First Principles of Technical Analysis

As Market Technicians, we must remember that despite our best efforts, the methods we employ are not perfect, nor will they ever be. Technical instruments, tools, and analysis are our best attempts to gauge supply and demand, and yet no person or group of people is able to know and accurately assess the infinite factors that combine and fluctuate to generate the forces of supply and demand – which exclusively determines what way, how fast, and far a stock or security will go.

There is no crystal ball or get-rich-quick methods in technical analysis.

 

 

The Market Technician’s duty is to interpret action while possessing a keen sense of judgement and perspective. A chart – while one of the best sources of data to analyze for technicians – is not perfect; it does not have all the answers, nor does it present its use value instantly and easily. It is possible to technically analyze the markets ad infinitum with so many combinations, indicators, and pliable variables – not to mention the innumerable indicators that are not widely used and those which have not yet been invented. These dizzying possibilities tend to short-circuit judgement as they attempt a purely mechanical approach to analyze what is not a purely mechanical cause-and-effect relationship. With so many various technical systems and forms of analysis, it is important to remember the First Principles of technical analysis.

 

The First Principles are those methods that are the most useful as they are simplistic and easily rationalized. They do not lend themselves to perfection or attempt to precisely time the day and time a stock will move and by how much. These methods work well together and supplement each other. Below are the First Principles of technical analysis, as originally outlined by Robert Edwards and John Magee in their pioneering work: Technical Analysis of Stock Trends.

 

The First Principles of Technical Analysis

 

1.  Area Patterns or Formations – These chart patterns, along with volume, indicate changes or continuations of the supply-demand balance. They can indicate the probability of moves in the same direction, in no direction, or in the reverse direction. These patterns can be described as the visual representation of periods where energy or pressure is accumulated. These periods more often than not give way to periods of movement where prices are propelled consistently in continuous motion, either up or down. The patterns can also be the representation of periods when pressure is dissipated and exhausted, which lend themselves to cause mean reversion in price or periods of consolidation and a lack of activity. In either case this knowledge can be transmuted to profits, the avoidance of losses, and the optimal use of time and money. Some of these patterns even go as far to indicate how far their pressure will push prices through minimum price targets that are established. Volume is a factor. But recall that volume is important only when it is an extreme deviation from the norm; it is also relative. Point and Figure area patterns are equally valid here, although volume analysis is not taken into consideration.

 

Ascending triangle in the Dow Transports broke out to the upside circa 1997

 

2. Trend Analysis with Trendlines - Together with Area Patterns, trend analysis helps determine the general direction in which prices have been moving. Additionally trendline analysis signifies when the trend deviates, as well as provides the Market Technician implications of its deviation. Trend analysis independent or in conjunction with area patterns may be used to signal to investors when to enter and exit positions. One of the great strengths of trendlines is that they often provide a reliable defense against premature relinquishment of profitable long-term positions.

 

2 1/2 year chart of Wynn. Simple trendline analysis would have kept you in the stock in recent market decline.

 

3. Support and Resistance – These levels are created by the previous commitments of market participants. Where are the levels where many shares changed hands over time? The levels have a two-fold purpose and use for market technicians. First, they are important because they indicate where it makes the most sense to initiate a position through entries that coincide with the least amount of risk. Second, they are useful in determining where price action is likely to slow down or retreat, and possibly reverse course. This is useful in determining where to take profits due to the likelihood that a stock will experience a sudden increase in supply or demand, as well as what levels it makes sense to scrutinize more than others.

 

Example of support and resistance annoted on a chart

 

4. Broad Market Background – What is the market as a whole telling you? What are the strongest and weakest areas of the market? This principle includes Dow Theory as well as sector analysis and relative strength. Dow Theory indicates to the technician the overall market trend, and therefore dictates the types of positions that are the most likely to succeed, as well as signals when these positions should be exited or reversed (depending on your strategy). It is important to remember that over time, the stock of good companies will tend to decline when all stocks are declining, and the stock of poor companies will tend to rise when all stocks are rising. Charles Dow originally noted that the stocks of the market move together like schools of fish, and this is why his theory is so valuable. Additionally, it is helpful to understand the strongest and weakest sectors of the market, as the stocks that make up a sector also generally move together. The investing implications are different in up and down markets, but only in opposite effect.

