Opening the Technical Analysis Toolbox
In This Chapter
* Defining technical analysis
* The straight scoop on buy-and-hold
* Defining trendedness
* Starting your technical analysis journey
Technical analysis is the study of the price behavior of securities (and often the accompanying volume, too) in order to predict upcoming price moves. Focusing on price behavior gives you a window into the mind of the market — what the key players are thinking — and helps you make better trading decisions. Technical analysis seeks to identify and measure market sentiment, which at the most basic level means optimistic, pessimistic, or uncertain about future prices.
In this chapter, I take you on a quick tour of key technical concepts and review why technical analysis works. Even when your indicators let you down — and they will — when you adopt the technical analysis mindset, you start to manage the whole trade, from entry to exit. After all, your goal is to make money trading securities, and that entails knowing when to sell as well as when to buy; in other words, managing market risk. But technical analysis is not a crystal ball and does sometimes fail, so I also discuss why technical analysis sometimes gets a bum rap. To dismiss all of technical analysis because it's not 100 percent perfect is a bit like saying doctors do not always diagnose and treat ailments correctly and therefore we might as well avoid all medical care.
Introducing Technical Analysis
Technical analysis is the study of how securities prices behave and how to exploit that information to make money while avoiding losses. Your immediate goal is to forecast the price of the security over some future time horizon in order to buy and sell the security to make a cash profit. The emphasis in technical analysis is to make profits from trading, not to consider owning a security as some kind of savings vehicle. In buy-and-hold investing, you hardly ever sell, sometimes waiting until you have a catastrophic loss. In technical trading, when you sell is just as important as when you buy.
Who are you?
Both traders and investors use technical analysis. So what's the difference between a trader and an investor? Most people consider that a trader is someone who holds securities for only a short period of time, anywhere from a minute to a year. An investor is someone who holds securities from many months to forever. You may also think of an investor as someone who seeks income from dividends or bond coupon payments.
Actually, the dividing line between trader and investor isn't fixed, except for purposes of taxation. Be careful not to fall into the semantic trap of thinking that a trader is a wild-eyed speculator while an investor is a respectable guy in a pinstriped suit. I use the word trader in this book, but don't let it distract you. People who consider themselves investors use technical methods, too.
You can use technical methods over any investment horizon, including the long term. If you're an expert in Blue Widget stock, for example, you can add to your holdings when the price is relatively low, take some partial profit when the price is relatively high, and dump it all when it falls more than you can stomach, only to buy it back when it bottoms. Technical analysis has tools for identifying each of these situations. You can also use technical tools to rotate your capital among several securities, allocating more capital to the ones delivering the highest gains or the lowest risk. At the other end of the holding period spectrum, you can use technical analysis to spot a high-probability trade and execute the purchase and sale in one hour.
Choosing a trading style
In general, trading styles are a function of the holding period, or how much time elapses between buying and selling the security.
[check] Position traders identify big-picture trends lasting weeks and months, and are willing to sit out retracements and sideways range-trading situations until they resolve back into a trend. Position traders hold securities for weeks, months, and years.
[check] Swing traders buy at relative lows and sell at relative highs, with "trend" defined as any move that indicators show is likely to persist for some additional time. Swing traders have a holding period of three to ten days, although analysts argue over the "right" holding period.
[check] Day traders are a sub-set of swing traders who prefer to get in and out in a single day, sometimes more than once. Day traders apply indicators to short-terms charts such as the 5-minute, 15-minute, and one-hour chart in order to identify micro-trends that may last only two or three hours. The micro-trend will often be a counter-trend to the big-picture trend on the daily chart.
[check] Scalpers have a holding period of seconds and minutes. Originally the term scalping referred to taking advantage of the bid-offer spread available by different parties or parties in different places, but with the advent of super-fast computer programs, scalping now includes algorithmic trading that automatically places rule-based buy and sell orders based on a few seconds' advantage in obtaining information or identifying a technical pattern.
