Intro
Like quality carpentry, quality technical analysis requires the right tool for the right job. While a hand saw can cut wood to build a table, a power saw with built in guides can do it with a much higher degree of precision. Conversely, the back end of a screwdriver can pound a nail but choosing the right tool, a hammer, protects both the carpenter and the tool. Here is a summary of what tools should be in a good technical toolbox.
Technical Tasks
Technical tasks are simply the four main area of analysis that technicians consider:
- Price
- Volume
- Time
- Sentiment
Many of today’s widely used indicators focus on only one of these areas. Further, many of today’s technicians use only a few indicators, leaving out one or more sectors of analysis completely. It’s akin to building a table with two or three legs. It may stand up for a while but it won’t be solid enough to deal with shifting or heavy loads.
Since the goal of any market analysis is to enable one to make money in the differential between price paid and price received, price is necessarily the most important factor. It is not a surprise that most market analysis revolves around this element.
Price
Price patterns, such as triangles and gaps, are used extensively. Measures of price momentum, such as the relative strength index and rate of change are popular. Finally, methods of smoothing out market noise, such as moving average systems, are created all the time.
Volume
Volume is the next area and it is important in gauging public participation in any market move. Liquidity, open interest and breadth are all terms used here although breadth can have its own category of analysis. Liquidity measures how easy it will be to trade (turnover) and how much catalyst is needed to cause a price change. The greater the volume the easier it will be to buy and sell.
Open interest, while usually confined to the futures markets, measures how many participants have put their money on the line by establishing either long or short positions. “Shares outstanding” in the stock market is not quite the same but it does indicate how much stock is available (short sales excluded). Available stock is the potential supply that can be offered for trading. And breadth covers such areas as how various market sectors or sheer numbers of stocks are participating in any price moves and how much money is flowing into or out of the market.
Time
The next area of analysis is time. Accumulation, distribution, bull phases and bear phases are common to all markets and each stage takes a certain amount of time to complete. Together they form the market cycle and knowing where the market is in its cycle aids in making the investment decision.
Further, the relative lengths of each cycle component and their durations yield clues to market direction. For example, in bull markets, the “up” phase of a cycle is usually longer than the “down” phase. When they “down” phase elongates and the “up” phase contracts the trend may be changing for the worse.
Seasonal analysis began with the agricultural commodities as they progressed through their growing, harvesting and selling seasons but can be seen in all markets. However, even casual observers of the stock market have heard the mantra: “sell in May and go away,” which is a seasonal cycle for stocks. They are usually weaker in the summer.
Economic and political cycles also affect the financial markets as capital flows and productivity change.
Sentiment
The least understood area of analysis is sentiment analysis. This covers such areas as degree of speculation, public opinion and consensus. It is measured by relative activities in speculative instruments, such as options and junk bonds, and polls of bullish opinions. Both rely on the “burning match” theory in which the flame is passed from investor to investor until there is nobody left to take the match. They last one holding it gets burned.
In the markets, as bullish opinion spreads, eventually everyone will have bought. There will be nobody left to whom the last investors can sell. No demand means the end of the rally.
This can also be measured subjectively in the media as glowing bullish news is reported only when the newspaper buyer and TV viewer are ready to receive it. Again, when the public has an overall bullish consensus, there is nobody left to buy.
Tools for Each Technical Task
The most common tools in each area are outlined below:
Price
- Trend identification
- Trendlines, channels
- Smoothing, Moving averages
- Patterns
- Triangles, flags, gaps, head-and-shoulders, rectangles, pennants
- Candlesticks
- Momentum
- Single line oscillators (Relative Strength Index, Departure, Momentum)
- Multiple line oscillators (Stochastics, MACD)
- Relative levels
- Benchmarking
- Log scaling
- Spreads and Ratios
Volume
- Participation
- Volume, Cumulative Volume, Money Flow, On-Balance Volume
- Liquidity
- Open interest, Shares issued, Turnover
- Breadth
- Up-down volume
- Advance-Decline
- Dow Theory, Sector Rotation Analysis
Time
- Cycles
- Form (translation)
- Seasonal
- Economic, political
- Time Frame
- Short, medium, long
- Cyclical vs. Secular
- Extent
- Length of trend or base
- Relation of correction to trend
Sentiment
- Speculation
- Options activity, put-call ratio
- Junk bonds, initial public offerings
- Margin levels, mutual fund cash levels
- Commitment of Traders report
- Effects of good and bad news
- Consensus
- Percent of newsletters bullish or bearish
- Public opinion
- Anecdotal
- Magazine covers
- Hem lines, Superbowl
Combination Tools
Some indicators were designed to cover more than one analysis area, as follows:
Price and Time
Market Profile shows time spend at each price during the day and forms a value area on the chart.
MESA (Maximum Entropy Spectral Analysis) finds cycles in the data and projects them forward.
Price and Volume
Money Flow (price times volume summed per trade) is used as a supply/demand indicator.
Price and Sentiment
Equivolume bars have width in proportion to volume. They are used to allocate significance to price bars.
Elliott Waves are wave structures that follow public emotions and can identify ebb and flow of trading activity.
Conclusion
Note – not all of these more esoteric analyses are available in Technician.
There are many variations of each study available but there is a limit to how much data one can reasonably combine into a trading strategy. Mechanical systems and artificial intelligence can go beyond this limit but in return for better analysis, they require greater expertise, computer power and discipline to set up and use. While the latest gadgets may be available to the carpenter, most practitioners will do fine work with a basic set of tools. As long as each is matched to the job at hand, the resulting quality is limited only by the skill of the craftsman.