Getting a Grasp of Technical Analysis

 | Nov 10, 2011 | 2:00 PM EST
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One of the most surprising things I've encountered recently has been the lack of understanding about the basics of technical analysis. I've always been aware of this issue regarding the general public, but recently I've come across some respected industry insiders who seem to misunderstand not just the inner workings of technical analysis, but the very building blocks of chart analysis.

My guess is this misunderstanding is self-inflicted, at least partly brought on by some practitioners of chart analysis. Some technicians feel they must pile on indicator after indicator until the various wiggling lines that cover the screen begin to resemble a plate of spaghetti. While doing so might impart to the viewer some useful information under the right circumstances (while creating the impression that the chartist is some kind of "sorcerer's apprentice"), it renders the chart useless to those in the trading community who aren't technical mavens. This is unnecessary and counterproductive.

Here's why: Almost all of the widely used technical indicators merely display a derivative of the price.  A moving average is a collection of prices that has been averaged out. Indicators that give overbought and oversold readings, called oscillators, take the current price and measure it against recent prices. With the notable exception of some volatility-based indicators, it all seems to come back to price. In fact, it has been said that price itself is the ultimate indicator.

TA newbies often believe that the price follows the indicator -- but, in fact, it's in fact a fallacy to say, "Indicator XYZ gave a buy signal, therefore the stock must go up." The price doesn't follow the indicator; it createsthe indicator. Because price is the ultimate indicator, it is not always necessary or even helpful to cover the chart (and obscure the price action) with every available indicator.

Here's a case in point. Two days ago I posted a chart of the S&P 500 Continuous Contract, saying, "The weekly chart of the S&P 500 indicates that resistance has become support."

That was the most important piece of information on the chart, but what does it mean? Quite simply, the price at which traders used to sell is now the price at which they like to buy. If the price comes back to that level and we buy with those traders, we just might make some money -- and we won't need any fancy indicators to do so. 

Until recently, traders liked to sell the S&P 500 Continuous Contract when it reached the 1220 area. The chart shows us that this happened several times in September. Now, traders are buying at 1220. This happened on three consecutive days earlier this month -- from Nov. 1 through Nov. 3.

Technical traders reason that, if buyers are stepping in at 1220, they should follow those buyers. More important, the trader should wait until the price reaches that level, since there is no indication that buyers will step in to prevent prices from falling at 1250, 1240 or 1230. Knowing when not to enter a trade is just as important as knowing when to get in.

If a trader decided to use this information yesterday, it would have kept him out of a bad trade. "I want to trade," says the trader. "Not yet," says the chart. "Wait for 1220." I can't help but notice that this morning's low on the contract is 1218.80, so a trader who entered early this morning at 1220 has seen the trade move more than 24 points in his favor at its best level (as of this writing), and only 1.2 points against at its worst.

S&P 500 Continuous Contract -- Daily
Source: TradeStation

Will this work every time? Of course not, but I've yet to see any technique -- technical, fundamental, or otherwise -- that works every time. We also use technical analysis to tell us where to get out if the trade goes against us, and where to take profit if it works in our favor. As long as a trader didn't use an ultra-close stop this morning, he or she has an opportunity to cash in on a nice winner right now.

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