 

Charles H. Dow - the father of technical analysis and Dow Theory

Summary

 

All four of the First Principles of technical analysis can be used in conjunction, and the resulting analysis will always be stronger when they are used together when possible, in proportion to the number of principles used. As Market Technicians, it is important to revert to these First Principles in times of doubt and uncertainty. “Stick to your guns,” as Edwards and Magee stated. That is not to say that recent technical developments and other momentum principles are not valid – they are, though they should rarely if ever be used in isolation. Combining all four First Principles with modern indicators, oscillators, and moving averages can generate profitable set-ups when used in conjunction, as well as shorter-term entry and exit signals to give the market technician a valuable edge.

 

Disclaimer: I am long Wynn Resorts at the time of this posting.

 

 

How To Draw and Use Trendlines to Make Investing Decisions

Trendlines are the backbone of technical analysis. They are an incredibly useful tool and yet they are also very simple. Knowing how to use them, however, can be slightly more complex. There is often a lot more to trendlines than what meets the eye, and the experienced technician is able to draw out and extrapolate the relevant information from the price action. Multiple trendlines can form large and significant market patterns. Therefore it is no surprise that trendlines are the building blocks of price interpretation. In this update I am going to explain the various ways you can use trendlines to make investing decisions, as well as their classical definitions and combinations, and how and when to draw them.

 

Drawing Trendlines

 

There may be more than one way to draw trendlines on a chart. I am going to explain the way that Robert Edwards and John Magee first described them in their pioneer work titled Technical Analysis of Stock Trends. This is one of the three books that the level 1 CMT exam covers as dictated by the MTA, and a very familiar source to Market Technicians. I also highly recommend this book to anyone who wants an in-depth yet elegantly simple education on technical analysis and investment principles.

 

Trendlines can be drawn on the upper bounds of price action or on the lower bounds of price action. An upper trendline is also known as a blue line and a lower trendline is also known as a red line. Trendlines require two established top reversal points for upper trendlines or two established bottom reversal points for lower trendlines, in order that these points may be connected by the line. Minor highs and lows are good candidates for potential reversal points. On a top these points are called reaction points and at a bottom they are called basing points.

 

These reversal points must have low (bottom) or high (top) that is flanked by two higher closes (bottom) or two lower closes (top). The established reversal points can more strictly be defined once the range of the current bar or candle has moved completely above (low) or below (top) the most recent extreme point in the move. In the figure the shaded area represents the level where the current candle must remain entirely outside of in its range. Once this has been accomplished a basing or reaction point has been established.

 

Trendline parallels can be drawn to create trend channels as price moves back and forth upon a fixed plane. Trendline parallels may be drawn with only one established top or bottom if the point is opposite either a red or blue line. These parallels are useful for estimating the extent of possible moves as well as making decisions to buy or sell stock and securities or preparing one to make such decisions. The parallel line should be drawn parallel to the original trendline, and in the same color but with a broken or dotted line. These parallels can be drawn when reversal points have been established as defined above.

 

There are certain cases where reversal points are obscure due to rounded or irregular reversal formations. In these cases a Market Technician must have experience with numerous forms of market action in order to confidently identify and establish these points.

 

Preparatory Trend Signals

 

Now that I have explained how to draw and define trendlines I will describe the various methods one can use to form investing decisions after the initial lines have been established. Please note that unless one is acting upon fundamental information, all buying signals shall be initiated in uptrends and all selling signals initiation in downtrends. Technicians are not justified in taking positions against the trend because these reactionary moves will always be smaller if you are fighting the trend. For example an uptrend, by definition, will be making higher highs and lower lows, and one is not justified in selling short on reactions. The appropriate decision is to wait until reactions have run their course and buy or pyramid at the bottom reversal points.

 

Preparatory Buying Signals

 

These are the buying signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the upside:

 

  • Contact with the ascending Blue Line if the Red Line is also ascending in parallel
  • Contact with the horizontal Blue Line if the Red Line is also horizontal or ascending
  • Penetration of a descending Blue Line on volume if Red Line is ascending

 

These are the buy signals that occur after a preparatory buy signal has been identified.

