What is Technical Analysis?

Technical Analysis

Most commodity traders incorporate technical analysis into their trading plan. Technical analysis differs from fundamental analysis in the sense that it utilizes prior price action to predict future price moves. Fundamental analysis basically focuses on supply and demand expectations of commodities to predict future price action.

Most commodity traders claim to either be a technical trader or a fundamental trader. In fact, most commodity traders utilize both methods. Mostly good traders trade off the charts but keep up on the fundamental picture to look for trades and to screen some marginal trades if they conflict with their charts.

To utilize technical analysis when trading commodities, you will want to start by looking at a price chart of the commodity you are interested in trading. NSE is a source on the Internet where you can find futures quotes and charts. Following the trend is one of the golden rules of trading so you will want to look for a chart that is steadily moving higher or lower.

Typically with technical trading, you will want to either buy an up-trending commodity when it is breaking out to new highs or it has corrected from the highs. This is a matter of preference to your individual trading style. Good traders normally like to buy retraced within a trend unless a market is extremely strong.

The good thing about technical analysis is that it applies to all charts, whether they are 5-minute charts for day trading futures or daily charts for longer term trading. The first thing you want to do is learn how to read charts and get a basic understanding of what types of patterns and indicators might setup market moves. From there, you can move on to more advanced commodity trading strategies with technical analysis.

It is important to understand that technical analysis is no an exact science. It is more of an art. The same goes for fundamental analysis. You will never be right every time when you trade commodities. Think of it as playing percentages. If you are right more often than you are wrong, you will come out ahead if your average loss is the same as your average gain.

Introduction

The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

In this tutorial, we'll introduce you to the subject of technical analysis. It's a broad topic, so we'll just cover the basics, providing you with the foundation you'll need to understand more advanced concepts down the road.

What Is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns; others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don't care whether a commodity is undervalued - the only thing that matters is a security's past trading data and what information this data can provide about where the security might move in the future.

The field of technical analysis is based on three assumptions:

1. The market discounts everything.

2. Price moves in trends.

3. History tends to repeat itself.

1. The Market Discounts Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular commodity in the market.

2. Price Moves in Trends

In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.

3. History Tends To Repeat Itself

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

What Is A Chart?

In technical analysis, charts are similar to the charts that you see in any business setting. A chart is simply a graphical representation of a series of prices over a set time frame. For example, a chart may show a commodity's price movement over a one-year period, where each point on the graph represents the closing price for each day the commodity is traded:

It is a representation of the price movements of a commodity over a 1.5 year period. The bottom of the graph, running horizontally (x-axis), is the date or time scale. On the right hand side, running vertically (y-axis), the price of the security is shown. By looking at the graph we see that in October 2004 (Point 1), the price of this commodity was around NPR 245, whereas in June 2005 (Point 2), the stock's price is around NPR 265. This tells us that the commodity has risen between October 2004 and June 2005.

Chart Properties

There are several things that you should be aware of when looking at a chart, as these factors can affect the information that is provided. They include the time scale, the price scale and the price point properties used.

The Time Scale

The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually. The shorter the time frame, the more detailed the chart. Each data point can represent the closing price of the period or show the open, the high, the low and the close depending on the chart used.

Intraday charts plot price movement within the period of one day. This means that the time scale could be as short as five minutes or could cover the whole trading day from the opening bell to the closing bell.

Daily charts are comprised of a series of price movements in which each price point on the chart is a full day’s trading condensed into one point. Again, each point on the graph can be simply the closing price or can entail the open, high, low and close for the commodity over the day. These data points are spread out over weekly, monthly and even yearly time scales to monitor both short-term and intermediate trends in price movement.

Weekly, monthly, quarterly and yearly charts are used to analyze longer term trends in the movement of a stock's price. Each data point in these graphs will be a condensed version of what happened over the specified period. So for a weekly chart, each data point will be a representation of the price movement of the week. For example, if you are looking at a chart of weekly data spread over a five-year period and each data point is the closing price for the week, the price that is plotted will be the closing price on the last trading day of the week, which is usually a Friday.

The Price Scale and Price Point Properties

The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to past data points. This may seem like a simple concept in that the price scale goes from lower prices to higher prices as you move along the scale from the bottom to the top. The problem, however, is in the structure of the scale itself. A scale can either be constructed in a linear (arithmetic) or logarithmic way, and both of these options are available on most charting services.

