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Technical Analysis For Dummies
By Barbara Rockefeller
John Wiley & SonsISBN: 0-7645-4044-0
Chapter OneOpening the Technical Analysis Toolbox
In This Chapter
* Defining technical analysis
* Befriending the trend
* Figuring out your definition of trendedness
* Getting the many names for technical analysis straight
Welcome to technical analysis, which, for you, may be a new way of looking at stocks and other securities. Simply put, technical analysis is a set of forecasting methods that can help you make better trading decisions.
In this chapter, I take you on a quick tour of key technical concepts and review why technical analysis works (and why sometimes it doesn't). You may be thinking that technical analysis is all about reading charts full of squiggles and lines, and although I give you plenty of material in this book about squiggles and lines, technical analysis is also about managing market risk.
Does that sound a bit too grand? Well, building a house isn't chiefly about hammers and nails, although you need them. Squiggles and lines are just tools. Think of tackling technical analysis as a project to build better trading practices. Yes, you need the squiggles and lines, but your goal is to use those tools to make money.
What Is Technical Analysis?
Technical analysis is the study of how securities prices behave and how to exploit that information to make money while avoiding losses. The technical style oftrading is opportunistic. 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 future time frame is unknown at the beginning of a trade, but it's not "forever" - as it may be with buy-and-hold investing. The emphasis in technical analysis is to make profits from trading, not to consider owning a security as some kind of savings vehicle. Therefore, technical analysis dictates a more active trading style than you may be used to.
Trading or investing: The many faces of technical analysis
Both traders and investors use technical analysis. What's the difference between a trader and an investor?
Okay, what's the difference between these holding periods?
Notice that I overlap the holding period of the trader and the investor. Actually, the dividing line between trader and investor isn't fixed (except for purposes of taxation). I use the word trader in this book, but don't let it distract you. People who choose to call 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 if the stock crashes. Technical analysis has a tool for identifying each of these situations. You can also use technical tools to rotate your capital among a number of securities depending on which ones are delivering the highest gains these days. At the other end of the investment horizon spectrum, you can use technical analysis to spot a high-probability trade, and execute the purchase and sale in the space of an hour.
Setting new rules
You may have the idea that because technical analysis entails an active trading style, you're about to embark on a wild and risk-laden adventure - like that one-hour trade I just mentioned in the last paragraph. Nothing could be further from the truth. Executing the one-hour trade has less inherent risk of loss than buying and holding a security indefinitely, without an exit plan, based on some expert's judgment of its value.
Preventing and controlling losses is more important to practically every technical trader you meet than outright profit-seeking. The technical analysis approach is demonstrably more risk-averse than the value-investing approach.
That's because 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 (from the many available) specifically to match your trading style with your sensitivity to risk. I talk about this in Chapter 4.
Using rules, especially rules to control losses, is the key feature of long-term success in trading. Anybody can get lucky - once. To make profits consistently requires you not only to identify the trading opportunity, but also to manage the risk of the trade. Most of the "trading rules" that you hear about, such as "Cut your losses and let your winners run," arise from the experience of technical traders. (I come back to this rule and the subject of managing the trade in Chapter 5.)
Making the case for managing the trade
To buy and hold securities for a very long period of time is a well-documented path to accumulating capital, but only if your timing is good - you're lucky enough to buy the security when its price is rising. If your timing isn't so hot or you're unlucky, it's a different story all together. Consider the following:
More recently, 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 starting capital to get your money back, as Table 1-1 shows. Ask yourself how often anyone makes a 100 percent return on investment.
Timing your entry and exit from the market is critical to making money and controlling losses. The central part of the book, Chapters 6 through 17, covers technical methods that aim to improve the timing of your entries and exits.
It's All about the Trend
You can look at most charts and see that in the big-picture sense, securities prices tend to move in trends, and trends persist for long periods of time. A trend is a discernible directional bias in the price - upwards, downwards, or sideways.
The trend is your friend. If you identify trends and trade with them, you can make more money trading securities. Trend identification gives you an advantage and helps you perform two functions near and dear to the heart:
Focusing on the price is right (and respectable)
Securities prices are the product of the collective decision-making of buyers and sellers. Prices incorporate (or discount) all known information about the security, and 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 and environmental factors that affect the price in Chapter 3 as well as Chapter 10.
Charles Dow, one of the founders of The Wall Street Journal, observed around the turn of the 20th century that whatever the true facts are about a security and whatever 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 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. Technical analysis isn't antithetical to fundamental analysis, as some critics think. The two can be used together. You can choose to trade only the highest quality securities on a fundamental basis, but time your purchases and sales according to technical criteria. This, by the way, is the basis of one of the top charting software packages (see the Appendix for the names of software and other valuable resources).
Technical analysis and fundamental analysis are compatible. The core ideas of technical analysis aren't some new and crackpot flash in the pan, but rather, they came into being over 100 years ago. Technical ideas have a respectable origin and have been embraced and explored by some very brainy and successful figures in American finance. To give you just a taste of the basic observations underlying technical analysis, Dow said
These ideas, and many more attributed to Dow (sometimes wrongly), are called Dow Theory and still cited today.
Charting your path
Prices and trends rule, so you have to be able to track and identify them. And to identify prices and trends, you have to see them. So here it is, the price chart (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 shun the security shown on the chart while it's downtrending and to identify the key reversal point - which is 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. A chart is the workspace of technical analysis. Technical analysts have developed numerous indicators based on price and volume that can be expressed as statistics, tables of numbers, and other formats, but the core method remains a graphic display of prices in a chart.
You absolutely, positively must become attuned to looking at charts and trying to figure out what the prices are telling you. On Figure 1-1, is this price going to make a new high - or is there evidence that the rally is over? (Yes, it did make a new high and no, the chart shows no evidence of the trend coming to an end.) By the time you finish this book, you'll know that at a glance, too.
Looking at the Many Faces of Trendedness
Trend means different things to different people. Trend is such a wide and flexible concept that a large variety of definitions is possible. In fact, to be pragmatic, you can say that a trend is a price move that your indicator identifies. In other words, you can define trend according to technical measures that appeal to your sense of logic and what works for you. In this book, definitions of trendedness are spread out under various technique headings so that you can choose which definition of trendedness suits your personality and trading style.
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 also have found many periods of time when this same security was not trending. In fact, some securities are frequently in a trending mode and others seldom trend, or their trends are short-lived. To complicate matters, some securities exhibit a "habit" of tidy trending while others trend in a sloppy way (with high variability around the average).
Charles Dow may have started the ball rolling in technical analysis over 100 years ago, but in the grand scheme of things, we're still in frontier days. Ask a group of technical traders, "What percentage of time are securities trending and what percentage of the time are they nontrending?" I guarantee that nobody can give you a single correct answer. Actually, most technical traders tell you that securities are typically in a trending mode about 30 percent of the time, but that statistic isn't based on hard facts. It's a guess because of two factors - the definition of trendedness the individual chooses to use and the time frame he looks at.
Choosing a definition
I trade foreign exchange and I say the pound, the euro, and the yen are trended about 60 percent of the time. I say that because 60 percent of the time, I can draw a linear regression line with a directional slope (up or down) around which currency prices cluster. (I discuss linear regression lines in Chapter 10.) Someone else may say currencies are trended only 40 percent of the time - using a different and equally valid definition of trendedness.
Only one thing is certain - no security is trending all the time. Even the best-behaved security spends some time going sideways (nontrending) while the people who trade that specific security make up their minds what they think about it. So no trend-identification technique is going to work all the time.
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).
Excerpted from Technical Analysis For Dummies by Barbara Rockefeller Excerpted by permission.
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