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How does the professional trader organize the endless stream of price data into a logical format that doesn't require rocket science to interpret? Technical analysis is an extremely visual medium and this one fact alone sets it apart from the colder method of fundamental “value-based” analysis. Price charts allow traders to look at past and present price action in order to make reasonable decisions and intelligent choices.
To assess or analyze a price chart both left-brain and right-brain functions of logic and creativity are active. So it's no revelation that over the last century two major forms of technical analysis methods have developed that focus along these lines of significant examination.
Pattern Analysis
The oldest form of interpreting price charts is PATTERN ANALYSIS. This method gained popularity through both the writings of Charles Dow and Technical Analysis of Stock Trends, a classic book written on the subject just after World War II.
Pattern analysis gains its power from the tendency of charts to repeat the same formations over and over again. These patterns have been categorized over the years as having a bullish or bearish bias. Some well-known ones include HEAD & SHOULDERS, TRIANGLES, RECTANGLES, WEDGES, DOUBLE & TRIPLE TOPS, DOUBLE & TRIPLE BOTTOMS, FLAGS and PENNANTS. Also, basic SUPPORT & RESISTANCE and TREND-LINES have great importance on price action.
Indicator Analysis
The newest form of interpreting price charts is INDICATOR ANALYSIS, a maths oriented examination of the basic elements of price, time and were available volume. These elements are run through a series of different calculations in order to evaluate and identify various types of opportunities in market price statistics and data. Indicator analysis uses a diverse range of maths calculations, some simple, others more complicated, these calculations are then used to measure the relationship of current price to past price action and thereby assess the probabilities associated with price moving in one of three directions up, down or sideways.
In total there are six categories of technical indicators as well as two groupings namely LEADING indicators and LAGGING indicators. Although there are six categories almost all indicators can be categorized as Trend, Trend - Confirming (following) and Oscillators.
For example:
A very popular trending indicator is the Moving Average.
Popular trend-confirming indicators include MACD and ADX.
Common oscillators include STOCHASTICS, RSI and RATE OF CHANGE.
A combination of the MACD and RSI are illustrated in the above price chart.
Trend-following indicators react much more smoothly to price action than oscillators. They look deeply into past price data and often have internal smoothing to filter out market noise and minor volatility to evaluate the overall direction of the “time frame” been studied.
Oscillators react very quickly to short-term changes in price, flipping back and forth between OVERBOUGHT and OVERSOLD levels. Prices rise and fall moving markets from extreme to extreme within all timeframe's. The core of investors and traders that make up the market tend to act with a group or crowd mentality. This "crowd" tends to develop known characteristics that repeat its self within all of these time frames.
Markets are a manifestation of human psychology and chart interpretation using patterns and indicators as a measure of that market psychology attempts to uncover growing pressure within the market that has a high probability of ultimately developing into price change. |
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