Technical Analysis:

Nothing More Than Using Futures and Options Intelligently to Manage Price Risk

Technical analysis involves making predictions (and placing trades) on the basis of price chart formations, trends, cycles or various momentum indicators. It is based on the assumption that chart action tells you more about the market’s “perception of the facts” than the facts themselves.

It is often described as “more of an art than a science,” and you know what that means. You can show 10 technicians the same chart and get 10 different interpretations. This is just one of the disparaging views of technical analysis you’ll hear from dyed-in-the-wool fundamentalists, who largely use commodity supply/demand data to project prices. Another favorite, “All the ships at the bottom of the ocean had plenty of charts on board.”

But now that we’ve acknowledged technical analysis has its critics, too, let’s focus on the fact that technical analysis is far and away the fastest-growing approach to successful futures and options trading. Defenders will say things like, “a price chart is like a road map: it tells you everything you need to know except how to fold it up!”

One big reason technical analysis is so popular is that large computer-generated trading approaches employed by huge trading funds are almost exclusively technically-driven. And if you’re going to dance among a herd of elephants, it’s best to follow their lead if you don’t want to get squashed.

You could say the goal of technical analysis is to discover the psychological balance of power between buyers and sellers. It is applied social psychology in its most basic form. Its aim is to recognize trends and changes in crowd behavior in order to make intelligent trading decisions.

To understand crowd behavior, you first have to understand individual behavior. The price of a futures contract is the result of a decision on the part of both a buyer and a seller. The buyer thinks prices are going up; the seller thinks they are going down. The closing price at the end of a trading session might be described as the best compromise buyer and seller could reach on that day.

Once the buyer and seller make their trade, their influence on the market is spent - until the time comes when each of them decides to close the trade by taking an opposite position, accepting either profit or loss in the process. Thus, there are two aspects to every trade: 1) each trade produces an offsetting influence on the market eventually; 2) the results of the trade (whether prices had to move higher or lower to be executed) will influence the decisions of other traders. Each trader’s reaction to price movement can be categorized into one of three groups present in the market at all times: 1) traders who already have long positions; 2) traders who already have short positions; and 3) those who have not yet taken a position but want to.

Traders in that third group are a mixed bunch. Some have a bullish bias about price direction; others a bearish bias. But a lack of conviction has kept them out of the market thus far. They have no vested interest in the market. Price movement will either reinforce their bias and cause them to act; or cast further doubt on their bias and cause them to remain out. Of the three types, the latter “undecided” group wields the most power, since their impact on prices is still in reserve.

Technical analysis based on three assumptions
1) At any point in time, the market has discounted all current fundamental factors. While no one person can possibly know all the fundamentals worldwide for a given commodity, technicians assume that collectively, all those with influence on the fundamentals have “made their opinions known” in the marketplace, in one way or another, by the actions they have taken. That’s why technicians often have disdain for fundamental information, dismissing any observation about supply or demand with a haughty reply, “So what? It’s already in the market.”

2) Prices most often move in trends or “waves.” They do not move haphazardly. And technicians believe there are predictable “patterns” to these trends or waves and have developed sophisticated “cause and effect” explanations as to why these trends or waves develop on the charts, as well as rules for anticipating them.

3) History repeats itself. Technicians believe anything that can affect the price of a commodity, be it fundamental, political, psychological or otherwise, will or has been reflected in price action before. And by studying how prices reacted under similar circumstances in the past, they believe they can forecast with reasonable accuracy how prices will react again.

The concept of trend is of absolute importance in technical analysis. The purpose of charting price action of a futures market is to identify trends in the early stages of development for the purpose of trading in the direction of the trend. Trends can move in three directions: up, down and sideways.

• An uptrend is distinguished by a series of higher highs and higher lows, with the trendline drawn connecting the lows.

• A downtrend is identified by a series of lower lows and lower highs, with the trendline drawn connecting the highs.

• A sideways trend is characterized by price action that is bound in a horizontal range rather than an uptrend or downtrend.

The market adage that the “trend is your friend” is a market variation of Newton’s first law of motion; that a trend in motion is more likely to continue than to reverse.  Just like predicting that next week’s weather will be about the same as this week’s weather is often as accurate as the actual six-to-ten day forecast from the National Weather Service. Studies have shown that a market’s probability of changing the direction of a trend already under way is as low as one in 30 on any given day.

A trend-following approach is predicated on riding an existing trend until it shows signs of changing. Trading with the trend in a bull market means looking for dips as a place to buy; trading with the trend in a bear market means looking for rallies to sell. Technically, it only takes two points to draw a trendline. But when three or more align, it makes for a much more reliable trendline.

Ideally, an uptrend on a daily chart should span a period of at least four weeks; a weekly chart at least four months and a monthly chart at least 18 months. And the best ones for trading are those that run at roughly a 45-degree angle. Those that run much steeper than that give too many false trendline breakouts; those that run much shallower than that give up most of the trading opportunity by the time they are penetrated.

Short-term trends can last from three to six weeks. Intermediate-term trends will last from six weeks to nine or ten months, and long-term trends last from one to two years or more.

Nine major tools used by technical traders: 1) Trendlines; 2) Volume and open interest; 3) Moving Averages; 4) Overbought/oversold oscillator; 5) The Williams %R Oscillator; 6) Relative strength index; 7) Stochastics; 8) Average directional movement index; and 9) Williams accumulation/distribution index.

More details on the nine technical tools outlined  in this article can be found online at www.montanamarketmanager.org/education/articles.html