Technical Analysis For Dummies

Barbara Rockefeller

• Publisher: For Dummies
• Year: 2019
• ISBN:
  9781119596707
• Edition: 4
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Grasp and apply the basic principles of technical analysis

Savvy traders know that the best way to maximize return is to interpret real-world market information for themselves rather than relying solely on the predictions of professional analysts. This straightforward guide shows you how to put this into profitable action—from basic principles and useful formulas to current theories on market trends and behavioral economics—to make the most lucrative decisions for your portfolio.

The latest edition of Technical Analysis for Dummies includes a brand-new chapter on making the right decisions in a bull or bear market, an updated look at unique formulas and key indicators, as well as refreshed and practical examples that reflect today today's financial atmosphere.

• Become an expert in spotting market trends and key indicators
• Get the skinny on the latest research on behavioral economics
• Take a deep dive into how to read market sentiment and make it work for you
• Get a look at the first innovation in charting for decades—straight from Japan

With comprehensive coverage from charting basics to the cutting edge, Technical Analysis for Dummies includes everything you need to the make informed independent market decisions that will maximize your profits. Happy trading!

Part 1

Getting Started with Technical Analysis

IN THIS PART …

Find out what technical analysis is and isn’t. Technical analysis bypasses fundamentals to make trading decisions on indicators that reveal market sentiment.

Understand supply and demand. Securities trading deals with two forms of supply and demand, the old-fashioned kind and also auction-style. You want to join the trading crowd to take advantage of momentum but very carefully, without going overboard.

Appreciate that indicators work most of the time because of the law of large numbers, but not always, and that’s because the market is made up of humans who behave irrationally sometimes.

Check out sentiment indicators and some useful measurement methods to get an overview of the trading environment, especially volume as an indicator of what the crowd is doing — as contrasted with what they might be saying.

Protect your capital from random moves and from manias and panics by managing the trade from entry to exit, including exits that mean you’ll be taking a loss. All trading involves taking losses and the secret of success lies in controlling them.

Chapter 1

Introducing Technical Analysis

IN THIS CHAPTER

Knowing what certain words mean

Accepting the idea that the trend is your friend

Figuring out what can go wrong

Technical analysis is the study of price behavior in financial markets in order to forecast the next price movement and to trade on that forecast with cold, hard cash. Focusing on price behavior gives you a window into the mind of the market — what the majority of key players are thinking — and helps you make better trading decisions. Technical analysis seeks to identify and measure market sentiment, described as optimistic (bullish), pessimistic (bearish), or uncertain about future prices (sideways range-trading).

To become a technical analyst, you need to figure out how to draw lines on your security price chart and work up the courage to place the buy and sell order with your broker. Each type of line is named an indicator, and I cover every major type of indicator in this book. You need to figure out whether the line/indicator embodies a bullish or bearish outlook (price rising or falling). Many lines/indicators contain a handy built-in buy-and-sell signal, but following those probably won’t match your risk appetite given the amount of capital you have. In practice, you’ll use a computer program to draw the lines (and to do whatever math underlies the lines). You’ll also have many books and websites to guide you in deciding which lines to draw.

Knowing how to draw lines is relatively easy. Placing the trades is hard. This is because your technical-based buy/sell decisions don’t come packaged with how much to trade, how long to hold, how much risk to take, or even how much risk is involved.

To help you start, this chapter provides an overview to this book and what you can expect. Consider it your jumping board into this book and the world of technical analysis.

FINDING THE ORIGINS OF TECHNICAL ANALYSIS

Technical analysis isn’t some newfangled flash in the pan. Observing prices and shutting out other noise has been in development for more than a century. Charles Dow, one of the founders of The Wall Street Journal, observed around the turn of the 20th century that the price of a security neatly cuts through all the clutter of words and is the one piece of hard information you can trust, no matter what the other facts about a security and what people are saying about it.

Here are some basic observations underlying technical analysis that are attributed to Dow himself:

• Securities prices move in trends much of the time.
• 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).
• 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.)
• Trends remain in place until some major event comes along to stop them.

These ideas are part of what is called Dow theory, although Charles Dow himself never called it that and many ideas are called Dow theory that would surprise Dow. An Internet search of the phrase Dow theory yields 23 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 gimmicky fad that will have a short shelf life.