Setting new rules
Get rid of the preconceived notion that because technical analysis entails an active trading style, or at least a more active style than buy-and-hold, you're about to embrace more risk. Exactly the opposite is true. Because you always know ahead of time where you will sell, you always know your gain or loss before you buy. So, for example, to conduct a one-hour trade is inherently less risky than buying and holding a security indefinitely without an exit plan. The existence of an exit plan is what defines and limits the risk. Where does the exit plan come from? The indicators you choose — and you choose indicators based in part on how much gain and loss they are likely to entail in real-time trading.
The one-hour trade entails risk management, whereas holding a security without an end in mind on some concept of hypothetical "value" is to take 100 percent risk. That supposedly "valuable" security can quickly tank and go to zero. Think of Enron, WorldCom, Lehman Brothers, or Bear Stearns — all failed companies whose stock price went to zero, even though "experts" said that these names were buying opportunities right up to the last minute.
Preventing and controlling losses is more important than outright profit seeking to practically every technical trader you meet. The technical analysis approach is demonstrably more risk averse than the value-investing approach.
To embrace technical analysis is to embrace a way of thinking that's always sensitive to risk. 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. In fact, you select your technical tools specifically to match your trading style with your sensitivity to risk.
Using rules is the key feature of lasting success in trading. Anybody can get lucky once or twice. To make profits consistently requires that you not only identify the trading opportunity, but also manage the risk of the trade over the lifetime of your ownership of the security. You never buy it and forget it.
The truth about buy-and-hold
Buy-and-hold is a philosophy that says most equities are best left unattended for long periods of time in your portfolio. They rise more or less in sync with the overall economy, saving you transactions costs and taxes. Besides, the market is efficient, meaning every security price already incorporates all the information available and is priced correctly. There is no point in selling Security X unless you need money for a nonmarket reason.
One reason to distrust buy-and-hold is that over really long periods, returns are not very good at all. According to the National Bureau of Economic Research, from 1836 to 2011, gold earned only an average 1.1 percent per year. Treasury bonds yielded 2.9 percent and equities earned 7.4 percent. Nobody lived over this span of time, of course, but the point is that in order to get high returns, you had to pick one of the periods when market was in a bull market phase.
In the United States, from 1900 to 2013, the Standard & Poor's equity index has been in 24 bull market phases, meaning it rose over 20 percent. Each one averaged about three years, and the average return of each of the bull markets was 127.36 percent.
In other words, to buy and hold securities for a long period of time is a well-documented path to accumulating capital, but only if you got in at the best time. Otherwise, buy-and-hold is a path to the poorhouse. Consider the following:
[check] If you had bought U.S. stocks at the price peak just ahead of the 1929 crash, it would've taken you over 20 years to recover your initial capital.
[check] Since the end of World War II, the Dow Jones Industrial Average has fallen by more than 20 percent on 13 occasions.
[check] From January 2000 to October 2002, the S&P 500 fell by 50 percent. If you owned all the stocks in the S&P 500 and held them throughout the entire period, you lost 50 percent of your stake, which means you now need to make a gain equivalent to 100 percent of your remaining capital to get your money back, as Table 1-1 shows. Ask yourself how often anyone makes a 100 percent return on investment.
That covers the factual aspect of buy-and-hold — you need to get lucky in your entry. Now consider the underlying assumption that all information is already incorporated into the price, the so-called efficient markets hypothesis. Even in the "weak" form of the argument, the assumption is patently untrue.
For one thing, if markets were actually efficient, we should not get bubbles and crashes, and yet undeniably we do. Behavioral economists have found that prices are influenced by all kinds of bias, including overconfidence, wishful thinking, and the whole panoply of possible errors in both reasoning and in evaluating information that's not always unambiguous.
Also, insider trading would not be so profitable (and periodically scandalous) if all information were available immediately. This is why securities analysts follow pharmaceutical and high-tech companies with a microscope — to get the news first. Not everyone can afford to keep up on all the news all the time about their securities.
