Technical analysis – Compasses are great, life-saving devices, helping us find the direction for our destination. It must have seemed like magic two millennia ago when this magnetic trick was first discovered. Now compasses are included as a default application on our mobile phones.
We continue to need help when navigating the woods, rivers and mountains of the untamed wild. Similarly, when navigating the charts of financial markets, we look for ways to assist us in determining clear directions by using technical analysis.
Visualizing the market’s momentum
The essence of technical analysis is to visually determine the larger momentum of the market. A brief history lesson. Technical analysis originated as early as 1900 with Charles H. Dow, who fleshed out several market theories in a series of editorials in his co-founded Wall Street Journal. He also co-founded the Dow Industrial Average, which we still trade today, and is seen as one of the primary indicators of market sentiment.
Those theories were further developed at key points between the 1920s and the 1960s by William Hamilton, E. George Shaefer and Richard Russell respectively, and ultimately achieved an established validity for trading the financial markets.
The Dow theory operates on the efficient markets hypothesis in which the market discounts everything, i.e., it works on the assumption that asset prices incorporate all available information. This is the antithesis of popular opinions of behavioural economics.
Earnings potential, competitive advantage, management competence – all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In theory, this means that even future events are discounted in the form of risk because the market participants prepare themselves against perceived risks in their own way.
Interestingly, Charles Dow also felt that the indices should confirm each other – the economics of some would help or impact the others since indices often represent different market sectors such as rail, technology, small business and pharmaceuticals.
So almost 100 years ago, the major market founders themselves theorized that prices could be relied upon to reliably represent the intentions of the market.
The Standard & Poor’s 500 index (the S&P 500, or just the S&P), was first operational in 1923. It is still actively traded today and is also a primary indicator of global market sentiment.
Many traders have made their fortunes and retired by basing their strategy on the consistency of the markets. But this has always been the result of a respect for the market itself, combined with a clear understanding of the price action and direction of the market. Conversely, there is evidence to suggest that financial pain has been, and will continue to be inflicted on individuals and the masses who fail to master this understanding.
When undertaking to determine the direction of any given market, it is best to categorise the price – identified by the most recent 4-5 swing lows and highs – into one of three categories, up, down, or no trend. Most importantly, we are not interested in no trend conditions for the present, because they are of no practical or safe use to us.
But, we do want to find either up-trending or down-trending charts as these have formed without our consent – meaning we have no impact on them – and they do not depend on us. All we wish to do is benefit from this established direction.
All we are really doing before we even consider placing a dime on a single trade is determining the greater momentum, i.e., the weighted direction of the market on the chart. If we are not capable of doing this on average, there is no sense in proceeding on that chart, or placing a trade, since it will likely only create risk where it wasn’t necessary.
The point of this is that a market either has a direction or it doesn’t, and we need to determine which is which. It should also become clear by now that why the market is in the condition it is, is simply not as relevant as tracking the direction.
Through technical analysis, when traders begin to focus on where the trends are, they quickly leave behind markets that in all probability have unprofitable and unpleasant experiences awaiting them, not to mention the waste of time they represent.
In summary, when looking for a clear direction to get me where I want to go, it is more financially beneficial for me to ask myself “Is this market clearly bullish or bearish?”, than to ask myself, ”Why is this market bullish or bearish?”
Trade With Precision
Please book in your calendar our next live webinar with Paul Harrison:
The Critical Trading Errors and how to avoid them
Date: Tuesday, November 7th, 2017
Time: 7:00 pm Sydney, 9:00 pm Auckland and 8:00 am London