If a price scale is constructed using a linear scale, the space between each price point (10, 20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a linear scale is the same distance on the chart as a move from 40 to 50. In other words, the price scale measures moves in absolute terms and does not show the effects of percent change.

If a price scale is in logarithmic terms, then the distance between points will be equal in terms of percent change. A price change from 10 to 20 is a 100% increase in the price while a move from 40 to 50 is only a 25% change, even though they are represented by the same distance on a linear scale. On a logarithmic scale, the distance of the 100% price change from 10 to 20 will not be the same as the 25% change from 40 to 50. In this case, the move from 10 to 20 is represented by a larger space one the chart, while the move from 40 to 50, is represented by a smaller space because, percentage-wise, it indicates a smaller move. In Figure 2, the logarithmic price scale on the right leaves the same amount of space between 10 and 20 as it does between 20 and 40 because these both represent 100% increases.

Chart Types

There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart.

Line Chart

The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in commodity data compared to the high and low for the day and this is why it is the only value used in line charts.

Bar Charts

The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. A bar that is colored red signals that the commodity has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Candlestick Charts

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colors to explain what has happened during the trading period.

A major problem with the candlestick color configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two color constructs for days up and one for days that the price falls. When the price of the commodity is up and closes above the opening trade, the candlestick will usually be white or clear. If the commodity has traded down for the period, then the candlestick will usually be red or black, depending on the site. If the stock's price has closed above the previous day’s close but below the day's open, the candlestick will be black or filled with the color that is used to indicate an up day.

Conclusion

Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being shown on a chart and the information that it provides.

A rounding bottom (or saucer bottom) is a long-term reversal pattern that signals a shift from a downward trend to an upward trend.
A moving average is the average price of a security over a set amount of time. There are three types: simple, linear and exponential.
Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend.
Indicators are calculations based on the price and the volume of a security that measure such things as money flow, trends, volatility and momentum. There are two types: leading and lagging.
The accumulation/distribution line is a volume indicator that attempts to measure the ratio of buying to selling of a security.
The average directional index (ADX) is a trend indicator that is used to measure the strength of a current trend.
The Aroon indicator is a trending indicator used to measure whether a security is in an uptrend or downtrend and the magnitude of that trend.
The Aroon oscillator plots the difference between the Aroon up and down lines by subtracting the two lines.
The moving average convergence divergence (MACD) is comprised of two exponential moving averages, which help to measure a security's momentum.
The relative strength index (RSI) helps to signal overbought and oversold conditions in a security.
The on-balance volume (OBV) indicator is one of the most well-known technical indicators that reflects movements in volume.
The stochastic oscillator compares a security's closing price to its price range over a given time period.

Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity. It is based on three assumptions: 1) the market discounts everything, 2) price moves in trends and 3) history tends to repeat itself.
Technicians believes that all the information which they need about the commodity can be found in its charts.
Technical traders take a short-term approach to analyzing the market.
Criticism of technical analysis stems from the efficient market hypothesis, which states that the market price is always the correct one, making any historical analysis useless.
One of the most important concepts in technical analysis is that of a trend, which is the general direction that a security is headed. There are three types of trends: up trends, downtrends and sideways/horizontal trends.
A trend line is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock.
A channel, or channel lines, is the addition of two parallel trend lines that act as strong areas of support and resistance.
Support is the price level through which a commodity or market seldom falls. Resistance is the price level that a commodity or market seldom surpasses.
Volume is the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security.
A chart is a graphical representation of a series of prices over a set time frame.
The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually.
The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to past data points. It can be either linear or logarithmic.
There are four main types of charts used by investors and traders: line charts, bar charts, candlestick charts and point and figure charts.
A chart pattern is a distinct formation on a commodity chart that creates a trading signal, or a sign of future price movements. There are two types: reversal and continuation.
A head and shoulders pattern is reversal pattern that signals a security is likely to move against its previous trend.
A cup and handle pattern is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.
Double tops and double bottoms are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through.
A triangle is a technical analysis pattern created by drawing trend lines along a price range that gets narrower over time because of lower tops and higher bottoms. Variations of a triangle include ascending and descending triangles.
Flags and pennants are short-term continuation patterns that are formed when there is a sharp price movement followed by a sideways price movement.
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction.
A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there is a large difference in prices between two sequential trading periods.
Triple tops and triple bottoms are reversal patterns that are formed when the price movement tests a level of support or resistance three times and is unable to break through, signaling a trend reversal.