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Fundamentals Of Technical Analysis

May 14, 2008
Technical analysis was truly an arcane art before the internet boom. Chartists perform technical analysis in their secret rooms with data that was carefully collected from professional sources. Those were the times when stock prices and data did not have a medium through which to be readily available to the public and be ran through publicly available software to produce the charts that are available today.

Today, with internet in almost every household, technical analysis became an art anyone could practice. Complex charts, technical indicators and analysis that was once the sole domain of a few highly paid wallstreet analysts are now available to anyone who wants it, often for free.

Technical analysis also became linked to short term aggressive trading instruments such as stock options and futures because of its excellent short term predictive nature.

With technical analysis this popular, I feel obligated to teach you once and for all everything you need to know about how to conduct proper technical analysis before you start looking at your first chart. A lot of amateurs fail at technical analysis simply because they didn't have the necessary basic knowledge to understand how to interpret technical indications properly in the first place. With the knowledge in this article, you will definite experience more success at technical analysis.

Summary of Technical Analysis Basics

2 Principles of Technical Analysis: Significance, Prudence

2 Key Tools: Charts, Indicators

2 Key Components: Price, Volume

5 Key Concepts: Resistance, Support, Trend, Patterns, Setups

2 Principles of Technical Analysis: Significance, Prudence

The two principles of technical analysis are the most important foundation in understanding technical analysis and interpreting technical analysis properly. Too many amateurs misinterpret technical indications simply because they did not understand these two simple principles. This is also the only part in this tutorial that addresses the mental aspect of technical analysis and should be clearly understood before moving on. The two principles of technical analysis are Significance and Prudence.

Technical Analysis Principle #1: Significance

Significance refers to the degree that a technical indication is true. Take breakout and reversal signals for example. Does a 0.5% close above a resistance level indicate a breakout? Does a 1% reversal in a bearish stock that has fallen more than 40% indicate a reversal? No. The degree of significance for both cases is just too weak. Most technical analysis beginners who do not understand the principle of significance would take a small fake out as a breakout and then act on the wrong stocks. The judgment of significance is, however, a matter of experience. How much of a breakout represents a significant breakout? How much of a reversal represents a significant reversal and how big a candle represents a strong morning star signal? The judgment of significance is something you need to acquire and refine as you put more years behind your ears.

Technical Analysis Principle #2: Prudence

Prudence refers to the ability to say "No" when in doubt. Technical analysis is more of an art than a science. This is because even though technical indications are scientifically generated, the interpretation of technical indications is highly subjective. You are going to experience many marginal or doubtful moments in technical analysis. Technical signals that "almost made it" as well as technical signals that are "neither here nor there". Those are the times to exercise the technical analysis principle of Prudence and to make the most conservative interpretation. When a signal is marginal, you should always exercise prudence by giving benefit of the doubt to disqualifying the signal. When a significant breakout signal is produced after a huge drawdown, you should exercise prudence by waiting for further confirmation or enter the position gradually over a few days.

2 Key Tools: Charts, Indicators

Technical Analysis Key Tool #1: Charts

Chart reading is the most fundamental tool in technical analysis and is also why technical analysis is frequently referred to as "Chartology". Before the popularization of the internet, during the age where analysts still read tapes, technical analysts have to obtain stock quotes from "secret sources" and then plot them down on huge chart papers in their secret rooms. What then is a chart? A chart is simply a plot of the stock prices made into a curve. A chart's basic function is to show the TREND of a stock's price action. Without a chart, a stock closing at a price of $50 has no meaning at all. With a chart, you can clearly see the price action trend down from $100 to $50, giving investors the first indication of where the future price action of that stock might be. In the beginning, charts are plotted merely as a single line joining the prices together. Recently, with more and more powerful computers and software, more innovative and informative plotting methods like candlesticks, bar charts and point and figure charts are developed and made easily available through the internet. No matter what type of chart you look at, the only aim is to provide an indication of where the future movement of the stock might be. Another important aspect of charts is "Chart Patterns". Different types of charting method can produce easily recognizable patterns and formations that can be associated with certain future expectations. Popular chart patterns include "morning stars" in candlestick charting, "double top breakout" in point and figure charting and "double bottom" formation.

