conclusions.
• In an auction, demand for the item often rises as the price rises.
• Visible demand begets more demand.

The Bandwagon Effect: Technical analysis seeks to identify and capitalize on crowd behavior, also known as the bandwagon effect. Traders often follow the crowd, buying when prices are rising and selling when prices are falling. This can lead to both manias and panics, where prices become detached from any reasonable concept of value.

• Technical analysis is the art of identifying crowd behavior in order to join the crowd and take advantage of its momentum.
• Emotional extremes lead to price extremes in the context of the hour, day, or week.
• As a technical trader, you want to be sensitive to what the crowd is doing without succumbing to the ruling passions of the crowd itself.

Individual vs. Crowd: Individuals behave differently when they are part of a crowd. In markets, this can lead to irrational behavior, such as buying at inflated prices or selling at depressed prices. Technical traders aim to be aware of crowd behavior without being swept away by it.

• A crowd is more than the sum of its parts.
• Otherwise sensible individuals can behave in the most extraordinary ways when they become part of a crowd.
• All the information you need to make a trading decision is embedded in the price.

3. Sentiment & Volume: Gauging the Market's Mind

The trend is your friend — until the end.

Market Sentiment: Market sentiment refers to the overall attitude of traders towards a particular security or market. It can be bullish (optimistic), bearish (pessimistic), or uncertain. Sentiment indicators help traders understand the overall market environment and can be useful when markets are not trending.

• Sentiment indicators, also called “market indicators,” describe the overall environment in which your specific securities are being priced.
• Sentiment indicators are useful to confirm a trend in your security that is starting or already in place.
• Sentiment indicator may offer guidance when trendedness collapses into non-trendedness or sideways, range-trading mode.

Volume as Confirmation: Volume, the number of shares or contracts traded, is a powerful confirming indicator of price moves. Rising volume during a price increase suggests strong demand, while falling volume during a price decrease suggests weak selling pressure.

• Volume is the most powerful confirming indicator of a price move.
• When a price rise is accompanied by rising volume, you have confirmation that the direction is associated with participation.
• A change in volume often predicts a change in price.

Sentiment Indicators: Sentiment indicators measure the overall mood of the market. Examples include the Bull/Bear Ratio, breadth indicators (ratio of advancing to declining issues), put/call ratios, and the VIX (volatility index). These indicators can help traders identify potential turning points in the market.

• Market indicators are not technical indicators in the strict sense but are consistent with the technical principle that we want to study what people do, not what they say.
• When the crowd is jumpy and nervous, it projects that anxiety into the future and assumes that prices will be abnormal.
• VIX is generally used as a contrary indicator.

4. Indicators: Your Trading Edge

The purpose of indicators is to clarify and enhance your perception of the price move.

Indicators as Tools: Indicators are calculations applied to price data to identify chart events, such as trends, trend strength, and potential turning points. They help traders make rational decisions by removing emotion from the trading process.

• An indicator is a calculation that you put on a chart to identify chart events.
• The purpose of indicators is to clarify and enhance your perception of the price move.
• You use indicators to gain an edge in buying low and selling high.

Types of Indicators: Indicators can be classified as either judgment-based (visual patterns) or math-based (calculations). Both types are equally valid and useful, and many traders use a combination of both.

• Judgment-based indicators include visual pattern-recognition methods such as bar, line, and pattern analysis, as well as candlesticks.
• Math-based indicators include moving averages, regression, momentum, and other types of calculations.
• The use of math does not confer a crown of authenticity on any technique.

Indicator Functions: Indicators help identify various market conditions, including the start of a trend, the strength of a trend, retracements, potential reversals, and range-trading. Each indicator works best in specific situations, and traders often choose indicators based on their trading style and risk tolerance.

• Indicators identify five conditions: A trend is beginning, a trend is strong or weak, a trend is retracing but will likely resume, a trend is ending and may reverse, and a price is range-trading.
• Each indicator works best in one situation and less well in others.
• The indicator you choose for each task depends on the security, the analytical time frame, and your affinity for specific indicators.

5. Trading Rules: Managing Risk & Reward

Preventing and controlling losses is more important than outright profit seeking to practically every technical trader you meet.

Trading Rules as a Plan: Trading rules are specific actions taken when certain conditions are met. They refine buy/sell signals from indicators and help manage risk. A trading plan should include rules for determining the trend, opening a position, managing risk, closing a position, and re-entering after a stop or target is hit.

