Fundamentals of Technical Analysis

Fundamentals of Technical Analysis

Technical analysis was truly an arcane art before the internet boom. Chartists perform
technical analysis in their secret rooms with data that was carefully collected from
professional sources. Those were the times when stock prices and data did not have a
medium through which to be readily available to the public and be ran through publicly
available software to produce the charts that are available today.

Today, with internet in almost every household, technical analysis became an art anyone
could practice. Complex charts, technical indicators and analysis that was once the sole
domain of a few highly paid wallstreet analysts are now available to anyone who wants it,
often for free.

Technical analysis also became linked to short term aggressive trading instruments such
as stock options and futures because of its excellent short term predictive nature.

With technical analysis this popular, I feel obligated to teach you once and for all
everything you need to know about how to conduct proper technical analysis before you
start looking at your first chart. A lot of amateurs fail at technical analysis simply because
they didn’t have the necessary basic knowledge to understand how to interpret technical
indications properly in the first place. With the knowledge in this article, you will definite
experience more success at technical analysis.

Summary of Technical Analysis Basics

2 Principles of Technical Analysis: Significance, Prudence

2 Key Tools: Charts, Indicators

2 Key Components: Price, Volume

5 Key Concepts: Resistance, Support, Trend, Patterns, Setups

2 Principles of Technical Analysis: Significance, Prudence

The two principles of technical analysis are the most important foundation in
understanding technical analysis and interpreting technical analysis properly. Too many
amateurs misinterpret technical indications simply because they did not understand these
two simple principles. This is also the only part in this tutorial that addresses the mental
aspect of technical analysis and should be clearly understood before moving on. The two
principles of technical analysis are Significance and Prudence.
Technical Analysis Principle #1: Significance

Significance refers to the degree that a technical indication is true. Take breakout and
reversal signals for example. Does a 0.5% close above a resistance level indicate a
breakout? Does a 1% reversal in a bearish stock that has fallen more than 40% indicate a
reversal? No. The degree of significance for both cases is just too weak. Most technical
analysis beginners who do not understand the principle of significance would take a small
fake out as a breakout and then act on the wrong stocks. The judgment of significance is,
however, a matter of experience. How much of a breakout represents a significant
breakout? How much of a reversal represents a significant reversal and how big a candle
represents a strong morning star signal? The judgment of significance is something you
need to acquire and refine as you put more years behind your ears.

Technical Analysis Principle #2: Prudence

Prudence refers to the ability to say “No” when in doubt. Technical analysis is more of an
art than a science. This is because even though technical indications are scientifically
generated, the interpretation of technical indications is highly subjective. You are going to
experience many marginal or doubtful moments in technical analysis. Technical signals
that “almost made it” as well as technical signals that are “neither here nor there”. Those
are the times to exercise the technical analysis principle of Prudence and to make the
most conservative interpretation. When a signal is marginal, you should always exercise
prudence by giving benefit of the doubt to disqualifying the signal. When a significant
breakout signal is produced after a huge drawdown, you should exercise prudence by
waiting for further confirmation or enter the position gradually over a few days.

2 Key Tools: Charts, Indicators

Technical Analysis Key Tool #1: Charts

Chart reading is the most fundamental tool in technical analysis and is also why technical
analysis is frequently referred to as “Chartology”. Before the popularization of the
internet, during the age where analysts still read tapes, technical analysts have to obtain
stock quotes from “secret sources” and then plot them down on huge chart papers in their
secret rooms. What then is a chart? A chart is simply a plot of the stock prices made into a
curve. A chart’s basic function is to show the TREND of a stock’s price action. Without a
chart, a stock closing at a price of $50 has no meaning at all. With a chart, you can clearly
see the price action trend down from $100 to $50, giving investors the first indication of
where the future price action of that stock might be. In the beginning, charts are plotted
merely as a single line joining the prices together. Recently, with more and more
powerful computers and software, more innovative and informative plotting methods like
candlesticks, bar charts and point and figure charts are developed and made easily
available through the internet. No matter what type of chart you look at, the only aim is to
provide an indication of where the future movement of the stock might be. Another
important aspect of charts is “Chart Patterns”. Different types of charting method can
produce easily recognizable patterns and formations that can be associated with certain
future expectations. Popular chart patterns include “morning stars” in candlestick
charting, “double top breakout” in point and figure charting and “double bottom”
formation.

Technical Analysis Key Tool #2: Indicators

Technical Indicators are the other key tool in technical analysis. Technical indicators are
graphical representations of various mathematical formulas based on the stock price and
transaction volume. The are literally thousands of technical indicators out there and more
are being developed daily as new finance theories are translated into mathematical
formulas every day. Technical indicators’ main function is to tell when a stock is
considered oversold or overbought and when a stock is considered weak or strong
relative to its past action. There are literally endless amount of formulas that can be used
to provide those indications, hence the endless number of technical indicators. Because
there are so many different technical indicators out there, beginners should start with a
few well known and widely used ones as those tends to be used by institutional investors
as well. It can be argued that the effectiveness of a technical indicator lies in its
popularity. The more investors acting on the same indicator, the stronger the predictive
nature of the indicator becomes. A self fulfilling prophecy? Maybe.

