Time Crunch Trading

On the surface, one could define technical analysis as the use of historical information to forecast the future. That is the classical definition, but things have started changing in recent years. Today technical analysis is viewed in terms of measuring and predicting human behavior. Regardless, it is still historical information which is being applied with the goal of anticipating market behavior in the future (in as much as they are a collection of individuals).

To be quite blunt, technical analysis does not care a bit about all the fundamental information and analysis presented in the last chapter. It takes the view that it is all accounted for in price and/or the movement of price over time. The technician instead focuses on price as the market determined measure of value since any given transaction is an agreement between buyer and seller as to value at a given point in time.

To take it all a step further, the technical analyst is concerned with price movement, or the lack thereof. A technician, through the application of one or more methods, attempts to determine future price direction in the market.
There are a number of different techniques for applying technical analysis that can readily be applied in part-time trading.

Charting

The foundation of technical analysis is in price charts and the interpretation of them. Charts, of course, are simply price plotted over time. The so-called “chartist” believes that patterns can be identified in the price action depicted by the charts which repeat with a measure of predictability. As such, they provide the opportunity for profit, and of course that is the name of the game.

These price charts come in many varieties from the very simple line charts in which price is plotted at given intervals, usually from the end of one period (the “close”) to the end of the next, to bar charts, to Japanese Candlesticks and others (see the Wheat futures line, bar, and candlestick chart examples below).

Each technician has his or her own preference, and some styles of charting, such as candlesticks, actually come with their own set of  terminology and analytic rules. The charting packages of most trading platforms these days offer a variety of chart types from which to choose. It all really boils down to observing price changes over time.

Chart patterns are the starting point of analysis if you are chartist. This is where the idea of technical analysis as an attempt to observe and anticipate behavior begins. We humans tend to fall into patterns of behavior, especially when considered in the group context (mass behavior). Charts show how the collection of market participants acted in the past. You then look for the kinds of price patterns this creates and attempt to profit by identifying the direction those patterns suggest for future market action.

There is not the space for an exhaustive study of chart patterns here. We will, however, cover a few key points, concepts which even the non-technician can come across as part of normal involvement in the markets.

The biggest of these ideas is that of support and resistance. In short, it is believed that specific prices or price regions can be barriers to future price movement. Support is a point below the current level at which it is expected price will cease to decline. Resistance is a point above the current price where an advance is expected to stall. Refer to the gold chart below.

 

Notice the two highlighted points. Both are examples of how highs can become resistance points. In each case a new high was put in by the market. It then pulled back, only to rally once more. In both cases, the rallies failed to overcome the resistance at those highs and fell back. They would eventually go on to break through, but our point is made.

Sticking with gold, we can also demonstrate an example of support.

In the case of the chart which follows, the market broke out from a period of consolidation. It rallied strongly, but then fell back. In doing so, it actually reached all the way down to the range from which it launched in the first place. Upon hitting that support point, though, gold rebounded and took off. This is an example of price area or range being the support or resistance rather than just a single price point.

 
The breach of a support or resistance level is important. In general terms, two things increase the significance of a given support or resistance level or area. One is the time frame. A weekly resistance point is thought to be more significant than a daily one, for example. The second is touches. The more a level has been tested (approached, but not broken) the stronger it is thought to be. The more important the support or resistance level (timeframe and touches), the more significant the break when it happens.

There are two ways traders use support and resistance levels in their methods. One is the range trade we mentioned at the start of the last chapter in which one sells as the market approaches resistance or buys as price reaches support expecting a turn.

The opposite is a break-out trader, which is a go-with approach where trades are taken in the direction of a break through support or resistance. As just stated, breaks are significant. If you are a break-out trader, you are making the play for the development or continuation of a trend in the direction of the break. That makes you a trend trader.

Since much support and resistance is based on consolidation, it is worth touching on that notion quickly. A consolidation is a period of primarily sideways price action. In the chart below we expand the view we had before of the consolidation area gold bounced off of to continue its rally. 

 

As the example shows, the consolidation came after a directional move. The market rallied considerably, then stalled out. In this case, the trend had been upward, but it works both ways. You can see an example of that on the S&P 500 chart which follows. After a sharp move lower, the market shifted in to a lengthy consolidation.

The S&P chart, in fact, shows quite clearly the two primary phases of the markets. There are clear trends where the market is moving directionally up or down. There are also periods of sideways action. In the highlighted case the range trading is very wide.

Along with support and resistance, and in conjunction with the idea of consolidation, is the continuation pattern.

As its name would suggest, a continuation pattern is one which it is expected that the market will recommence a given directional move. Continuation patterns are visible formations which appear on the charts. They have names like flag and pennant—basic descriptions of their appearance.