The Trend Is Your Friend
You can look at most charts and see that in some time frame, securities prices tend to move in trends, and trends often persist for long periods of time. A trend is a discernible directional bias in the price — upwards, downwards, or sideways. Many people do not consider "sideways" a trend in its own right, but rather a departure from an upward or downward direction. And yet it can be useful to consider sideways a trend, because when you widen the timeframe to include more time, you often see that a sideways move is a transition phase from up to down or down to up. It can also be up to higher up or down to lower down.
De-cluttering your mind
Securities prices are the product of the collective decision making of buyers and sellers. Prices incorporate all known information, including assumptions, about the security. Prices change as new information becomes available. All known information consists of hundreds of factors ranging from accurate facts to opinions, guesses, and emotions — and previous prices. They all go into the supply and demand for a security and result in its price. I talk about supply and demand in Chapter 2.
Charles Dow, one of the founders of The Wall Street Journal, observed around the turn of the 20th century that no matter what the facts are about a security and what people are saying about it, the price neatly cuts through all the clutter of words and is the one piece of hard information you can trust.
Note, however, that prices on a chart don't tell you anything about the underlying value of the security. Where the price "should" be is a totally different subject, named fundamental analysis. Most technical traders use both forms of analysis, because technical analysis isn't antithetical to fundamental analysis, as some critics think. The two are compatible and can be used together. Many analysts choose to trade only the highest-quality securities on a fundamental basis, but time purchases and sales according to technical criteria.
The core ideas of technical analysis are not a new flash in the pan, but rather came into being over 100 years ago. Here are some basic observations underlying technical analysis that are attributed to Dow himself:
[check] Securities prices move in trends much of the time.
[check] Trends can be identified with patterns that you see repeatedly (which I cover in Chapter 9) and with support and resistance trendlines (see Chapter 10).
[check] Primary trends (lasting months or years) are punctuated by secondary movements (lasting weeks or months) in the opposite direction of the primary trend. Secondary trends, today called retracements, are the very devil to deal with as a trader. (See Chapter 2 for more on retracements.)
[check] Trends remain in place until some major event comes along to stop them.
These ideas and many more attributed to Dow (sometimes wrongly) are called Dow theory, although he never called it that as far as anyone knows. An Internet search of the phrase Dow theory yields over seven million hits. A key point is that traders were using technical ideas long before the advent of electronic communication and software programs — technical analysis is hardly a new-fangled fad that will have a short shelf life. It has already survived over 100 years. In Japan, the candlestick version of charting is said to have begun in the 1700s.
Charting your path
The price chart is the primary workspace of technical analysis. Many technical analysts work only with mathematical re-formulations of prices in order to devise probabilistically optimum trades, but the chart is the starting point for everyone and remains the main workspace for the majority. See Figure 1-1. This chart shows a classic uptrend following a downtrend.
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 — the best place to buy (shown in the circle) — as early as possible. Figure 1-1 is a good example of the kind of chart with which you spend most of your time.
To say that something is "on a trend" is to say that it is moving in a specific direction and exhibits evidence of a tendency to continue in that same direction. We could say that the use of social media like Twitter and Facebook are a trend, or that the trend in economically advanced economies is for families to have fewer children than in the past.
What's the difference between trendiness and trendedness? Trendiness implies a fashion or fad that may wither and blow away. Trendedness refers to a measurable directional bias. It's a more serious word reflecting a more serious and enduring phenomenon. Twitter may not be around 30 years from now, but securities charts will still be exhibiting price trendedness.
Creating a chart like the one in Figure 1-1 is easy. To illustrate classic trend behavior, I could've taken any security out of thousands in my database and found some period of time over which the security's price looked like this chart. However, I could have also found many time periods when this same security was not trending. In fact, some securities are frequently in a trending mode, others seldom trend, or their trends are short lived. To complicate matters, some securities exhibit a "habit" of tidy trending whereas others trend in a sloppy way (with high variability around the average).
I give you the key definitions of trendedness in Parts III through V. Chapter 6 describes it as a series of higher highs together with a series of higher lows (for an uptrend). In Chapter 12, trendedness is defined as the price rising above a moving average or a short-term moving average rising above a long-term moving average (also an uptrend). The rest of the chapters contain other definitions.