Why Technical Analysis?If you are visiting this website, there is good chance that you already have a keen interest in Technical Analysis, however, it is always worth taking a moment to consider the nature of Technical Analysis and how we might use it.
What is Technical Analysis?
Quite simply, Technical Analysis can be defined as the study of investor behaviour and the subsequent price action. The only data that we need to perform our studies are the price histories of the instruments. This data alone (which may also include time and volume information) will enable us to form our view.
Technical Analysis vs Fundamental Analysis
Fundamental Analysis concerns itself with establishing the value of stocks and other instruments. The fundamental analyst will concern himself with financial statements, demand forecasts, quality of management, earnings and growth etc. He will then make a judgement on the share or commodity price, often relative to its sector or market peers as being over or undervalued. The majority of research that you will receive from Brokers on Investment Banks will be based on company fundamentals. At Chartcraft, while we would not dismiss the work of many talented fundamental analysts, we take a more pragmatic approach; our view is that the investor sentiment is the single most important factor in determining an instrument’s price.
A good historic example of this was the instance of many leading UK value-based funds falling into the trap of buying “cheap” “old economy” stocks in the mid to late 1990’s. The problem? As investors continued to put their money into TMT, “old economy” stocks kept getting cheaper! Technical analysts were able to avoid this trap by establishing that value stocks were in downtrends. In a nutshell, the fundamental analysts were making decisions based on their own (subjective) opinions while the technical analysts were listening to what the market was telling them.
We believe that Technical Analysis holds the key to determining investor sentiment. Some investors and market “experts” believe that the two disciplines are mutually exclusive. We would dispute this theory. Many successful traders use a combination of fundamental stock selection procedures and technical analysis timing filters with excellent results.
HistoryIt is probably not unreasonable to assume that all civilisations where commerce has flourished have had traders who pay close attention to prices and their movements. However, rather than dwell upon the wonders of the Phoenician market for olive oil forwards, our story starts with one Charles Dow, inventor of the first stock market index in 1884. Mr Dow wrote a series of articles for the Wall Street Journal in the later years of the 19 th century. This body of work was later to be known as “Dow Theory” and formed the basis of what we know as Technical Analysis. While we will not go into the finer details of Dow Theory in this piece, the most important concepts that Mr Dow recognised were that prices reflect the current balance of supply and demand (i.e. the hopes and fears of investor), and most importantly, defining the concept of trend. We will be looking the concept of trend in a little more detail later on in this piece.
Certainly, the concept of studying price action was fairly well established in the early part of the 20 th century. One of the greatest books on trading ever written is “Reminiscence of a Stock Operator”, first published in 1923. Its author, a Mr E. Lefevre wrote that he “would study the changes on the tape, always looking for the repetitions and parallelisms of behaviour”. Although Mr Lefevre might not admit it, he had undoubtedly become a technical analyst.
Our story now takes us to the highly regarded book written by AW Cohen, the founder of Chartcraft. Published in 1947, “Stock Market Timing” was quickly to become the bible of point and figure charting. One of Mr Cohen’s many contributions to the field of Technical Analysis was the establishment of the 3-box reversal system. This technique eliminates all minor and confusing moves, lending itself to easy interpretation.
Since this time, Point and Figure charting has moved in and out of fashion with investors in a variety of asset classes. It is currently undergoing a renaissance amongst professional equity traders as the current choppy market conditions make P&F disciplines invaluable for establishing key trends and areas of supply and demand. The advent of computerised chart construction and web-based delivery also means that P&F charts are available in a wide range of instruments to all investors, be they market professionals or private individuals.
How a Point and Figure Chart is ConstructedThe primary tool of all Technical Analysts is the chart. Chartcraft is the market leader in Point and Figure Charting. These charts differs from conventional line, bar or candle charts in several major aspects:
- There is no fixed time axis: A point and figure chart only moves along the X-axis when a trend reversal takes place. For example, an instrument trading a very narrow range for and extended period of time will simply be represented by a single point, not a horizontal line.
- Noise reduction: a conventional high/low/close chart will show the ranges of every single trade on the day. At Chartanalysts, we use only the closing price. Furthermore, extended small range trading periods will be smoothed by the construction method, enabling to user to quickly establish the primary trend and key areas of supply and demand.