• A trading rule is the specific action you take when certain conditions are met.
• Managing the trade isn't exclusive to technical analysis. But all successful technical traders manage their trades.
• The paramount rule in technical trading is to control losses.

Trading Styles: Trading styles vary based on holding periods and risk tolerance. Trend-followers hold positions for longer periods, while swing traders buy at relative lows and sell at relative highs. Day traders and scalpers have even shorter holding periods.

• Position traders identify big-picture trends lasting weeks and months.
• Swing traders buy at relative lows and sell at relative highs.
• Day traders are a sub-set of swing traders who prefer to get in and out in a single day.

Stop-Loss Orders: Stop-loss orders are crucial for controlling losses. They are orders given to a broker to exit a trade if the price moves against you by a certain amount. Mental stops are unreliable, and it's essential to set a stop-loss order at the same time you enter a position.

• A stop-loss order is an order you give to your broker to sell your position if it goes against you too far and reaches the maximum loss you're prepared to accept.
• Mental stops are hogwash.
• Setting a stop-loss order is like buying insurance in case the store burns down.

6. Bar Reading: Decoding Price Action

The price bar and its placement on the chart deliver a ton of information about market sentiment.

Price Bar Components: The price bar consists of four components: the open, high, low, and close. Each component provides insights into market sentiment and the battle between buyers and sellers.

• The price bar describes and defines the trading action in a security for a given period.
• The opening price is the very first trade done between a buyer and a seller on the trading day.
• The closing price is literally the last price at which a buyer bought and a seller sold before the closing bell.

Interpreting Bars: The relationship between the open, high, low, and close of a bar reveals the prevailing sentiment of the day. A close near the high suggests bullishness, while a close near the low suggests bearishness.

• If the price opened at the low and closed at the high, the winners that day were the buyers.
• If the price opened at the high and closed at the low, the winners that day were the sellers.
• The price bar tells you the outcome of the battle between the buyers (bulls) and the sellers (bears).

Identifying Trends: Trends are identified by a series of higher highs and higher lows (uptrend) or lower highs and lower lows (downtrend). The close relative to the open also provides clues about the strength of the trend.

• To embrace technical analysis is to embrace a way of thinking that's always sensitive to risk.
• At the most basic level, your goal as a technical trader is to sit on your hands while the security is falling and wait to identify the reversal point.
• A trend is a discernible directional bias in the price — upwards, downwards, or sideways.

7. Patterns: Recognizing Market Geometry

Trends can be identified with patterns that you see repeatedly.

Patterns as Indicators: Patterns are geometric shapes formed by price movements on a chart. They are used to identify potential continuation or reversal points in a trend.

• Patterns can be identified with patterns that you see repeatedly.
• Patterns can be identified with support and resistance trendlines.
• Patterns are a shorthand way to identify and measure market sentiment.

Continuation Patterns: Continuation patterns suggest that the current trend is likely to continue. Examples include ascending and descending triangles, and the dead-cat bounce.

• Continuation patterns are a good place to add more to a position, because you expect an additional move in the same direction.
• A dead-cat bounce is a peculiar continuation pattern that looks like a reversal at the beginning, with a sizeable upward retracement of a downmove, but then fades back to the same downward direction.
• Continuation patterns serve as reassurance that you've identified the trend correctly.

Reversal Patterns: Reversal patterns indicate that a trend is likely to change direction. Examples include double bottoms, double tops, and head-and-shoulders patterns.

• Reversal patterns are a warning to exit when you're invested in the security.
• A reversal pattern is also advance notice that a good entry place may be coming up.
• The head-and-shoulders pattern is the most widely recognized of all the patterns.

8. Dynamic Lines: Following the Flow

The price chart is the primary workspace of technical analysis.

Moving Averages: Moving averages are dynamic lines that smooth out price data to identify trends. They are calculated by averaging prices over a specific period.

• A moving average is an arithmetic method of smoothing price numbers so that you can see and measure a trend.
• Moving averages are the workhorses of technical analysis.
• The moving average is a lagging indicator.

Types of Moving Averages: Different types of moving averages exist, including simple, weighted, and exponential moving averages. Each type has its own way of weighting recent prices, making them more or less responsive to current market conditions.

• Weighted and exponential moving averages are more sensitive to recent price changes.
• Adaptive moving averages adjust to changing market conditions.
• Moving average rules vs. Donchian rules.

Moving Average Crossovers: Crossovers occur when a shorter-term moving average crosses above or below a longer-term moving average. These crossovers are often used as buy/sell signals.

