What is Technical Analysis?

| May 24, 2006

You may have noticed that we spend a great deal of time talking about things called money flow, momentum, and oscillators. All of these things are technical indicators and fall under the rather broad umbrella of the field known as technical analysis (TA). But what exactly is TA, and how does it work? Essentially, TA is an attempt to better understand and predict price behavior. Technical indicators characterize different facets of price movement, and through the careful examination of a complimentary set of indicators it is possible to predict future moves with a reasonable level of statistical confidence.

Technical Indicators

There are literally dozens of different technical indicators that can be used to perform TA. Of course, it’s not necessary to monitor them all in order to develop a relatively comprehensive understanding of the technical state of a given chart, but it is helpful to use a diverse set of indicators that compliment each other well. Let’s take a look at three of the indicators that we use here at PMI.

Below is a daily chart of the Dow Jones Industrial Average:

The top portion of the chart displays the price movement itself using the Japanese candlestick technique, so named because the daily price data graphics resemble candlesticks. On the graph above, a white candlestick represents an up day, while a red one represents a down session.

The first section below the price chart is labeled “CMF,” which stands for Chaikin Money Flow. This technical indicator attempts to characterize accumulation and distribution. When CMF is above the center line and the graph is green, that represents accumulation, while the red areas below the center line represent distribution. On the chart above, the CMF value is at 0.24 and well into the accumulation area, which is precisely what you would expect given the uptrend over the last three weeks.

The second section, labeled “MACD,” is a momentum indicator called Moving Average Convergence Divergence. MACD attempts to characterize the upward or downward momentum of prices. Those of you who have taken–and remember something about–a classical physics course are no doubt familiar with Newton’s Laws of Motion. One of them states that objects in motion tend to stay in motion, while objects at rest tend to stay at rest. The same can be said for prices. When prices trend strongly in one direction they develop momentum as well, and that momentum tends to keep the price moving in the same direction. On the MACD chart above, when those two lines are above the center line and have a positive slope, that indicates that upward momentum is strong, while a negative slope below the center line indicates strong downward momentum. As you can see, upward momentum is currently very strong on this chart, just as you would expect given the sharp, persistent rise.

The final technical indicator displayed above is “RSI,” which stands for Relative Strength Indicator. RSI is a member of the oscillator family, and these indicators identify price move extremes. When RSI moves above the 70 level, as it is now, it registers an overbought reading, and when it moves below the 30 level, an oversold signal is given. Overbought and oversold indications simply mean that the trend is extremely strong at the moment, and the current overbought indication is exactly what one would expect given the strength of the current uptrend. Further, as you might suspect, extreme readings can also sometimes indicate that prices have come too far, too fast, suggesting that a correction or period of consolidation is likely moving forward.

When viewed in isolation, each of these three technical indicators are of limited usefulness. However, when combined and properly analyzed, they provide an excellent statistical basis for understanding current price behavior and predicting future moves. Now, given that each of these tools apparently only addresses the present state of price movement, you may be wondering what predictive value they can possibly have? That is an excellent question!

Technical Divergences

Below is a daily chart of the NASDAQ Composite index from late March, 2000; you may recognize this as the very top of the secular bull market that ended that year, with this particular average reaching the 5,000 level:

As usual, the top portion of the chart displays the actual price movement itself, while the three technical indicators displayed below it are CMF, MACD, and RSI, respectively. This particular chart is a textbook example of a negative divergence, which is a bearish warning sign that–in this particular instance–accurately predicted the beginning of the great “crash” to come. Divergences are one of the most reliable indicators of potential trend changes, and–as such–we make extensive use of them as part of our statistical analysis. So, what precisely is a divergence?

First, examine the price movement during the month of March. The short-term uptrend that began at the end of January terminated on March 10th just over 5,000. It was then followed by a short-term downtrend to about 4,600, and another short-term uptrend to just under 5,000. In qualitative terms, the long-term uptrend attempted and failed to move above 5,000 twice before turning lower a second time. This is not unusual, as prices will oftentimes require multiple attempts before they are able to break above important resistance levels. So, then, what makes this particular instance of two failed attempts bearish in character?

Now take a look at each of the three technical indicators displayed above. Notice their values during the first attempt to move above 5,000, and then take note of the their values during the second attempt. How did they change? In each instance they moved significantly lower, and that is what is characterized as a negative divergence. You see, when a trend is healthy, technical indicators will confirm price movements by moving to extremes as prices do the same. When technical indicators move in the opposite direction of price, as they did above in March, that is often an indication of a weakening trend, as well as a warning that the trend is vulnerable to a meaningful change in direction.

Of course, just because a negative divergence has developed, that is certainly no guarantee that a trend change will always occur moving forward. If you analyze the month of January on the chart above, you should notice yet another negative divergence between price action and all of the displayed technical indicators. However, this one did not lead to a new downtrend, reinforcing the fact that anything can–and often does–happen in the stock market. Wondering what happened to the NASDAQ immediately following the negative divergence in March? Have a look:

As you can see, this particular negative divergence was right on target, as they often are. The recognition and characterization of divergences is an important part of TA, and an invaluable part of our analysis here at PMI.

A Useful Tool

Hopefully, you now understand the basics of TA, what it is and how it can be applied to the analysis of price movement. However, it is also important to understand what it is not: a crystal ball. There are no certainties in the markets, only possibilities and probabilities, and no strategy or process can ever provide a guarantee of success every time you invest or trade. Like Dow Theory, TA provides its practitioners with a set of tools that, when properly applied, improves their chances of success. As we often stress here at PMI, it is both unnecessary and impossible to make profitable investment and trading decisions all of the time. The real key is to sufficiently manage risk and limit losses when they occur, as they inevitably will. TA assists in the risk management process by getting the odds on your side, which is–ultimately–the real key to long-term profitability.

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