Technical Analysis
A L a y m a n ' s V i e w
“Nature is a machine. The family is a machine. The life cycle is like a machine. So how does the machine work when you have a financial crisis? How does deleveraging work – what is the nature of that machine?”
- Ray Dalio
A close friend of mine who had spent his career as a stock analyst and trader decided to share the fundamentals of technical analysis based on his years of experience. Inspired by him, this article emerged as my layman's view of his insights into markets.
What is Technical Analysis?
Technical analysis attempts to understand market sentiment behind price trends by discovering patterns rather than analysing a security's fundamentals. The latter is described as fundamental analysis which involves understanding a company’s financial statements to gain insight into the inherent value of the business.
The key idea behind technical analysis is that while market values do provide some insight into a security's price, historically price movements happen in identifiable patterns that repeat.
Investor Warren Buffet said “Be fearful when others are greedy and greedy only when others are fearful.” He is speaking to the inherent psychology of human beings to succumb to herd mentality in times of exuberance or crisis. Rapid market reaction to news is an expression of this. This tendency is what contributes to the patterns that technical analysis uncovers. It's as much an art as science.
Forecasting the direction of a price is the outcome of the analysis. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are questionable. By concentrating on the what (price observation) and putting aside the why (underlying factors for price) they approach the market with a direct view of supply and demand.
Three Core Ideas:
1. Everything is Priced In.
A security's price includes fundamentals and broad market factors. The only thing left to look at is movements linked to supply & demand.
2. Prices Move in Trends
A security's price is likely to continue a past trend than move erratically. The time horizon of the trend is a big question here.
3. Times Change, but Human Nature Doesn't.
A security's price is influenced by emotions like fear or excitement. By understanding human nature, market movements can be better explored.
Two Approaches:
1. Top-Down.
Macro-economic analysis, first focusing on economies, then sectors, and then companies in the case of stocks. For example, a trader may be interested in stocks that broke out from their 50-day moving average as a buying opportunity. Traders using this approach focus on short term gains as opposed to long term valuations.
2. Bottom-Up.
Looks the opposite way, from the movement individual stocks up. By observing the trends of the stock historically and in relation to the market, specific patterns could emerge that give clues to entry and exit points.
Price Charts:
Charts represent the playground that technicians operate in. Two variables considered are the timeframe and the indicators. Keep in mind that no technical indicator is perfect, and than managing risk is always important.
Timeframes
Timeframes used depends on the trader's horizon. Intra-day traders, those who open and close trading positions within a single day, favor analyzing price movement on shorter time frame charts, such as the 15-minute charts. Long-term traders who hold market positions for long periods of time are more inclined to analyze markets using hourly, 4-hour, daily, or even weekly charts.
Indicators
Moving Average:
A moving average is a widely used technical indicator that smooths out trends by filtering out the “noise” from random price fluctuations. The most common applications of moving averages are to identify trend direction and to determine support and resistance levels. When asset prices cross over their moving averages, it may generate a trading signal for technical traders.
Support & Resistance Levels:
These are used to create high and low ranges that help identify price-points where the probability of exceeding the range is unlikely. Support occurs where a downtrend trend is expected to pause due to a concentration of demand. Resistance happens where an uptrend is expected to pause temporarily, due to a concentration of supply.
Fibonacci Retracements
Fibonacci retracement levels use horizontal lines to indicate where possible support and resistance levels are. Each level is associated with a percentage. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8% and 78.6%. If a trader wants to buy, they watch for the price to stall at a Fibonacci level and then bounce off that level before buying. It is foolish to assume the price will definitely reverse after hitting a Fibonacci level.
Pivot Points
Pivot points don't use percentages like the Fibonacci Retracements above and are based on fixed numbers: the high, low, and close of the prior day. It is used to see the overall trend of the market over different time frames.
Limitations:
Beyond mixed signals and biases that are present in any kind of analysis, technical analysis can uniquely contribute to a self fulfilling prophecy. For example, many traders will place a stop-loss order on a security. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.
Trends also go out the window during black swan events. Writing this in the time of Covid-19, it seems even more pertinent.