Investors who understand technical analysis can have more knowledgeable trades.
Tue, Nov 23, 2010
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By Reico Wong
INVESTORS looking to make more knowledgeable trades and reap profits from financial markets will do well to understand technical analysis.
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While investment brokers and analysts use this tool to make sense of statistics generated by market activity, one does not have to be an expert to be able to grasp at least the basics.
Simply put, technical analysis is the study of a particular asset's historical prices and volume data represented in a graphical form, with the aim of identifying patterns to forecast future activity and price movements.
Still, experts warn that technical analysis cannot provide absolute predictions and investors should not be reliant on it alone.
Investors need to first note the three underlying assumptions of technical analysis - all information that has or could affect a company is already priced into its stock at any given time; price movements are believed to follow trends; and history tends to repeat itself as investors repeat their behaviour.
Here is a look at identifying certain trends using technical analysis:
TREND LINES
The first step is to identify an overall trend. Stock and other asset prices do not move in a straight line but in a series of highs and lows. The pattern of highs and lows constitutes a trend.
The two easiest trends to spot and trade in are the uptrends and downtrends. A formal uptrend occurs when each successive peak and trough is higher than the ones found earlier in the trend. The same logic applies for the downtrend, but in terms of lower successive peaks and troughs.
In the case of a formal uptrend, experts suggest that one considers selling the asset once it fails to create a new peak or trough to avoid the large losses that can result from a reversed trend. If a formal downtrend is noted, one should sell the asset quickly to cut losses.
The market could also trade sideways, defined as a series of ups and downs that do not exceed a certain minimum and maximum price point. These are also known as support and resistance points, respectively.
Also note that the more frequent the series of highs and lows in a trend, the more volatile the market is likely to be and, correspondingly, the more difficult it is to trade in.
"A sideways volatile market is the worst to trade in because it is the least predictable, with no directional bias," said Mr Winston Ng, chief executive of FXDS Learning Group.
"Violent fluctuations will mislead one into thinking that the directional trend of the market has changed, when actually nothing has happened and it is still locked in its range."
SUPPORT & RESISTANCE LINES
After identifying the overall trend, trend lines - also known as support and resistance lines - need to be drawn up. As mentioned earlier, such lines mark the points where asset prices hit a minimum and maximum.
One needs to keep in mind these boundaries to make trading decisions, as these are where orders consolidate and revolve around. It also allows one to identify when a trend is reversing.
A break below an identified support point would be considered bearish, while a break above an identified resistance point would be considered bullish.
Investors are advised not to trade at the two major points, since the surrounding area of the points typically comes with a high level of volatility.
Mr Ng highlighted some rules to drawing up good support and resistance lines for an analysis:
Firstly, find any three points and draw a line as its floor (support line) or its ceiling (resistance line). Then, use parallel lines to draw channels where possible. Leave the lines as they are even if they look like triangles when drawn.
Draw lines which are most obvious and not those difficult to see. Also, it is normal to give and take a little as the lines actually mark narrow bands of area.
CHART PATTERNS
There are different types of charts used to reflect market activity, but certain graphical patterns can always be established. The patterns fall into two main categories - trend reversal, and consolidation break-out or continuation. Double tops and double bottoms are the most common trend-reversal patterns found.
The pattern is created when price movements test the support or resistance points twice and is unable to breach them. It signals that the trend is about to change.
Experts say traders should sell on the break of the support line of a double top and buy on the resistance line of a double bottom.
Mr Ng added that, in a double- top situation, traders should protect and cut losses if the price rises above the support line by more than 10 per cent.
Similarly, losses should be cut if the price falls below the resistance line by more than 10 per cent in a double-bottom situation. Another popular trend-reversal pattern is known as heads and shoulders. This is formed when successive peak formations start to deteriorate.
Once again, traders should sell on the break of the support line of a heads-and-shoulders pattern; and buy on the break of the resistance line in the case of such an inverted pattern.
Last but not least is the consolidation pattern known as flags and pennants. As the name suggests, a price pattern reflecting a flagpole and flag (either triangular or rectangular) can be seen.
A sharp price movement (the flagpole) is followed generally by a sideways price movement (the flag). This pattern is then repeated. If the flag pattern is in an uptrend, this means the market is bullish. Traders may then want to look into going into a long-term position, and buy particularly at the break point of the trading range captured by the flag.
If the flag is flipped upside down, a bearish market is likely to follow. Traders would similarly want to sell at the break point of the trading range captured by the flag.
Ultimately, technical analysis does not necessarily have to be complex and can be applied to any security with historical trading data.
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