Profitable Trading from Technical Analysis

By: Rick Ratchford
Submitted: 2007-01-17 16:17:22
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While it is good to have a sound knowledge about the markets you wish to trade (fundamentals), to become a consistently profitable trader, one must identify trends and quantify risk and reward by employing Technical Analysis.

What is Technical Analysis?

Technical Analysis is the study of market behavior for the purpose of forecasting future price direction. Usually, price charts are used by the technician for this purpose. The technician makes three assumptions about what is seen on a price chart:

1) Prices tend to move in trends of various time frames.

2) Market price action discounts everything that is relevant to the market.

3) History repeats itself.

Let's consider the first assumption.

According to Newton's first law of motion, he suggests that "...an object in motion tends to stay in motion with the same speed and in the same direction unless acted upon by an unbalanced force."

The fact that prices tend to move in trends is undeniable. At some point, the market becomes "unbalanced" and the result is a change in trend.

Trend patterns, in its basic descriptive form, is that a bull trend will form higher swing tops and bottoms, while a bearish trend will form lower swing tops and bottoms.

These patterns are easily discernable to the chart technician.

Respecting the time frame of the chart is also important when dealing with trends. For example, a weekly price chart is a chart where each individual price bar represents a complete week of trading. A small bull trend correction (where weekly prices are currently moving down in what is clearly overall an upward trending market), this small correction can appear as a respectable size bear trend when viewed on a daily chart (where each individual price bar represents one trading day), or a lower time frame chart such as an hourly chart (where each individual price bar represents just one hour of trading).

So trends are respective to their time frames viewed and analyzed.

The second assumption is that price action discounts everything that is relevant to the market. Technical Analysis is based on the premise that anything that can affect the price of a stock or commodity, whether it be due to politics, weather or some other fundamental influence, or psychological is reflected by price action.

Shifts in supply and demand manifest itself in the ebb and flow of price action, and the trained technician can then note whether the underlying fundamentals are bullish or bearish.

The third assumption is that history repeats itself. Price charts are a graphical study of human psychology. Traders react pretty much today as they did in the past when holding a winning or losing position, or to various fundamental factors.

The fact that history repeats are evident by the patterns on the chart that repeat time and time again. Because they repeat, many books on Technical Analysis highlight various patterns that a chartist should watch for. For example, the Head-and-Shoulders pattern is a common pattern that has good forecasting value. The technician recognizing this common pattern will have noted how price usually behaves when forming this pattern and will expect it price to react in the same way in the future. More times than not, price will do so.

Other patterns that repeat are bull and bear flags, ascending/descending triangles, channels, consolidation patterns, expansion patterns and several others.

The more one studies price charts and becomes familiar with these repeating patterns, the more one can anticipate future market price action. This makes Technical Analysis a must for anyone who wants to improve their win/loss or risk/reward ratios in trading. Timing is critical for successful trading, for bad timing usually results in many losses.

The bulk of the money in trading can be made by trading with the trend. The technician's first job then is to determine what that trend is by applying simple charting techniques. Such techniques are recognizing the trend pattern of higher or lower swings (for bull or bear trends respectively), and applying simple graphical reference indicators such as trendlines.

Trendlines may be a basic tool for the technician, but can also be one of the most important as well. With a properly drawn trendline, the technician not only exposes the trend and potential future support or resistance areas, but is also able to expose other important chart patterns by forming channels (two parallel trendlines that may contain all the swing tops and bottoms of a particular trend), wedges, flags, triangles and others. The crossing of two trendlines, such as in the use of identifying a bullish or bearish triangle, is called the APEX and is often used to determine a price objective for price when it breaks out of the triangle.

Technical Analysis includes many indicators and oscillators to further help take historical price data and determine likely future price action. Stochastic, moving average lines, %R, MACD, Bollinger Bands are some common indicators that technical's may employ. Other tools are Fibonacci Retracements, Gann Angles, previous major highs and lows for support/resistance, market sentiment studies or reports such as the Commitment of Traders (COT) also can prove useful for predictive purposes.

Without Technical Analysis, it can be almost impossible for a trader to be profitable. Timing is crucial, and Technical Analysis provides the trader with the means to forecast future market action from historical price action.

Article source: Expert Articles