 

  • If the Blue Line has been ascending, draw the Blue Parallel and buy at or near this line
  • If the Blue Line has been horizontal or descending in the case of rectangles, triangles, and other various reversal patterns, buy on a reaction of 40 to 60% of the move from the last previous minor bottom to the extreme top of the most recent move

 

See Diagram 1 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate buy signals.

A. Penetration of an ascending Blue Line

B. Penetration of a horizontal Blue Line

C. Penetration of a descending Blue Line without other technical indications is not conclusive evidence of a change in trend, and does not justify long committments

D. Contact with the Blue Line of an ascending parallel trend pattern

E. Contact with the Blue Line of an ascending divergent pattern

F. The contact with a Blue Line here does not suggest a buy on the next, since trend appears to be converging in a rising wedge – a bearish formation

G. Contact with the Blue Line of a rectangle at its fifth point of reversal

H. Contact with the Blue Line of an ascending triangle

I. Penetration on volume of a descending Blue Line when the Red Line is ascending in a symmetrical triangle

 

 

Preparatory Shorting Signals

 

These are the short selling signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the downside:

 

  • Penetration of a Red Line to a new low closing
  • Contact with the descending Red Line if the Blue Line is also descending and the trends are not converging in a wedge formation
  • Penetration of the ascending Red Line with or without volume if the Blue Line is descending in the case of a symmetrical triangle

 

These are the sell signals that occur after a preparatory buy signal has been identified.

 

  • If the Red Line has been descending, draw the Red Parallel and sell at or near this line
  • If the Red Line has been horizontal or ascending, in the case of rectangles triangles, and various reversal patterns, sell on a rally of 40 to 60% of the distance from the last previous minor top to the extreme bottom of the most recent move

 

See Diagram 2 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate short selling signals.

 

J. Penetration of a descending Red Line

K. Penetration of a horizontal Red Line

L. The penetration of an ascending Red Line without other technical indications is not conclusive evidence of a change in trend, and does not justify short committments

M. Contact with the Red Line of a descending parallel trend

N. Contact with the Red Line of a descending divergent trend pattern

O. Contact with the Red Line in this case does not suggest a short sale on the next rally, since the trend appears to be converging in a falling wedge – a bullish formation.

P. Contact with the Red Line of a rectangle at its fifth point of reversal

Q. Contact with the Red Line of a descending triangle

R Penetration of the ascending Red Line with or without volume when the Blue Line is descending to form a symmetrical triangle.

 

Some Additional Notes

 

If a stock that has been trending and stalls in a congestion zone of two to three weeks or longer without providing any signal one way or another by price or volume action, it is wise to consider this consolidation as a key area and therefore its own minor top or bottom. This allows one to adjust their stops accordingly in the event that the trend peters out from this key level or pyramid to their position in the event that the trend continues higher. Again this takes some experience on the part of the Market Technician to determine just when and where to place the stop. Remember stops are never moved down in an uptrend (or up in a downtrend in the case of short selling) but should be moved up with each minor bottom according to the investor’s tolerance for risk and their investment strategy. For example, a long-term fundamental investor may choose to wait out any intermediate reactions as they develop while a short-to-intermediate investor might choose to close out their position on any break in a major trend.

 

Keep in mind that climatic volume often occurs at the end of an uptrend, and while not a selling signal itself, it is wise not to add further commitments to your open position after this warning signal. These climatic moves often signal the beginning or near beginning of an intermediate trend, and the astute investor would be wise to closely monitor their position in the event this type of volume has occurred. These moves are dangerous as weak investors flock to the rapid price advance and great volume, setting the stage for final “blow-off” moves where the reversal volume and price action become exacerbated.

 

Trading Intermediate Trends

 

Intermediate trends may be traded after an extended move or serious of moves in the primary direction. Typically a technician would look for any warning signs that the trend is exhausted and confirmed on breaks from either the ascending Red Line (in an uptrend) or the descending Blue Line (in a downtrend). Keep in mind that price targets in the opposite direction should be kept in line with intermediate reactionary moves and not more until proven otherwise.