- Simple visual representation: Rising prices are shown by a vertical line of XXX’s. Falling prices are shown by a vertical line of 000’s
First, we must choose the scale. Over the last few months the stock has traded a range of 45 to 75, so we’re going to choose a scale of one unit equals one dollar. If the stock had traded a wider range, or has experienced a larger move, we might choose a different scale. In this instance we will also be rounding up or down to the nearest whole number.
Let’s start from Monday. The stock has been in an uptrend for a few days, so we start with and X. Hence:
We can now see a clearly displayed uptrend. But what happens if we add Fridays’s closing price of 70? Now the chart will look like this:
The point and figure chart is now showing that there has been a change of trend and a clear visual signal is given. Chartcraft use the three-box reversal method of chart construction. This means that the price has to move more than 3 units in the opposite direction before we show a change of trend. Had the price only declined to, say 72, the column of XXX’s would have remained intact. The purpose of this technique is to smooth out minor market moves and focus on the underlying trend.
How to read a Point and Figure ChartThe basic premise of P&F charting is that the law of supply and demand governs the price of a stock or other financial instrument. There are three possible scenarios:
- An uptrend, indicated by a rising column of XXX’s. From this we ascertain that demand has overcome supply.
- A downtrend, indicated by falling column of 000’s. From this we ascertain supply has overcome demand.
- An interruption of these vertical columns by short alternating columns of XXX’s and 000s . This indicates Supply and Demand contesting for supremacy. This may indicate a potential change of trend, or simply be a continuation pattern (trend and countertrend).
The Trend is your Friend
How do we define a trend? Dow divided trends into major, secondary and minor. We shall focus only on the trend and counter-trend. As we have mentioned above, the most consistent uptrend will be shown on a P&F chart as a rising column of XXX’s. However, these very consistent or accelerating uptrends are unusual (and in some cases unsustainable), so a more usual scenario will be continuation patterns caused by profit taking or short closing as the instrument’s price rises. This pattern has the primary characteristics of trend Higher Highs, and Higher Lows. See example:
It’s always interesting to try and pick the tops and bottoms in stocks, but Dow Theory tells us that a trend is more likely to continue than change. We must assume a trend is in place until we see a clear indication otherwise. The wise trader will ascertain the underlying market condition, be it an uptrend, a downtrend or a range-trading environment before opening a position. Reversals or changes of trend can be excellent opportunities for exploiting the speedy and major moves that often follow, however, one should be aware that constantly betting against the market is a strategy that is unlikely to pay dividends. If in doubt, remember that the “trend is your friend”.
Some SignalsYou may be asking, how do I tell a continuation pattern from a change of trend? Point and Figure charting has the answer. Here are a few of the signals that we use at Chartcraft.
|The Base Break-out |
A stock that has been in a downtrend may form a base. A base can be identified when the instrument ceases to make new lows. This signals a potential change of trend. A base break-out can be defined when the instrument rallies to break the resistance at the top of the range. This is an indication that supply is being exhausted.
|Confirmed Rally above Base|
When a stock has rallied to break the resistance at the top of its base or trading range, we then look for a key confirmation of the change in investor sentiment; the conversion of resistance to support.
|Break of the Triple Top, a continuation pattern.|
The stock reaches a price level three times in a row. On the third instance, the stock breaks out. Supply has been overcome and the primary trend (uptrend) reasserts. A buy signal.
|Reversal after Downtrend Extension|
The instrument has declined consistently over a considerable price range without reverse/countertrend. The first three-box reversal can be a strong signal of supply exhaustion. A failure would be indicated by the creation of a Lower Low.
Using Point and Figure Charts to Trade
P&F charting can supply you with entry levels and timing, profit targets and stop-loss levels. What it cannot supply a trader with is discipline. We are all aware of the theory of “run your profits and take your losses”, but as you may well be aware, human nature tends to greedily take profits a the first opportunity while hoarding our failures in the hope that they “might recover one day”.
P&F will supply you with clear stop levels and identification of trend to help you avoid these problems in addition to supplying you with entry and exit signals. Let us suppose that we are running a long position in an instrument that displays an orderly trend and countertrend uptrend. When can identify that this uptrend has broken? The answer is, when the instrument posts a lower low (see example). This would a suitable level for a stop loss or exit point.
What about targets? The long-term nature of P&F charts make them ideal for the identification of previous congestion areas were there may be a potential change in the balance of supply and demand (see example of Reuters 1997-2001). Supply is shown as a red circle, demand as blue. Remember, break-outs often lead to historic resistance levels converting to support.