• The crossover rule states that you buy at the point where the price crosses above the moving average line and sell at the point where it falls below the moving average line.
• Using Multiple Moving Averages.
• Delving into Moving Average Convergence and Divergence.

9. Volatility: Measuring Market Jitters

Volatility is a measure of price variation, either the total movement between low and high over some fixed period of time or a variation away from a central measure, like an average.

Volatility Defined: Volatility measures the degree of price variation over time. It reflects the level of risk and opportunity in a security. High volatility implies greater price swings, while low volatility implies smaller price swings.

• Volatility is the degree of variation of a price series over time.
• The higher the volatility, the higher the risk — and the opportunity.
• A change in volatility implies a change in the expected price range to come.

Measuring Volatility: Volatility can be measured in several ways, including tracking the maximum move, considering the standard deviation, and using the average true range (ATR) indicator.

• Tracking the maximum move.
• Considering the standard deviation.
• Using the average true range indicator.

Bollinger Bands: Bollinger bands are a popular way to visualize volatility. They consist of a moving average with bands on either side that represent two standard deviations from the average. Prices tend to stay within the bands, and breakouts of the bands can signal potential trading opportunities.

• Applying Volatility Measures: Bollinger Bands.
• Bollinger bands are not generally used to set stops.
• Bollinger bands display the end of the upmove in two ways.

10. Time-less Charts: Focusing on Price

Point-and-figure charting strips away time and displays only significant prices on the chart.

Point-and-Figure Charts: Point-and-figure (P&F) charts ignore time and focus solely on significant price movements. They use Xs to represent rising prices and Os to represent falling prices, creating a visual representation of price action without the clutter of time-based data.

• Point-and-figure charting strips away time and displays only significant prices on the chart.
• Point-and-figure is the only major technique to ignore volume altogether.
• P&F analysis is suitable for trading that has a medium- to long-term holding period.

Box Size and Reversal Amount: P&F charts use a box size to determine the minimum price movement required to add a new X or O. The reversal amount determines how far the price must move in the opposite direction to start a new column.

• Dealing with box size.
• Defining box size.
• Choosing a box size.

Patterns and Projections: P&F charts can be used to identify patterns, such as support and resistance, double tops and bottoms, and triangles. They also offer methods for projecting future price movements using vertical and horizontal counts.

• Applying Patterns.
• Projecting Prices after a Breakout.
• Using vertical price projection.

11. Combining Techniques: Building Your System

To blend technical methods with your own personal risk profile isn't the work of one day.

Positive Expectancy: A positive expectancy means that your trading system is likely to generate more profits than losses over time. It is calculated by considering the probability of winning, the average win, the probability of losing, and the average loss.

• Defining positive expectancy.
• Tearing down expectancy.
• Enhancing positive expectancy by entering gradually and exiting at once.

Trading Styles: Trading styles range from fully systematic to discretionary. Systematic traders follow every signal from their indicators, while discretionary traders use their judgment to make trading decisions.

• Semi-system “discretionary” trading.
• Solving the squaring problem — setups.
• Adding a New Indicator: Introducing Complexity.

Combining Indicators: Combining multiple indicators can improve the accuracy of trading signals. However, it's important to choose indicators that complement each other and to avoid overcomplicating your trading system.

• Choosing a ruling concept.
• Studying a case in complexity.
• Sailing into Outer Space.

12. Cycles & Waves: The Big Picture

Financial cycles follow the economic and business cycles but with the addition of something new — risk management.

Economic Cycles: Economies exhibit cyclical patterns of expansion and contraction, known as the business cycle. These cycles can influence financial markets, but they are not always predictable.

• Defining a Cycle.
• Financial cycles.
• Following the earth's axis: Seasonality and calendar effects.

Seasonality: Seasonality refers to predictable patterns in prices that occur at specific times of the year. These patterns can be useful for timing trades in certain markets.

• Big-Picture Crowd Theories.
• The Gann 50 percent retracement.
• Magic numbers: “The secret of the universe”.

Magic Numbers: Some technical traders believe in the power of magic numbers, such as Fibonacci retracements and Gann angles. While these concepts may have some historical significance, they should be used with caution and skepticism.

• Seeing too many retracements.
• Technical analysis (so far) remains an art, not a science, even when it uses scientific methods.
• You're welcome to use magic numbers in your application of technical analysis. You're also welcome to omit them with no loss of analytical power.

Last updated: January 27, 2025