Tuesday, April 8, 2014

Technical Analysis and Its Applications

Many people think that only traders apply technical analysis in trading and long term investors apply more on fundamental analysis. In this article I will go into the details of the application of technical analysis and show you how it can benefit not only the traders but also long term investors.

Firstly, I would like to clarify that technical analysis can be used for short term, medium term and long term analysis and not short term only. For example, with the help of moving averages we can tell whether the security is gaining a support in the short term, medium term or long term.

For short term analysis, we may use 5 days, 10 days or 20 days moving averages on the chart. If price is above these short term averages, we can say that the security is short term bullish. On the other hand, we may also use 200 day moving average for a longer term analysis. If the security's price is above the 200 day moving average, it is considered long term bullish; If below the 200 day moving average, it would be long term bearish, and we may advice the long term investors to sell their holdings in their portfolio.

Top Down Approach
We may also use technical analysis the way we use fundamental analysis in a top down manner. First we analyse the chart of the market index (such as KLCI) to get the overall view of the market. Then we analyse the sector index such as plantation sector index, finance sector index, and conduct comparative analysis between the company and the sector index or the KLCI index. After we get the overall view of the market and the sector, we can then analyse individual stock, their support and resistance, momentum and the trendline analysis.

Leading Indicator
According to John Murphy, Technical analysis serve as a leading indicator for the economic and business condition in the market. Charles Dow also shared the same view whereby the original intention of his Dow theory was to forecast the business activity at his time.

Technical analysis is built on the assumption that "history repeats itself", by knowing the pattern of the historical data, we can forecast into the future price trend. For people who are familiar with cycle analysis and planetary cycles, you will know that these knowledge will help you forecast years ahead which is extremely useful to any long term investors.

Assist in Price Entry and Exit
Technical analysis is a very useful tool for timing the entry and exit of the market. For example, in a trending market, we may use a simple moving average to help us or to give us signal to buy and sell securities. In a horizontal or sideways market, we may use a stochastic or RSI for the timing of entry and exit. How to execute these trades I will discuss later in my Youtube videos. 

Support and Resistance
Using trendlines and moving averages we can determine the support and resistance zones for a particular security. The support and resistance levels are important in setting your stop loss. Not only traders need stop loss, long term investors are advice to use stop loss too such as the 200 day moving average is generally used for the stop loss for a long term investor.

There are many momentum indicators that we can apply from any charting software to give you an idea whether a particular security is still trending, and if it does, how bullish is it? Is it overbullish that it is about to reverse soon? All these information can be answered by studying the momentum indicators like the stochastic and the RSI, or some even more sophisticated momentum indicator like the Average Directional Index (ADX). However, momentum indicators are more for short term application rather than long term.

Finally, I would like to share with you one little story about the Great Depression. In 1929, Irving Fisher, the greatest economist at that time proclaimed that the stock market was in a "permanently plateu". Days later the Dow Jones Industrial Average (DJIA) plunged drastically. Over a period of three years, DJIA fell from 381 points to a low of 41 points in 1932.

This is because during the peak of the economic activity, we see all the rosy pictures and data, based on the rosy data, analysts kept raising target prices for stocks. However, in technical analysis perspective, the market was due for a correction as it was way overbought prior to the crash. In other words, we can say that the stock market reflects the economic condition months ahead, if we can use technical analysis to forecast the stock market, we can really predict the economic condition in the market.

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