 

Summary

 

  • Trendlines are the building blocks of technical analysis
  • Two or more trends can meet to form patterns
  • Trends can alternate to form larger patterns
  • You need at least two established reversal points to form a trendline
  • The top trendline is blue – “upper trendline”
  • The bottom trendline is red – “lower trendline”
  • The Blue Parallel is the bottom line of a Blue Line and is dotted
  • The Red Parallel is the top line of a Red Line and is dotted
  • Initiating positions must be justified by going long on uptrends and short on downtrends, since reactions will be smaller than rallies in uptrends and vice versa for downtrends
  • Be wary of climatic volume near upper trendlines for a top and lower trendlines for a bottom
  • Intermediate reactionary trends may be traded provided climatic volume has occurred and price targets are in line with intermediate moves

Using Technical Analysis to Reduce Risk

One of the most important investing tools you have is your stop loss. In market times that are as tough as the ones we’ve been experiencing, having a good defense is essential to your financial health. A good defense makes for a good offense.

 

The shields of Gondor.

When you make an investment you either begin making profit on it or you begin taking a loss on it. Let’s assume you made a $1,000 investment. A 10% gain on that investment means you would make $100, while a 10% loss means you would lose $100. You either gain or lose $100, so what’s the big deal? Now let’s assume with the remaining $900 of your initial investment, you earn 10%. But you only had $900 this time, so you gain $90 instead of $100. If you had gained $100 first then lost 10%, you would also have $990.

 

If instead of a 10% loss, you took a 20% loss on your initial $1,000 investment, then you’d end up with $800. An equivalent gain to earn back your $200 is now 25% and an equivalent 20% gain would only earn you back $160 of your initial $200 loss. You’re out $40, an increase of four times while your losses only doubled.

 

A 50% loss is where it gets interesting, because if you’ve lost 50% on your investment, you must make a fully doubled 100% to get your money back. An equivalent return of 50% profit after 50% of losses is only $250. Now you’re out $250, and not only that, but you’ve had to work a lot harder to just do that (earning 50% ROI). See the chart below:

 

 

 

Starting Position % Lost % To Recover Loss Amount Lost $ Remainder $
$1,000 8 8.7 80 920
10 11.1 100 900
20 25.0 200 800
30 42.8 300 700
40 66.6 400 600
50 100 500 500

 

 

An 80% loss on investment means you’d need to earn 500% in order to just get back to even. This is why you should cut your losses before this point. You must use your defense. In short, you must survive. You can’t play in the game again unless you keep the Jacksons, Franklins, and McKinleys – the players. This is how panics happen. Investors have held on way past the appropriate amount they should risk until finally they dump their holdings at any price they can get. They’ve created a dangerous situation for themselves (by not cutting losses or taking too much initial risk) that spirals out of control against them. Most investors can stomach a 10% loss without too much grief, but when they start losing multiples of that, primitive survival instincts awaken to life. Fear sets in. Our highly developed survival instincts which may or may not be attuned to our financial survival tell us to take flight. We get rid of the situation by selling in a panic. It is human nature.

 

This is why technical analysis is so essential to investing. Not only does it track the human element, but more importantly it allows you to create trades where you decide the amount you risk and the cut-off point where a good investment decision has turned sour. There are many technical setups that offer several percentage points of upside with only very limited downside risk, sometimes as low as one percent or less. These scenarios present themselves at various times to the astute investor, who in his/her research and analysis notes these situations as they develop, watches them, comprehends when they are confirmed or rejected, and arrives at an investment decision based on either outcome.

 

With many stocks plunging well into the double-digit losses over the last two weeks, and the Dow down over 600 points today alone, you can see why it is important to establish technical levels that would indicate your judgment is incorrect. By timing investments to include a max percentage loss before the trade is established an investor can avoid situations like being stuck in the middle of the market decline we’ve been experiencing. A good rule of thumb is to lose no more than 10% on a single investment, but depending on the volatility of the issue and your own risk tolerance, you may determine a level that is most suitable for you – whether it be more or less than 10%.

 

The take-away is to preserve your earning power. Preserve your sanity. Defend yourself and you will live to fight another day.