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Basic Principles of Technical Analysis

23 May 2018  |  Education
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There are two primary methods used when analyzing securities and making investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves reviewing a company’s financial statements and reports in order to determine the fair value of the business, whereas technical analysis assumes that all publicly-available information is already priced into the security, and instead focuses on the statistical analysis of the price movements. In today’s piece we will focus some popular indicators used when conducting technical analysis.

Technical Analysis

Technical analysis is the method in which a securities historical price behavior is the primary determinant in making a trading or investment decision. It is a trading tool used to evaluate securities and attempts to forecast their future movements by analyzing statistics gathered from trading activity, such as volume and price movement. Unlike fundamental analysis, technical analysis instead focuses on the price action of a securities chart or graph and uses various analytical tools to measure the strength of price movements in order to forewarn potential changes or continuations.

When conducting Technical Analysis, it is important to understand the underlying assumptions that come with the methodology. While technical analysis can be traced back to the Sixteenth Century rice markets in Japan, it also incorporates the basic concepts of Dow Theory. This is a theory which states that there exists a relationship between market trends and business activities. Two basic assumptions of Dow Theory that permeate throughout all of technical analysis are:

1.  Market price discounts everything – This means the market price of a security at any point in time accurately reflects all publicly available information.

2.  Price moves in trends – This means a stock price is more likely to continue a past trend than move randomly. This enables market traders to profit by investing according to the existing trend.

Overtime, numerous technical indicators have been developed in attempts to anticipate future price movements. Some indicators are focused on identifying the current market trends, whilst others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators includes trendlines, moving averages, volume, Bollinger Bands, etc. In this piece we will focus specifically on moving averages and how they are used to identify trading opportunities.

What is a moving average (MA)?

A moving average (MA) is used to smooth out price fluctuations by filtering out the ‘noise’ when looking at the price action of a security’s chart. It is defined as the sum of a given number of period price closes divided by the number of periods selected, ‘n.’ – It is essentially the average price over a given period of time.

The two basic and commonly used moving averages are the simple moving average (SMA), which is the average of a security over a defined number of time periods, and the exponential moving average (EMA), which gives greater weight to more recent prices.

Breaking it down

A moving average (MA) is calculated in different ways depending on its type. Today, we’ll look at an example of how a simple moving average is calculated using a 5-day SMA indicator. As the table below states, the 5-day average would use the average of the closing prices for the first 5 days as the first data point. The next data point would drop the earliest price (day 1), add the price on day 6 and take the average, and so on as shown below.

Day Closing Price 5-Day SMA Values used for SMA
1 10
2 10
3 11
4 9
5 8 9.6 Average of day 1 - 5
6 8 9.2 Average of day 2 - 6
7 9 9 Average of day 3 - 7
8 10 8.8 Average of day 4 - 8
9 11 9.2 Average of day 5 - 9
10 12 10 Average of day 6 - 10

The main purpose in using moving averages is to identify trend direction of a given security. Using a smaller ‘n,’ or time period reveals the trend in the fast time frame and the trendline will quickly respond to changes in price action. Vice versa, the larger the ‘n,’ the smoother the indicator and the longer the time frame of the trend is revealed. One of the drawbacks with the longer moving average is that it tends to lag current price action.

As the Chart of the S&P 500 below shows, the larger the number of time periods, ‘n,’ the smoother the chart and greater the lag in price, evident by the red line with a n=200 periods. The blue line, on the other hand uses a time period of 50, which mimics the price action much more closely. As you can see, the overall trend line is much smoother in representing the price action than the candle sticks, and dependent on the time period selected (n) will determine how closely it mimics the price action.

Tech Analysis_graph4

 (Source: Trading view: 02/05/2018)
Blue line – n = 50
Red line – n = 200

How to use moving averages

One of the most common methods of using moving averages to identify trading opportunities is to look for ‘crossovers’ between short and long-term moving averages. These are commonly referred to as the Golden Cross and Death Cross.

A Death Cross is a crossover resulting from a security’s short-term moving average breaking below its long-term moving average. It holds such a name as often when this occurs, the trend may indicate the beginning of a bear market or price reduction in the security. Taking the above chart of the S&P as an example, where the orange arrow lies, we see as the blue line (50-day SMA) ‘crosses’ below the red line (200-day SMA) the overall price of the security drops as time progresses.

On the other hand, Golden Crosses are a bullish break out pattern formed from a crossover involving a security’s short-term average breaking above its long-term moving average. Using the same example of the S&P 500, as indicated by the blue arrow – we see as the blue line (50-day SMA) crosses above the red line (200-day SMA), the overall price action of the security begins to increase.

As demonstrated, using these tools may be a great way to confirm whether a trend is continuing or reversing. In short, using multiple moving averages, where one has a fast time period and the other a slow time period allows traders to identify opportunities through crossovers. Some traders take these cross-overs as trading signals, going long when the fast-moving average crosses above the slow-moving average and going short when the fast-moving average crosses below the slower moving average.

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