Market Scheming

Wednesday, March 16, 2011

Why you should not ignore technical analysis


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Why you should not ignore technical analysis

The topic of technical analysis is rarely bought up in classes, and when it is brought up explanations range broadly.  I have heard informed views such as technical analysis can measure momentum aiding trend trading, while other views from professors cast off technical analysis as voodoo.  However, debating the merits of technical analysis with so called “fundamentalists” is generally infuriating since as the saying goes: “You can’t teach old dogs new tricks”.  One argument I will agree with is that technical analysis can in many cases be a self fulfilling prophecy as if many people are looking at the same indicator and react in a similar fashion the reaction will cause the expected result.  However, a market with only technical analysis would be no market at all as fundamentals do tend to matter over the long term.  For people that are instantly skeptical about any mention of technical analysis my response is the more knowledge the better.  Why not understand both fundamentals (eg. demand/supply, financial statements, and industry trends) and technical analysis.  Where I see the most value in technical analysis is how to choose entry and exit points.  Assume you really wanted to get into a specific stock based on the fundamentals and you are planning on holding the stock for 5 years.  One way is to blindly enter a market buy order and hold the stock.  Alternatively, you can look at the current technicals of the stock and determine if the stock makes sense to buy at its current price.  If it doesn’t make sense to purchase now, setting up a limit buy order above a key support level and wait for a pull back.
The purpose of this paper is not to get into the debate of fundamental vs technical analysis, but to expose people to some specific indicators and tools.  It will be up to the reader to play with some of these tools and determine if technical analysis is something they believe is useful.
The chart to be analyzed is Yamaha Gold (TSX: YRI) and was randomly selected from a list of mining companies I generally follow.
The tools/indicators that will be discussed are Fibonacci Retracement levels, Bollinger Bands, Moving Average Convergence-Divergence (MACD), and Slow Stochastic. I will leave it up to the reader to research way these tools/indicators are calculated due to limited space, the focus will be on the usage. I have skipped moving averages as generally people have been exposed to them, if not  readers are encouraged to plot 20 day, 50 day, and 200 day moving averages on a chart and see how price action interacts with these.


Fibonacci Retracement levels are derived from the Fibonacci series.  Fibonacci series is defined by the following: Fn = Fn-1 + Fn-2, where F0 = 0 and F1 = 1.  The beginning of the series is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21… The way this tool works in charting software (www.freestockcharts.com) is you draw from a low to a high and levels corresponding to 23.6%, 38.2%, 50%, and 61.8% of the price move are drawn.  These levels indicate where pull backs are most likely to find support.  In the case of YRI, the move is from August low to the December high.  The support came in at precisely the 61.8% retracement level.  Fibonacci levels also are used for projections when coupled with Elliot Wave Theory but that is a topic for another day.
Bollinger Bands are very interesting tool to use.  This is one of the most powerful and easy to use technical analysis tools.  Above I mentioned that even if you want to go long a stock for 5 years there are times it does not make sense to buy.  If price action is above a Bollinger Band it does not make sense to buy, conversely if the price action is below a Bollinger Band it does not make sense to go short.  The bands are rendered with the purpose of encapsulating all price action 95% of the time (2 standard deviations).  Therefore, there is a 2.5% probability that price stays above the Bollinger Band.  One element of technical analysis is that you want to take high probability trades and this is an example of a low probability trade.  Using YRI as an example in December price traded 3 times above the band before a major correction.  To take a trade on the first day above the band was a gamble, and if you got out during the next 2 days good for you.  However, it was not a logical trade in terms of the technicals.
Now to the first oscillator: Moving Average Convergence-Divergence (MACD). The MACD indicator is made up of two lines the MACD line and the signal line (smoother as it is the 9 day moving average of the MACD line).  Along with these lines there is a histogram overlaid which shows the difference between the MACD line and the signal line.  A buy signal is generated as the MACD line crosses above the signal line and a sell signal is generated as the MACD line crosses below the signal line.  MACD is a momentum oscillator, therefore buy and sell signals should be filtered based on where they take place above or below the 0 level (dashed line).  Above the 0 level, buy signals would be considered stronger signals than sell signals as momentum is in the direction of the trade.  Consider YRI, August 3rd there was a clear buy signal (entry $9.75) and September 8th there was a sell signal (exit $10.70).  Obviously if the trader bought / sold below the signal dates they could have squeezed out more profit but perfect timing is practically impossible.   The latest rally could have been mostly captured with a buy signal on Feb 1st and a sell signal March 10th.
Lastly, Slow Stochastics is also an oscillator that does show momentum but typically used to identify overbought and oversold conditions.  There are 2 lines the K and D line where the D line is a 5 day moving average of the K line.  When the K line is above the 80 level the stock is overbought and when the K line is below the 20 level the stock is oversold.  One caveat to this is if the K and D line remain above the 80 (or below the 20) level the condition changes from overbought (oversold) to “locked in”.  This typically results in a continuation of the previous trend so a lock in above the 80 level instead of being overbought (you may consider lighten up your position) it would signal that the trend is actually accelerating.  This “locked in” state lasts until the K line moves below 80 (or above 20).  On the YRI this locked in condition is not demonstrated well, for a better example see the any major index mid December through January.  To see how overbought / oversold conditions work, consider a situation where you wanted to buy YRI back in November after seeing on the 5th a strong move.  Well you could buy blindly or look at the Slow Stochastics and realize that the stock is overbought and therefore not a quality buying opportunity.  You then wait until November 26th when the stock is oversold to jump in.
Technical analysis indicators should never be used in isolation, as there will always be false signals.  However, when multiple indicators signal confirm each other along with fundamentals the probability of making a correct trade raises dramatically. 
In conclusion, technical analysis has its place in this world and you are short changing yourself to flatly deny its value without taking time to understand.  If you determine there is no value for yourself in technical analysis that is fine but at least you are not exposed to how other people perceived and trade

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