Building on Dow theory were Robert D. Edwards and John Magee, whose Technical Analysis of Stock Trends (St. Lucie Press) was the first major book to use the term “technical analysis” in the title. It was published in 1948 and has been in print ever since. Edwards and Magee expanded on Dow’s observations, covering many of the core concepts of technical analysis such as support and resistance, breakouts, retracements, many patterns, and more. Edwards and Magee noted the universal pattern of a primary upmove followed by a shallower secondary pullback and then another upmove. You’ll see this configuration repeatedly as you explore technical analysis. Edwards and Magee were the first to introduce the tools still in use today to evaluate the pattern and to trade it profitably.

What’s different from Dow’s day and Edwards and Magee’s day is the advent of computers that take drawing lines and calculating indicators away from paper and colored pencils to a screen and cursors. Something else that differs from Dow’s day is the continuous incursion of the scientific method into everyday life. At the turn of the last century, the scientific method was confined to scientists. Regular people would take a homemade folk remedy for a malady because their grandmother swore by it. Today the average person wants to know if that remedy was scientifically tested in double-blind tests and the results peer-reviewed. The comparable development in technical analysis is to take an observation about market prices and volume and to test what percentage of the time the observation results in a correct deduction.

Stepping Up to Science

It may be hard to consider drawing lines on a chart as “scientific” in any sense of the word, but it’s through the scientific method that scientists can forecast outcomes in the physical world and through the scientific method that you can forecast price outcomes in financial markets. Technical analysis of securities prices follows the scientific method in that it entails systematic observation of the subject with standard measurement methods to form a hypothesis and then testing the hypothesis many, many times to validate the theory. But there’s a problem. In a hard science like fluid dynamics, the thing being observed and measured is an object — in this case, water. In technical analysis, the thing being measured isn’t hard — it’s market sentiment generated by human beings, who have far more variability than physical objects. Even given human variability, market sentiment tends to move in repetitive and predictable ways. Technical analysis gives you the tools to identify which sentiment the market has on display at any one time.

Today’s technical analysis has a wider understanding and appreciation of statistics and probability, and thus the value and pitfalls of forecasting. The theory of probability originated in the 16th and 17th centuries, but dealt mostly with the outcome of games and thus the best way to bet on games. Not until the 1920s and 1930s did statistics and probability enter the general public mainstream. Today even ordinary people routinely ask health questions of their doctors in probability terms, such as what percentage of small children without the measles vaccination does it take for the rest of the school class to risk a measles outbreak?

Throughout this book I use words like “highly likely” and “forecast.” I say, for example, technical analysts use lines and indicators to identify price moves that provide a fairly reliable forecast of upcoming future price moves. The word “forecast” makes everybody squeamish because everyone knows stories of catastrophically bad ones. History is full of them, like a top economist saying in 1929 that the stock market was in fine fettle — just before the crash.

But don’t be misled. Although the word is riddled with negative implications, everyone makes forecasts all the time. They just don’t think of them as forecasts. In fact, you make forecasts many times every day. You take this travel route over some other route because you forecast it will save time or aggravation. On a larger scale, when you move to a new city, take a new job, get married, have children, or buy a house, you’re making a forecast about the outcome. Every life decision you make is a forecast — a bet — almost always made on incomplete or hidden information. Technical analysis entails forecasting, but don’t let that scare you. You’ll have plenty of data in dozens of formats to help you, and I describe nearly all of them in this book.

Unpacking Lingo

To get you started, most of the vocabulary associated with technical analysis that you need to know you learned in grade school. Here is a list of some of the important lingo to know:

• Chart: The workspace of technical analysis is a chart. Much of the time the chart will show time along the horizontal axis and price along the vertical axis, but not always. (Some charts are formed differently, as I discuss in Chapter 15).
• Bar: The price information on the chart is presented in several different formats, but usually you’ll see each period’s price as a standard bar showing the price open, high, low, and close. (Refer to Chapter 6 for more about bars.) Bars, or a series of bars, can be used alone to detect patterns that reveal how participants in that market feel about the security and therefore what might happen next to the price. (Chapters 7, 8, and 9 discuss how technical analysts use bars to forecast prices.)
• Candlesticks: Another method of showing the same information that the bar does is the candlestick bar (see Chapter 8).
• Lines: ...