Getting technical

Rémy Gaussens, head of forex, fixed income and commodity research at Trading Central, explains why technical analysis theory can benefit traders.
Getting technical
By Administrator
Tue 01 May 2007 12:00 AM

The origin of Technical Analysis began with Charles Dow, the cofounder together with Edward Jones of Dow Jones & Company, established in 1882.

At the end of the 19th century, Charles Dow wrote several editorials for the Wall Street Journal regarding market movements, which are now considered to be the basis of the Technical Analysis (TA) theory. TA is today defined by John J. Murphy, a leading analyst, as "the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends".

This is an important point, as TA does not focus on the fundamental reasons to explain why markets move. Rather, it observes the buyers and sellers within the market and determines which side has the strongest influence, and whether there are signs of exhaustion by looking at volume and prices.

This works on a key assumption within TA theory that an asset price at any given time reflects all information available. Now if you consider time as being continuous, any variation of the price determines a new level, which constitutes a new basis for further variations.

It is thus possible to use price evolution, on different levels, to try to figure out further likely evolutions.

This dynamic aspect of TA is highlighted with the common use of "moving averages" by investors and technical analysts, which act as trailing stops. This kind of tool is very useful when prices move in trends, as was the case in the oil market for several years.

When looking at oil prices since 2004, one can state that the 20-month moving average acted as a relevant trailing stop level allowing investors to benefit from the largest part of the rising trend and to cut long positions in October 2006.

This instrument allows investors to deal with trend-following strategies and provides them various reference points on which they set a trailing stop: the moving average. If the market closes below the average level, the position has to be closed. Buyers and sellers tend to have some other references points, allowing them to gauge the trends and different levels at which to buy or sell. Those levels are usually the basis of a buying or selling movement. Obvious reference points are historical highs and lows; others are round numbers, congestion levels, trend lines, pattern targets, Fibonacci retracements or projections.

For example, on gold spot, US$575 maintained the price under pressure during Q1 2006 but now tends to be a strong long term support area. This level is also a 50% retracement of the July 2005 to May 2006 up leg.

In the same way, on EUR/USD, the 1.29 horizontal level acted as resistance in the middle of 2006 before triggering a bullish acceleration when bypassed at the end of November. This level also acted as support in February this year. Knowing these different types of levels allows investors to take profits when prices are approaching them or to open a position around them and quickly cut the position if they are bypassed.

When referring to money management theory, knowing these reference points helps identify stop levels and manage a clear risk reward.

Another investor reference is growing price rates, also defined as so-called "rising trend lines" which, in fact, just highlight the underlying rhythm of return of an asset.

As long as this rhythm of return exists (the trend line is not broken down), the trend remains on the upside (for example) and new investors come to benefit from this trend.

The arrival of new investors in this asset fuels the demand side of the market and maintains the rhythm of return. Afterwards, the price will approach a resistance (or reference level) and a part of the market will take profits.

The resistance might also be a parallel to the rising trend line and this creates a bullish channel: when prices are close to the channel resistance, investors judge the asset return too high and take profits.

For example, the EUR/USD and gold have been trading in bullish channels since October 2006 (1.25 on EUR/USD and $560 on gold). As long as the supports of those channels are not broken down, the trend remains clearly bullish.

Then, the bullish trend will come to an end when the price breaks below the lower boundary of the bullish channel or breaks below the rising trend line. This will signal a possible downturn.


This is what happened on oil prices: a long term rising trend line that had been in place since the September 2003 bottom ($27) was broken in early September 2006 ($68) and consequently signalled the market collapse.

A major collapse can be foreseen with the use of technical analysis by various signals. No matter what a major financial institution would declare concerning the likelihood that oil will reach $100 or $200 a barrel within two years, if the market is overbought and all investors are already long, no more buyers are available within the market.

This would trigger a signal in one or more of the technical indicators stating that the market is out of breath and a downturn is expected.

In a way, TA focuses only on the real reasons that make market movements happen. For example, in a rising trend, demand exceeds what is available on the market. So when a bullish trend comes to an end, it is because there are fewer buyers and more sellers entering the market. This fact is highlighted on technical indicators by the occurrence of bearish signals and occasionally bearish divergences. This was the case on last year's crude oil top. The monthly RSI (Relative Strength Index) posted a bearish divergence calling for the huge downturn and this signal was validated by the end of August.

Referring to the previous examples of oil, there were at least three TA tools that illustrated the bullish trend exhaustion. These three signals were valid at three different times: a close below the 20-month moving average in October (a trend follower indicator), downside breakout of a rising trend line early September (a chartist tool) & validation on a weekly bearish divergence on RSI by the end of August (an oscillator).

The main advantage of TA over fundamental analysis is to provide an invalidation level - this means that an analysis is correct until this level is penetrated; in fact, it is correct until a stop level is activated. This helps in building trading strategies with clear stop levels, allowing investors to manage their risk efficiently. Moreover, TA can also estimate target prices (resistances if the trade is bullish, supports in short positions) when the market moves with you.

To sum up, TA provides entry, stop and target levels, allowing for a complete trading strategy to be devised.

Investors then just have to gauge whether this strategy conforms to their money management theory.

Another major benefit of technical analysis is that it provides a perfect tool to estimate time targets, which is crucial for option dealers.

The advantage of TA compared to fundamental analysis is that it allows forecasting on different time scales. TA provides a range of clues in order to help find a consensus, such as determining the price at which EUR/USD will trade in three hours to where it will be in three or six months.

This is possible by gauging the inclination of a trend line or a channel leading to an estimation of the time needed for an asset to reach a target price - helping estimate a time reward.

It is for this reason that TA is used by brokers and traders looking at intraday trends and levels, as well as by asset managers looking at longer-term positions.

Regarding three different markets, forex, gold & crude oil, one can state that the efficiency of TA is higher on markets where the intrinsic value or "fundamental price" is the most difficult to evaluate. Forex has no real fundamentals: it is a matter of country GDP growth, interest rate, trade balance - some or none of them.

This leads to a market mainly driven by psychological reactions.

On the contrary, the price of producing oil is a bit easier to estimate, thus the market is in possession of more reference points to evaluate prices.

Gold has its safe-haven status, while raw materials are somewhere between the two previous products. It is easy to see that the fewer fundamental reference points market players have, the more relevant technical analysis is.

However, even in markets where fundamentals are readable, it often appears that the asset price evolution does not necessarily reflect actual fundamentals of the market, as over-reaction effects, both on the downside and on the upside, are quite common, especially related to announcements. As TA is based on a psychological view of the market, investors who make the market are always subject to same sentiments of fear and greed, which tend to always bring the same market actions. This is why, in all markets, having psychological references coming from technical analysis is always useful.

About Trading Central

Rémy Gaussens works for Trading Central International, an investment research provider to financial market professionals which specialises in technical analysis. For more information, contact James Heygate-Browne at
james@tradingcentral.com

or visit
www.tradingcentral.com

.

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