Technical Indicator Wisdom 14
Trend lines are one of the simplest and most effective charting tools.
What Are You?
The fight is never ending. I have seen professional traders hail technical analysis as God-sent, while analysts say clearly that they ignore technicals as these “give false promise to success.”
I have indeed been involved in so many debates about the advantages of one system or the other and what I can conclude is that both have merits and, therefore, use all that is available to you to make the best decisions you can. Simply don’t ignore the benefits of one over the other.
At the last workshop I held in 2016, I asked the group of attendees the question: “Are you technically biased or are you more fundamentally focused in hour analysis to determine what to buy in the market?”
As expected, the room suddenly became divided into two. However, before the workshop became so rowdy that the conference organizers asked us to leave—I intervened and asked another question: “Why do you feel so strongly that you have to take sides?”
The room became quiet. They were simply not sure what the question meant. Surely, I said, we can use both systems and get the best of both worlds in our pursuit of becoming professional traders. The answer was not well accepted and the reason became obvious after some discussion:
• Those who want to trade now—without delay—don’t want to undertake tasks that seem rather too academic and complex for them.
• Those who are more disciplined and analytical want to see what is happening for the company and its future.
• Remember the formula (Share Price = PE × EPS)? In fact, it suggests that both investor sentiment (PE) and the financial strength (EPS) are equally important.
Strangely, the first group tended to be engineers, while the second group was made up of economists and bankers.
Fundamental research tends to focus on identifying and analyzing the variables and environmental factors that influence securities, while technical analysis is completely focused on assessing price and related trends. In addition, the latter believes that all environmental factors are already discounted in the price of a security. Therefore, there is no need to understand why events take place.
Given the vast discrepancies and viewpoints between users of these systems, it is easy to understand why traders tend to favor one form of analysis over the other.
Advantages of these Systems
Fundamental Point of View
The primary purpose of fundamental analysis is the investigation into a wide range of factors that have and could in future affect the company’s financials.
These include, among others:
• Wider environmental factors of economics, politics, business, and technology.
• These include global, regional, and country-specific trends and key value drivers.
• Research on variables that influence the financial strength of a company.
• The key ratios of the company’s financial statements.
Fundamentals thus provide traders with analytical tools to enable them to assess the true value of a company’s earnings and potential future earnings; thereby, to determine whether such securities are under or overvalued. Imagine selling a share when it hit a technical sell trigger, only to discover that the company is about to merge with a multinational and the share price quadruples?
Fundamental analysis should be applied to all investments, whether in the equity market, bonds, or derivatives. An example would be to assess the coal industry, and to determine that the world price was about to collapse. Would you buy coal-related securities under such conditions?
Wisdom of Technical Triggers
Many years ago, a wizened-old stockbroker described the differences between technical and fundamental analysis as follows.
Imagine standing in a field. You look up at the sky and ask the question: Will it rain in a month’s time? Or maybe a year? I’ll have to assess weather patterns and other metrological factors. That is fundamental analysis.
Now, imagine standing in the same field, looking up at the sky and asking: “Will it rain today? Will it rain in an hour’s time?” That is technical analysis. Not quite understanding what he meant, I asked: “Are you saying that technical analysis is using obvious factors, like will it rain in the next hour?”
The old man shook his head: “No, it means that the shorter the time-frame to your investment, the more important the current variables are, such as will it rain, how long will it rain, and will it continue or reverse to sunshine?” In other words, fundamentals become less important in the short term, that is, you are using a company’s latest set of accounts. Viewed differently, the longer your timeframe for investing, the less important technicals become over the financial strength of the company.
Technical analysts is the sole use of price, index, and market statistics to form graphs that are mathematically computed to determine trends; whether up, down, or sideways. This is further honed down to assess and conclude whether trends have strength and momentum to continue along its forecast direction. This is without doubt an important tool for traders and investors, especially in determining when trends can change.
In particular, professional traders are serious users of technical triggers. The main reason for this is that technical indicators and signals can be applied to either intraday or longer period trading. Like fundamental analysis, technical analysis also works across different types of instruments, from equities to futures to commodity markets.
Now let me add my viewpoint. Both systems are important, whatever the timeframe you are using. For instance, if a share price has fallen from 140 cents to 125 cents, technical indicators would often suggest that the share has been oversold and could bounce. The question is:
• Why would the share bounce?
• How do we know that the share has yet to reach fair value?
• If fair value is 110 cents, the share could continue to fall until it reaches 110 cents.
• Determining fair value takes fundamental analysis, which is the use of EPS, in addition to investor sentiment.
