on volatility behavior of the underlying
• Exit extended trends at technically significant price-reversal levels
• Time entries and exits based on market order flow
• Define percent risk in terms of significant price levels
• Use volume and open interest analysis to gauge strength of an underlying move in order to time entries and exits
• Use market breadth and broad market sentiment to gauge the strength of an underlying move in order to time entries and exits
• Forecast potential peaks (for shorting or liquidating positions) as well as potential troughs (for getting long and covering positions) via the use of cycle and seasonality analysis
Fundamentally Based Market Timing offers the ability to:
• Gauge undervalued stocks with a potential to appreciate in value, but lacking information regarding the precise price or time to get long or to cover
• Gauge overvalued stocks with a risk of depreciating in value, but lacking information regarding the precise price or time to get short or to liquidate
• Screen and participate in fundamentally strong stocks in a sector or industry as part of an active asset allocation or rotation strategy, but lacking information regarding the precise price or time to get long
The Fundamentalist versus Technical Analysts
Listed below are some characteristics of the fundamentalist and technical analyst:
The Fundamentalist:
• Is mainly concerned with intrinsic value
• Strives to understand the underlying causes for potential market moves
• Is focused on which company to participate in
• Can tell you which company to invest in, but cannot tell you the most advantageous moment to start participating in that stock
The Technical Analyst:
• Is mainly concerned with structure and dynamics of market and price action
• Is more concerned with the effects of potential market moves rather than the cause of them
• Cannot usually determine what the intrinsic value of an asset is or whether it is under-or overvalued, but is able to determine precisely when to start participating, purely from the perspective of price performance
• Is not concerned with the underlying factors that led to the rise in price; this is irrelevant for all practical purposes as they believe that price is a reflection of all information available in the markets and therefore that is all that really matters
In short, from what we have covered so far, we know that technical analysis:
• Uses past information
• Uses charts
• Identifies past and current price action
• Forecasts potential future price action based on historical price behavior (especially the start of a new trend)
Technical Data and Information
Technical analysts study market action. Market action itself is mainly comprised of the study of:
• Price action
• Volume action
• Open interest action
• Sentiment
• Market breadth
• Flow of funds
Of all the data that technical analysts employ, price is the most important, followed closely by volume action. Price itself is comprised of an opening, high, low, and closing price, normally referred to as OHLC data. OHLC data normally refers to the daily opening, high, low, and closing prices, but it may be used to denote the OHLC of any bar interval, from 1-minute bars right up to the monthly and yearly bars.
1.4 Classifying Technical Analysis
Technical analysis may be categorized into four distinct branches, that is, classical, statistical, sentiment, and behavioral analysis. Regardless of which branch is employed, all analysis is eventually interpreted via the various behavioral traits, filters, and biases unique to each analyst. Behavioral traits include both the psychological and emotional elements. See Figure 1.6.
Figure 1.6 The Four Branches of Technical Analysis.
Classical technical analysis involves the use of the conventional bar, chart, and Japanese candlestick patterns, oscillator and overlay indicators, as well as market breadth, relative strength, and cycle analysis. Statistical analysis is more quantitative, as opposed to the more qualitative nature of classical technical analysis. It studies the dispersion, central tendencies, skewness, volatility, regression analysis, hypothesis testing, correlation, covariance, and so on. Sentiment analysis is concerned with the psychology of market participants, which includes their emotions and level of optimism or pessimism in the markets. It studies professional and public opinion via polls and questionnaires, trading and investment decisions via flow of funds in the markets, as well as the positions taken by large institutions and hedgers. Finally, behavioral analysis studies the way market participants react to news, profit and losses, the actions of other market participants, and with their own psychological and emotional biases, preferences, and expectations.
Mean Reverting versus Non–Mean Reverting Approach
The type of technical studies employed also depends on the approach taken by traders and analysts with respect to their personal preferences and biases regarding the action of price in the markets. Basically, traders either adopt a contrarian or a momentum-seeking type approach. Being more contrarian in their approach implies that they do not usually expect the price to traverse large distances. In fact they are constantly on the lookout for impending reversals in the markets. In essence, they expect price to be more mean reverting, returning to an average price or balance between supply and demand. Those that adopt the mean-reverting approach prefer to employ technical studies that help pinpoint levels of overbought and oversold activity, which includes divergence analysis, regression analysis, moving average bands, and Bollinger bands. They prefer to trade consolidations rather than trend action. They normally buy at support and short at resistance. Limit entry orders are their preferred mode of order entry. Conversely, being more momentum seeking in their approach implies that they usually expect the price to traverse large distances and for trends to continue to remain intact. They are constantly on the lookout for continuation type breakouts in the markets. In short, they expect price to be more non–mean reverting, where demand creates further demand and supply creates further supply, both driven by a powerful positive-feedback cycle. Those that adopt the non–mean reverting approach prefer to employ technical studies that help pinpoint breakout or trend continuation activity, which includes chart pattern breakouts, moving average breakouts, Darvas Box breakouts, and Donchian channel breakouts. They prefer to trade trends rather than ranging action. They normally short at the breach of support and long at breach of resistance. Stop entry orders are their preferred mode of entry
