The Philosophy of Technical Analysis

Calling technical analysis a philosophy is probably a bit of a stretch, but plenty of technical traders are almost cultish in their devotion to it. More than anything, technical analysis is a subjective approach aimed at bringing a sense of order to seemingly random price movements.

Traders use technical analysis to identify trade opportunities, refine their trading strategies (entry and exit), and manage their market risk.

What is technical analysis?

In a nutshell, technical analysis is the study of historical price movements to predict future price movements. You’re probably familiar with the standard disclaimer that “past performance is no guarantee of future results," a statement that tends to call into question the validity of using past price data to forecast future price developments.

But technical analysis is able get beyond those concerns based on two main considerations:

ü  Markets are made up of humans. Human psychology and investing behavior haven't changed very much over the years, whether it’s the Dutch tulip frenzy of the 1600s or the dot-com Internet bubble of the 19905. The emotional forces that dictate buying and selling decisions are reflected in historical price patterns that appear over and over in all manner of financial markets. As long as humans are still making the decisions (or are writing the programs for the computers that make the decisions), you’ll be able to look at past behavior as a guide to what is likely to happen in the future.

ü  Technical analysis is widely practiced in all markets. This is the self-fulfilling-prophecy aspect of technical analysis. The greater the number of traders who focus on technical analysis, the more likely it is that their actions will reflect the interpretations of technical analysis, reinforcing the impact of that analysis. Believe me when I say that professional currency traders who do not practice some form of technical analysis are a rarity. And the popularity and application of technical analysis by traders have probably never been greater than they are today.

What technical analysis is not

Despite its name, technical analysis is not some engineer-designed, sure-fire, guaranteed method of market analysis. There are no such methods, period. Technical analysis involves a high degree of subjectivity where individual interpretations can vary significantly. Two technical traders looking at the same currency chart could reach opposite conclusions about the course of future prices. What’s more, they could both be right, depending on their timing and specific strategies.

Technical analysis requires a great deal of patience, practice, and experimentation based on individual preferences and circumstances. Short-term traders focusing on the next few minutes and hours find certain tools and approaches more helpful than long-term traders do; long-term traders looking at multiday or multiweek trades use other tools and indicators entirely. Certain technical approaches work better in some currency pairs than in others. Overall market conditions of volatility and liquidity also influence which technical approach works best. The key is to develop your own approach based on your particular circumstances (time frame, risk appetite, discipline).

No single, magical technical indicator or approach always works. Be careful about becoming too reliant on any single indicator. A particular indicator may yield excellent signals in certain market environments but fail when market conditions begin to change. I suggest becoming familiar with several different approaches and indicators, and settling on a diversified model that employs some of each.

Forms of technical analysis

Technical analysis can be broken down into three main approaches:

ü  Chart analysis: Visual inspection of price charts to identify price trends, ranges, support, and resistance levels.

ü  Pattern recognition: Identifies chart formations or patterns that provide specific predictive signals, such as a reversal or a breakout

ü  Momentum and trend analysis: Looks at the rate of change of prices for indications of market sentiment regarding the price movement. Trend indicators seek to determine the presence of a trend and its strength.

Finding support and resistance

One of the basic building blocks of technical analysis is the concept of support and resistance:

ü  Support: A price level where buying interest overwhelms selling interest, causing a price decline to stop, bottom out, or pause. Think of support as a floor for prices in a down move.

ü  Resistance: The opposite of support. Resistance is where selling interest materializes and slows or overpowers buying interest, causing prices to peak, stall, or pause in a price rally. Think of resistance as the ceiling in a price advance.

Support and resistance levels are identified based on prior price action, such as highs and lows and very short-term consolidation periods, known as congestion zones (where prices get all stopped up and can’t move one way or the other for a period of time). Support and resistance can also be determined by drawing trend lines. Still another form of supporter resistance comes from Fibonacci retracement levels, which we save for later post.