The technical analysis industry is globally represented by The International Federation of Technical Analysts (IFTA).
In the United States, the industry is represented by two national organizations:
• The Market Technicians Association (MTA)
• The American Association of Professional Technical Analysts (AAPTA)
In the old days, technical analysis was called charting, which is actually a better name as the trader doesn’t really have to do anything technical as it is simply a method of determining if a stock or the overall market is worth buying or selling. I understand the argument that some indicators are technical and seriously complex, but it doesn’t have to be.
Charts or graphs do signify and identify patterns and trends and they can even highlight potential future strengths and weaknesses in specific securities or markets, but the problem is that it doesn’t always work.
The argument is countered by those using technical analysis by saying that fundamental factors also do not always make sense.
• Technical analysis gives us a clear picture of past performance and all its related trends.
• Simultaneously, fundamental analysis gives us deeper understanding of the financial and overall market variables that will ultimately influence price.
• When both fundamentals and technicals line up, traders can buy with confidence, but my contention is that when they do not line up, the combination of the two systems provides the trader with awareness of the risks in trading in such stocks.
Basic Recommendation for Novice Traders
A starting point for novice traders:
• Use technical analysis only for liquid, tradable, and transparent stocks.
• Depending on the exchange that you are using to trade, this number will differ, but as a rule of thumb—only trade stocks that have a volume of more than 400,000 shares per day.
• Keep a watch on the broader market or industry for daily trends and intermarket correlations.
• Determine the power of the share’s trend.
Technical signals: volume and momentum
Moving averages
Support and resistance levels
• Determine the strength of that power. Assess how much power is behind a trend.
MACD
Stochastic
Volume
If the stock passes all these tests, we have a strategic entry level.
Trends
• A trend line is simply a line drawn on a share price graph that touches three high and low points. This is the easiest technical indicator as it doesn’t need mathematical formula to derive the trend.
• If prices are generally rising, then the general trend is up.
Support and Resistance
• If you draw two lines on a graph, the first touching thee points at the bottom of the graph and the second touching three points at the top of the graph—you end up with an upper and lower price levels that show the trader where buyers (lower line) come into the market and where sellers (upper line) exit the market.
Moving Averages
• Also called simply price averages, these are average prices over a defined period of time. The norm is to use two averages in a graph, such as 50 days and 200 days (longer-term averages) or 9 and 21 days (shorter-term averages).
• Some analysts add a 200-day moving average to test for future strength. If the line is below, then the share is moving in the right direction (profitable), but if it is above the share price, then the share is weakening over time.
• They help us determine if a trend is turning as prices move above or below the averages.
Volume and Momentum
• These two indicators confirm the health of a trend and identify if the day’s prices outnumber the days when prices fall (momentum).
• If either volume or momentum starts to decline, traders can surmise that the trend is weakening.
Relative Performance
• This is used to identify whether a stock is stronger than another stock.
• The relative performance chart is drawn by dividing the price of a stock by a relevant market index or another company’s share price. If the ratio is going up, then the stock is outperforming the market or company.
• The alternative is if the ratio is going down, then stock is weakening relative to its competitor or market.
What Kind of Trader Are You?
See Appendices for some tests.
Ultimately, traders should make up their own minds as to how to trade and what sort of analysis makes them comfortable.
Over the years, I spent many hours discussing such issues with global professional traders, who recommend the following:
“All historical prices, company information, and economic figures are easily and readily available—so why not use them? In order to become a true trader you will need to know how to effectively use all systems and types of analysis.”
Where Do You Go From Here?
Novice traders can take comfort from the very essence that many others have started before you and many have, in fact succeeded in changing their careers to that of trader. The following is a basic guideline which was given to me over a decade ago. It is still relevant today and is split into three basic steps:
Rules |
Take Cognizance |
|
1 |
Rules to success |
• Plan everything. • Buy value. • Diversify according to skill.
• Understand volatility. • Carefully select your sources of information. The above applies to local markets, then regional exchanges, and finally global bourses. |
2 |
Three crucial questions |
• Which is the leading indicator: stock market or the economy? • What is the current stage of your exchange’s cycle? • Do you know what investor sentiment is? |
3 |
Trading plan vs. business plan |
• This is your business, so be serious about it. • Have a strategy. • Have realistic expectations. • Check costs. • Assess risk-to-reward ratios. • Take total responsibility for your trades. • Have a trading journal. • Believe in yourself and never hesitate. |
Start with equities.My recommendation is not to rely on just one method of analysis. Use them all in a balanced and logical strategy.
Part IV, Chapter 15 sets out questions to assess whether you are ready to become a full-time trader.