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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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