Technical Analysis Key Tool #2: Indicators

Technical Indicators are the other key tool in technical analysis. Technical indicators are graphical representations of various mathematical formulas based on the stock price and transaction volume. The are literally thousands of technical indicators out there and more are being developed daily as new finance theories are translated into mathematical formulas every day. Technical indicators' main function is to tell when a stock is considered oversold or overbought and when a stock is considered weak or strong relative to its past action. There are literally endless amount of formulas that can be used to provide those indications, hence the endless number of technical indicators. Because there are so many different technical indicators out there, beginners should start with a few well known and widely used ones as those tends to be used by institutional investors as well. It can be argued that the effectiveness of a technical indicator lies in its popularity. The more investors acting on the same indicator, the stronger the predictive nature of the indicator becomes. A self fulfilling prophecy? Maybe.

2 Key Components: Price, Volume

Surprisingly, so many different charting methods and technical indicators used in technical analysis all stems from the same 2 key components, Price and Volume. The price and volume of a stock are the only two publicly available information pertaining to that stock. Out of its price and volume, stock charts and technical indicators are created. Candlestick and bar charts are constructed out of the opening price, closing price as well as high and low prices. Relative Strength Index is created out of the price as well as volume of a stock compared against its historical data.

5 Key Concepts: Resistance, Support, Trend, Patterns, Setups

The 5 key concepts of technical analysis are the 5 most important analytical methods in technical analysis. Understanding all 5 are critical to the mastery of technical analysis. All 5 key concepts work together to help technical analysts predict future stock movement and know when to buy or sell a stock. Of particular importance is the ability to tell when to buy or sell a stock. This is the kind of information that fundamental analysis will not provide.

Technical Analysis Key Concept #1: Resistance Level

A resistance level is a price level at which most investors sells a particular stock at, resulting in the stock falling every time that price level is hit. It acts almost like a brick ceiling from which the stock falls down every time it hits its head on it. Resistance levels are identified from reading price charts, particularly point and figure charts. It is a level which you might want to at least take some profit off the table. Even though resistance levels make excellent selling points, a breakout of a resistance level does spur a stock strongly to upside, creating an excellent buying opportunity. When anticipating resistance level breakouts, it is important to apply the 2 key principles of technical analysis outlined above.

Technical Analysis Key Concept #2: Support Level

A support level is a price level at which most investors BUYS a particular stock at, resulting in the stock rising every time that price level is hit. Support levels are the reverse of resistance levels and acts almost like a trampoline on which the stock rebounds every time it lands on it. Support levels are also identified from reading price charts and is a level where you might consider buying a stock at, especially when a stock hits a correction. Even though support levels make excellent buying points, a breakdown of a support level does spur a stock down a lot more. This is why the 2 key principles of technical analysis are important when timing an entry using support levels.

Technical Analysis Key Concept #3: Trend

The main objective of looking at the trend of a stock through price charts is the anticipation that the trend is going to continue going in the same direction generally. It is like buying fashion that conforms to the current trend. If no other information is available, an investor looking at a price chart would always have a better feel of where a stock is going than an investor looking merely at a closing price, right? Of course, no trends go on and on forever. This is where technical indicators come in to provide an indication of how strong or weak a trend is.

Technical Analysis Key Concept #4: Patterns

Chart Patterns are shapes formed by price charts. Some popular chart patterns are "Double Bottoms" and "Head and Shoulder Formation". They are so named based on the shape formed by a price chart. These easily recognizable patterns provide an interpretation on what investors are expecting the stock price to head towards. Double Bottoms typically indicate a reversal and head and shoulder formations typically indicate a switch to a bear trend. There are a ton of chart patterns out there and all needs to be interpreted in conjunction with the right technical indicators while applying the 2 key principles of technical analysis.

Technical Analysis Key Concept #5: Setups

Setups are specific patterns formed by using different charting methods. A morning star setup using candlesticks charting may not show up as a buying signal in a point and figure chart. This is why different charting methods need to be used to cross check buying or selling setups produced by one charting method. A setup is a lot more specific than a chart pattern. A chart patterns tells you where a stock might be heading and a setup tells you when you can buy or sell a stock. Setups need to be interpreted together with the other key concepts while applying the technical analysis principles. A buying setup occurring at support levels or a selling setup occurring at resistance levels makes the setups more convincing.

Fundamentals of Technical Analysis - Conclusion

All the fundamentals of technical analysis needs to be used together like all parts of a car, nothing can be left out if you want to be successful with technical analysis. So far, you might notice that technical analysis has the ability to precisely time entries and exits on high probability stocks. This is also what makes technical analysis so important to options trading. Trading Stock options requires the stock in question to move as expected quickly in order to reduce the effects of time decay and to maximize profits. I hope this article has been useful to you as you start your journey in trading and to your future success.
About the Author
Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset Management ( MastersoEquity.com ) and author of OptionTradingPedia.com . He is a fund manager specializing in options trading and his revolutionary Star Trading System has helped thousands.
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