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Showing posts with label Technical Analysis. Show all posts
Showing posts with label Technical Analysis. Show all posts

Thursday, August 19, 2010

Assumption of Technical Analysis

"The future influences the present just as much as the past." - Friedrich Nietzsche (1844 - 1900)

Technical Analysis is built on some fundamental assumptions in regards to the fashion in which a market operates. These assumptions are not only integral to you as an aspiring Technical Analyst, but are also central to Technical Analysis as a theory.

In summary, these assumptions include:

1. Price discounts everything.

2. Prices usually always move in trends and

3. History repeats itself over time.

A more detailed explanation of these assumptions will now be explored.

Price Discounts Everything

What exactly does this mean? In a nut shell, this first assumption seeks to incorporate all the fundamental, political, macro and micro economic data as well as the risk component of a stock into the current market price at any one period.

This infers that the market price can be heavily influenced by an investor's perception of supply and demand, as well as the general broad economic overview at the time the price is captured.

Therefore, it can be assumed that Technical Analysts believe that the current market price of a stock reflects all the relatively important information that Fundamental Analysts are seeking to provide qualitative and quantitative explanations for.

This is one of the key reasons that Technical Analysts do not focus on the underlying data behind price variation, but rather focus on what the market is valuing the stock at.

Prices usually always Move in Trends

Prices usually occur in Trends, although some theorists argue that prices are completed random. Randomness of price is specifically related to the Efficient Market Hypothesis. This theory is based on the fact that markets are "efficient" and information dissemination occurs instantaneously across the market.

In the real world however, this is never entirely achievable because of a varying number of factors and therefore complete randomness -- in its true form -- is never absolutely reflected.

Quite simply, the more efficient a market becomes, the faster information is dispersed to the market and as a consequence, the faster price changes to reflect this information.

From a charting perspective, this infers that prices follow a distinctly more "step-like-pattern" as opposed to a smooth trend for inefficient markets. In consideration of this, prices can only adjust as fast as the news spreads across the market. It is important to realize that there is a subtle difference between information being available to the market, and investors actually processing this information to act rationally upon it.

Equally, since different investors have different risk preferences it infers that their reactions to this information will vary and increase the level of randomness in the market.

Those that have had several years experience in the market will be able to differentiate between these factors and as a consequence, will know which stocks will trend in patterns and which will not.

History Repeats Itself over Time

The psychology of trading and human nature in general is based on emotional factors. Pride, greed, hope, anger, sadness and ego are all factors that affect the market place as much as they do our normal lives. Even if some investors are completely risk adverse and others are risk tolerant - these factors all have a substantial impact on the decision making process you adopt.

If you wrote down all the goals you seek to achieve in your trading strategy, you would find that the majority relate in some way to making a profit.

Is this a bad thing?

It could be argued that either side of this argument will present differing strengths and weaknesses. The most significant factor to realize is that you are not the only person motivated by profit. All traders tend to react in the same way each time they encounter a situation which is similar.

While it is true that some traders react positively from any mistakes made and learn from them, other participants decide to leave the market and therefore create a balancing pendulum of traders entering and leaving the market.

Consequently, the same oversights are made by each generation of traders in the market which infers that history tends to repeat itself as time moves forward.

Another important market factor to consider is that most people act like sheep when it comes to a trading situation - "once the flock begins to move, all the other sheep follow."

So what? You ask, How Does this Affect Me?

Quite simply, all our emotions tell us to follow what the majority of people are doing and as a result we are heavily influenced by market majority. This idea of "majority rules" negatively affects trading interpretations because it adversely influences what degree we interpret both buyers? and sellers? nature in the market and how they are reacting to a situation. This then persuades our judgment about future price direction and our independency of making market decisions.

Technical Analysis: Momentum Investing

Momentum investing is a system of buying stocks or other securities that have had high returns over recent times. The basic is if a stock is having a up momentum, price going up, it usually goes up more until one point. It has been reported that this strategy yields average returns of 1% per month for the following 3-12 months. Momentum investors try to seek out stocks with the potential to double or triple within just a few months.

