Chapter 2: The Basic Principle of Technical Analysis– The Trend
- Pring: The art of technical analysis– for it is an art– is to identify trend changes at an early stage and to maintain an investment position until the weight of the evidence indicates that the trend has reversed.
- Technical analysis is based on one major assumption– trend. Markets trend.
- Trends exist in all lengths, but tend to have the same characteristics regardless of length.
- To help identify trend early, we use charts, moving averages, oscillators, support and resistance, and more techniques
- Decide when to enter, and when to exit at either a profit or a loss
- Trend can suddenly change direction unexpectedly so it’s important to be aware of risks and protect against large losses
- Advantage of technical analysis: price point can be established at which the investor knows that something is wrong either with the analysis or the financial asset’s price behavior.
- Risk of loss can therefore be determined right at the beginning of the investment.
- What is a trend?
- Types of Trends
- Rising trend (uptrend): prices reach higher peaks and higher troughs
- Declining trend (downtrend): prices reach lower troughs and lower peaks.
- Sideways trend (flat trend): prices trade in a range without significant underlying upward or downward movement
- From a technical analyst’s perspective, a trend is a directional movement of prices that remains in effect long enough to be identified and still be playable.
- Types of Trends
- How are Trends Identified?
- Linear least-squares regression
- statistical technique
- not of much use to technical analyst for trend analysis
- dependent on sizable amount of past price data for accurate results
- by the time enough historical data is accumulated, the trend is likely beginning to change direction
- slope of regression line represents the trend
- See Appendix A “Basic Statistics” for details.
- Moving averages
- smooth out shorter and smaller trends within the trend of interest and identifies the longer trends
- Chapter 13: “Breakouts, Stops, and Retracements” discusses the use of moving averages.
- Trend lines
- draw lines between extreme points, tops, and bottoms, separated by reasonable time periods
- originated before computer graphic software, when trend lines were hand drawn
- you must define reversal points
- Chapter 12: “Trends– The Basics” covers several methods of determining reversal points
- get a “feeling” of price direction and limits
- get a “feeling” of slope, or rate of change of prices
- trend lines can define limits to price action which if broken can warn that the trend might be changing.
- Trends Develop from Supply and Demand
- each buyer (demand) bids for a certain quantity at a certain price
- each seller (supply) offers a certain quantity and “asks” for a certain price
- when buyer and seller agree and transact, they establish a price for that instant in time
- the number of players and different reasons for their participation in supply and demand is close to infinite
- therefore, technical analyst believes it is futile to analyze components of supply and demand except through the prices it creates
- economic information affecting prices is often vague, late, or misplaced.
- prices are readily available, are extremely accurate, have historic records, and are specific
- prices determine profit or loss for trades, not corporate earnings nor Federal Reserve policy
- price is what determines success and fortunately, for whatever reason, prices tend to trend.
- What Trends Are There?
- What Other Assumptions Do Technical Analysts Make?
- price is determined by the interaction of supply and demand
- price discounts everything
- prices are nonrandom (corollary to the notion that markets trend)
- history will repeat itself, and humans will behave similarly to how they have in the past in similar circumstances.
- like trend lines, these patterns are fractal
- emotions are affected by earlier emotions through emotional feedback
- Conclusion
- Review Questions
- Linear least-squares regression
Proceed to Chapter 3: History of Technical Analysis (in Kirkpatrick and Dahlquist)
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