One of the key concepts of support and resistance is that after a support or resistance level is broken, it shifts direction. In other words, after a support level is broken in a move to the downside, it becomes resistance in price attempts to rally. After a resistance level is broken to the upside, it will subsequently act as support for further price gains.

Not all support and resistance are created equal

Support and resistance come in all shapes and sizes. Some support or resistance levels are stronger or weaker than others, and technical analysts typically refer to support as either minor or major. But those terms are subjective and difficult to quantify with any precision.

The best way to get a handle on the relative strength of a support or resistance level is to view it in the context of time and price significance.

ü  The longer the time frame of the price point, the "greater its significance. A weekly high/low is more important than a daily high/low, which is more important than an hourly high/low, and so on, down the time scale.

ü  Trend-line support or resistance strength is also a function of time frame and durability. A trend line based on daily charts tends to be stronger than a trend line based on hourly prices. A trend line that dates back six months has greater significance than one that's only a week or two old. Also, the more often a trend line is tested (meaning, prices touch the trend line but do not break through it, or break through it only very briefly and by small amounts), the more valid it is.

ü  The strength of retracement support or resistance level depends on the nature of the support or resistance during the retracement. A retracement refers to a price movement in the opposite direction of a previous price advance or decline. The distance that prices reverse, or retrace, is called a retracement. For example, trend lines that were support in a down move will act as resistance in any retracement higher. The strength of the trend-line support on the way down, such as how many attempts were needed to break below it, will give a good indication of its likely strength as resistance in the retracement.

Support and resistance are made to be broken

I don’t want to leave you with the impression that support and resistance levels are immutable forces in the market that are never challenged or broken. Without a doubt, forex markets spend much of the time testing support or resistance levels, looking for the weak side in which to push prices.

Different trading styles focus on different types of support and resistance:

ü  Tests and breaks of short-term support or resistance levels are the meat and potatoes of intraday trading. Short-term traders focus on the nearest support or resistance levels as guides to the immediate direction of prices.

ü  Tests and breaks of longer-term support and resistance levels are the fuel that fires longer-term trends or defines medium-term ranges. Medium to longer term traders focus on more significant support or resistance levels to guide their trading.

One of the keys to assessing the significance of a break of support or resistance levels is the strength of follow-through that occurs after the level is broken. Follow-through is the price action that takes place after technical support or resistance is broken. After resistance is broken, for example, prices should accelerate higher as shorts who sold in front of the resistance buy back their positions and new buyers enter the market, because resistance has been surpassed. The amount of follow-through buying or selling that materializes, or fails to materialize, after the break of a technical support or resistance level is an important indication of the strength of the underlying move.

Waiting for confirmation

I am tempted to title this section “Looking for confirmation,” but I thought that sounded too proactive in the sense that if you go looking for something on a chart, odds are you can find it and rationalize it as confirmation. The more disciplined approach involves waiting for confirmation, letting market prices provide you with unambiguous signs of a change in direction or break of a chart pattern.

Confirmation refers to price movements that verify, or confirm, a technical observation that suggests a particular outcome. For example, certain chart patterns are useful predictors of a potential reversal in price direction. But note that the central observation in this case is that prices are moving in a trend or steady direction. Blindly following a pattern that suggests that a trend is about to end is very risky. After all, the trend is your friend, so why would you take the risk of going against the trend?

If you’re patient and wait for price action to provide you with confirmation that a trend is indeed reversing, essentially confirming that the observed chart pattern is playing out as you expected, you‘re reducing the risks of being wrong-sided or premature in your trade. The trade-off is that you may sacrifice a better entry level for a higher degree of certainty in the overall trade setup. Looked at the other way around, you’re reducing the risks of getting into a trade setup too soon and being wrong if the setup doesn’t play out as you expected.

Technical-based observations provide you with a heads-up alert that a price shift may soon take place, for example, prices may be stalling in a move higher and ready to reverse lower. Confirmation comes when prices break an established trend line, prior high or low, or other key technical levels of support or resistance. Be careful about looking for confirmation from multiple technical indicators, because they may be measuring the same thing, just in slightly different formats. Price is the key element of confirmation.