The weekly gold chart which follows provides a sample continuation pattern. As you can see, the market rallied up from about 380 in May of 2004 to near 460 in December. It then proceeded to move sideways in a triangular consolidation for about nine months.

In the second half of 2005 the upper part of the triangle (outlined by the two trend lines) was broken. The market then took off very rapidly in to new high territory. Thus, the consolidation became a continuation pattern.

At the same time there are reversal patterns.

As you can easily guess, a reversal pattern is a visual formation on a chart which indicates that one trend has ended and another started. They have names like head-and-shoulders.

The EUR/USD chart below shows an inverted head-and-shoulders pattern, which many traders consider a bullish reversal pattern. It comprises a low from which the market rallies but fails and then makes a lower low. The first low is the shoulder, with the lower one the head. The market then rallies again, falls back, but not to by very much, creating the second shoulder (normally at about the same area as the first shoulder).

The idea behind the head-and-shoulders (be it regular or inverted) is that once the market breaks the “neckline” a reversal from one trend to the other has taken place. In the chart example, the trend shifts from down to up. Some folks use the pattern to project future prices as well.

Continuation and reversal patterns are far from exact things, though. History rarely repeats exactly, so no two chart patterns are going to look identical. This is what chart analysis is often considered fairly subjective - more art than science.

Getting away from patterns, but keeping in the charting theme, we come to the trend line.

A trend line is an attempt to describe a directional move (a trend). Down trend lines follow a set of declining peaks, as in our USD/CAD example below. Up trend lines follow rising peaks.

 

There can be quite specific rules as to how they get drawn, but the final analysis is the same. The trend line is intended to give you an indication of direction. If a trend line is broken it suggests a change in the market, either to consolidation or to a slower (less steep) trend. As such, trend lines are not dissimilar to the idea of support and resistance.

Indicators

An indicator is a tool employed to make certain kinds of market assessments. They come in a wide range of varieties from those which are very simple to those which are very complex. They run the gamut of intentions from trying to measure volatility, to determining trend, to getting a read on how powerfully the market is moving in a given direction.

An indicator is derived from price and/or volume, is generally calculated on a running basis, and normally is plotted along with price on a chart. Some indicators, such as moving averages, are plotted in an overlay fashion right on top of price. Others have their own scales, and thus require a separate plot, generally positioned below the main price section.

The following weekly Cotton futures chart shows examples of both kinds of indicators.

We have several different things going on.

First, the price chart is in Candlestick format. Second, there is an overlay plot on the price chart (red line). That is the 10-week moving average, which simply shows the average price for Cotton over the last ten weekly observations on a running basis.

The plot separate from the main chart area depicts the Average Directional Index (ADX). ADX is a popular indicator for determining whether a market is trending or not.

There is an additional category of indicators which take on the important technical concept of overbought/oversold. In short, overbought means the market has rallied too much or too rapidly in a given period of time. As such, it requires some time to settle down. This could either mean retracing (pulling back part of the rally), or consolidating. Oversold means the market has moved lower too far and/or too fast.

The well-known Relative Strength Index (RSI) indicator is one of a number of overbought/oversold indicators which are intended to point out such conditions.

The Unleaded Gasoline futures chart below shows how RSI is most often plotted. It also includes in the main chart as an overlay, the Bollinger Bands study, another often used indicator.

Bollinger Bands fall in to the category of volatility-based indicators. The more volatile a market has been during the measurement period, the farther apart the bands will be. Markets move from periods of relative calm to those of intense activity. Indicators which focus on that are intended to either point out likely changes in volatility or to use it as a way to make directional interpretation (i.e. trend or consolidation continuation).

By the way, the aforementioned moving averages are not used by analysts to forecast, but rather fall in to the category of trend indicators. This group tries to identify the current trend so that the trader can take the proper directional positions. In the case of a moving average, the trend is considered to be up when price is above the average and down when it is below.

There are also momentum indicators, ones designed to measure how strongly a market is moving. The idea is that markets with high momentum will tend to continue in their current direction, while those with lower momentum are more likely to turn.

A very simple momentum indicator is Rate of Change (ROC), which is shown on the Corn futures chart following. An n-period ROC is calculated by taking the most recent period close and subtracting the close from n-periods ago. For example, a 5-day ROC would be calculated as C0 - C-5 where C is the daily closing price.

Obviously, a high positive ROC means the market has been moving aggressively higher, just as a high negative one indicates a market moving sharply lower. The ROC is about as simple as it gets. Other momentum indicators are significantly more complex, with some incorporating volume as well as price.

 

The collection of technical analysis tools and indicators is vast. Topics such as cycle analysis and sentiment indicators, have not yet been brought up, to name just a few. This is not a book on technical analysis, though. We will carry some basic technical methods forward with us in our discussion of part-time trading, but you are encouraged to do your own further exploration if it is an area of interest to you.