You can see momentum investing was on the dot-com stocks. The prices of these stocks seemed to rise for no good reason, despite lack of earnings - or sometimes even the prospect of earnings. The price of the stock keep going up until it burst.

As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy, with the promise of high upside and limited downside. But the risk of this strategy is that, while momentum investors can all pile in at the same time, they cannot all sell at the same time unless markets are both highly liquid (easy to sell because many people want to buy) and continuous (prices do not gap sharply downward with no opportunity to sell).

When there is no good fundamental on the stock, it can go down very quickly. When a bad news comes out, previous buyers will try to get out. The stocks become highly illiquid and prices become discontinuous. This will drive prices lower and also leads to margin calls, and thus more selling. This happened when technology and dot-com bubbles burst in March 2000.

What do they look for in momentum investing?

Momentum investing usually looks for rapid earning growth or recent positive changes in earnings-growth forecasts. Earnings momentum starts with strong quarterly year-over-year earnings growth. Momentum investors also looks for a positive earnings surprise in the last reported quarter, meaning that the reported earnings exceeded the forecasts.

Momentum investing is not a buy-and-hold strategy. Momentum investors typically hold a stock for a few weeks / months. However, they usually monitor their holdings daily.

When to sell?

Momentum stocks get hammered when something goes wrong. Consequently, momentum investors must act quickly at the first sign of trouble. When there is bad news coming out, that's the sign to sell, especially when the price go down quickly with big volume.

Momentum investing is risky, and requires close attention and discipline. When price go down, think that it can go down further, not it can go up again.

Tuesday, August 17, 2010

Technical Analysis: Volume

Volume is an important aspect of technical analysis because it is used to confirm trends. Trading volume is the number of shares traded daily, on average. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. For example, that a stock jumps 5% in one trading day with high volume, usually goes up again the next day. If the volume is below average, there may not be enough conviction to support a trend reversal. Volume should move with the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end.

Very low trading volumes signal lack of interest. The higher the volume, the more active the security. Low volume levels are characteristic of consolidation periods (prices move sideways). High volume levels are characteristic of market tops when there is a strong consensus that prices will move higher/lower. High volume levels are also very common at the beginning of new trends. Just before market bottoms, volume will often increase due to panic-driven selling.

Volume can help determine the health of an existing trend. A healthy up-trend should have higher volume on the upward price, and lower volume on the downward price. A healthy downtrend usually has higher volume on the downward price and lower volume on the upward price. Volume is closely monitored by technicians and chartists to form ideas on upcoming trend reversals. If volume is starting to decrease in an uptrend, it is usually a sign that the upward run is about to end.

Accumulation and distribution

Accumulation is when the market is controlled by buyers. A down-trend that stalls while volume remains high signals that accumulation is taking place. Sellers have lost control to buyers and a reversal is likely. An Accumulation occurs when volume increases and closing price moves higher, or when downwards trend there is little or no price movement and an increase in volume.

Distribution is when the market is controlled by sellers. An up-trend that stalls while volume remains high is a sign that distribution is taking place. Buyers have lost control to sellers and a reversal is likely. It happened when volume increases (compared to yesterday) and closing price moves lower, or after trending upwards, there is little or no price movement and an increase in volume.

What is Technical Analysis?

Technical analysis is done by looking at previous price, and volume data. Technical analyst looks at past chart of price and different indicator to make prediction about the future prices. The human emotion is an important aspect here. Their willingness to buy stock at a certain price will determine future price. This analysis assumes that price moves at trend, and history repeats itself.

It is believed that this analysis is more art than science. Because of that, there has been plenty of critics to this analysis, due to lack of evidence of it's performance. But it is still a popular method in the world, through its easiness. Critics also came from well known fundamental analyst, Warren Buffet. It is also inconsistant with market hypothesis, like Efficient Market Hypothesis (EMH) and Random Walk Hypothesis.

The most popular method used in this analysis is volume, support and resistance, bollinger band, moving average, momentum, stochastic oscillator and indicator such as MACD.

There are a lots of technical analysis used. But the most widely used are support and resistance, moving average, volume and momentum investing.