2 Key Components: Price, Volume

Surprisingly, so many different charting methods and technical indicators used in

technical analysis all stems from the same 2 key components, Price and Volume. The
price and volume of a stock are the only two publicly available information pertaining to
that stock. Out of its price and volume, stock charts and technical indicators are created.
Candlestick and bar charts are constructed out of the opening price, closing price as well
as high and low prices. Relative Strength Index is created out of the price as well as
volume of a stock compared against its historical data.

5 Key Concepts: Resistance, Support, Trend, Patterns, Setups

The 5 key concepts of technical analysis are the 5 most important analytical methods in
technical analysis. Understanding all 5 are critical to the mastery of technical analysis.
All 5 key concepts work together to help technical analysts predict future stock
movement and know when to buy or sell a stock. Of particular importance is the ability to
tell when to buy or sell a stock. This is the kind of information that fundamental analysis
will not provide.

Technical Analysis Key Concept #1: Resistance Level

A resistance level is a price level at which most investors sells a particular stock at,
resulting in the stock falling every time that price level is hit. It acts almost like a brick
ceiling from which the stock falls down every time it hits its head on it. Resistance levels
are identified from reading price charts, particularly point and figure charts. It is a level
which you might want to at least take some profit off the table. Even though resistance
levels make excellent selling points, a breakout of a resistance level does spur a stock
strongly to upside, creating an excellent buying opportunity. When anticipating resistance
level breakouts, it is important to apply the 2 key principles of technical analysis outlined
above.

Technical Analysis Key Concept #2: Support Level

A support level is a price level at which most investors BUYS a particular stock at,
resulting in the stock rising every time that price level is hit. Support levels are the
reverse of resistance levels and acts almost like a trampoline on which the stock rebounds
every time it lands on it. Support levels are also identified from reading price charts and
is a level where you might consider buying a stock at, especially when a stock hits a
correction. Even though support levels make excellent buying points, a breakdown of a
support level does spur a stock down a lot more. This is why the 2 key principles of
technical analysis are important when timing an entry using support levels.

Technical Analysis Key Concept #3: Trend

The main objective of looking at the trend of a stock through price charts is the
anticipation that the trend is going to continue going in the same direction generally. It is
like buying fashion that conforms to the current trend. If no other information is
available, an investor looking at a price chart would always have a better feel of where a
stock is going than an investor looking merely at a closing price, right? Of course, no
trends go on and on forever. This is where technical indicators come in to provide an
indication of how strong or weak a trend is.

Technical Analysis Key Concept #4: Patterns

Chart Patterns are shapes formed by price charts. Some popular chart patterns are
“Double Bottoms” and “Head and Shoulder Formation”. They are so named based on the
shape formed by a price chart. These easily recognizable patterns provide an
interpretation on what investors are expecting the stock price to head towards. Double
Bottoms typically indicate a reversal and head and shoulder formations typically indicate
a switch to a bear trend. There are a ton of chart patterns out there and all needs to be
interpreted in conjunction with the right technical indicators while applying the 2 key
principles of technical analysis.

Technical Analysis Key Concept #5: Setups

Setups are specific patterns formed by using different charting methods. A morning star
setup using candlesticks charting may not show up as a buying signal in a point and
figure chart. This is why different charting methods need to be used to cross check
buying or selling setups produced by one charting method. A setup is a lot more specific
than a chart pattern. A chart patterns tells you where a stock might be heading and a setup
tells you when you can buy or sell a stock. Setups need to be interpreted together with the
other key concepts while applying the technical analysis principles. A buying setup
occurring at support levels or a selling setup occurring at resistance levels makes the
setups more convincing.

Fundamentals of Technical Analysis – Conclusion

All the fundamentals of technical analysis needs to be used together like all parts of a car,
nothing can be left out if you want to be successful with technical analysis. So far, you
might notice that technical analysis has the ability to precisely time entries and exits on
high probability stocks. This is also what makes technical analysis so important to
options trading (http://www.optiontradingpedia.com). Trading Stock options requires the
stock in question to move as expected quickly in order to reduce the effects of time decay
and to maximize profits. I hope this article has been useful to you as you start your
journey in trading and to your future success.

By Jason Ng

Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset
Management (MastersoEquity.com) and author of free Options Trading education site,
Optiontradingpedia.com. He is a fund manager specializing in options trading and his
revolutionary Star Trading System has helped thousands.