Why Technical Analysis?
Pay your money; take your pick. Technical analysis, despite its faults, has attracted more traders than fundamental analysis has, for the following reasons:
• Technical analysis input (primarily prices in FOREX) is objective,
transparent, and available to everyone.
• Technical analysis offers a nearly infinite number of possibilities for
manipulation and application. Despite the millions of hours of effort
expended on technical analysis, the field is wide open. Who knows
what you might discover?
• Technical analysis allows traders to see the markets at many different
price levels—of their choosing—at the same time.
• Technical analysis lets traders easily time their entries and exits as well
as monitor their trades while they are open and active.
If you are right using technical analysis, you will probably make money on a trade. If you are right using fundamental analysis, the leverage inherent in the market may well cause you to get stopped out or exit the trade before you
can collect on your judgment.
Despite the fundamentalists’ concept that prices used in technical analysis are “instant history,” the technical market paradigm infers that actions in the market of buying and selling obviously have reactions in the markets of selling and buying. Past prices contain information about future prices. Whether this information can be usefully deciphered is an issue for the theorists.
Charting
Price charts of market behavior have been around for centuries, probably almost as long as markets have existed in both the East and West. The most important types of charts used today are bar charts, candlestick charts, point and figure charts, and swing charts.
All charts share the primary characteristic of visually depicting price behavior over some period of time. They differ as to their secondary characteristics and type and degree of visual impact.
Bar Charts
Bar charts are the most popular and enduring for all trading, whether stocks, options, futures, or FOREX. They are time-specific, meaning that they are scaled according to time increments. For FOREX this can be ticks: 5-second,
10-second, 30-second, 1-minute, 5-minute, 10-minute, 30-minute, 1-hour, 12-hour, daily, or weekly.
Time-Specific versus Price-Specific
Charts constructed as a function of time units are said to be time-specific. For example, a bar chart using five-minute, daily, or weekly information is time specific. Point and figure charts are price-specific; they require only price unit information to construct them. Goodman Swing Charts are both time- and price-specific; information for both time and price is required.
Candlestick Charts
Candlestick charts, a charting idea from the East, are especially popular in FOREX. Candlestick chart patterns emphasize the technical analysis paradigm—that past prices carry information about future prices. Candlesticks are also time-specific.
I used candlestick charts in the 1980s to trade cocoon futures on the Japanese commodity exchange. When in Rome, do as the Romans do!
Point and Figure Charts
Point and figure (P&F) charts have fallen from favor over the past 20 years. Perhaps this is a good reason to give them some extra consideration now. Point and figure charts are price-specific. Instead of scaling as a function of time, P&F charts are scaled as a function of price. In the end, it is a half-dozen of one and six of the other. Prices occur over time, and time is relevant only as it depicts changing prices.
To understand the market’s ability to discount and immunize itself, we need only to consider the commodity spread relationships in grain futures. Useful and effective in the 1950s and 1960s, they have shifted so dramatically
as to be worthless today.
Swing Charts
Swing charts can be either time-specific or price-specific, although most of them are price-specific in the manner of P&F charts. I like swing charts very much for my close-up view of markets when I am looking to enter or exit. They are also, obviously, useful for detecting swings in the market. When I discuss the FxCodex method of trading, you will see how important the information derived from swing charts can be to trading currencies. There is no best chart technique. Many traders use more than one for studying the markets. I use bar charts and swing charts and occasionally refer to
point and figure charts. If you haven’t selected a primary chart tool, look at the same market over the identical period of time with each type. Which one speaks to you? If you have already selected a charting technique, feel free to use it to develop your personal codex.
I strongly encourage a charting method as your primary tool both for watching the markets and for deriving buy and sell signals.
Indicators
Indicators are popular with traders. The classification and sheer variety of indicators is vast, and a full discussion of them is beyond the scope of this work. Because most of us aren’t math and statistics experts, anything that uses dazzling displays of mathematical pyrotechnics often seems somehow magical and infallible to us. Many traders use an indicator battery (IB), which is a selection of perhaps a dozen or more indicators covering all the technical bases. If you use an IB,
you need to have ad hoc rules (or a meta-indicator or indicators) to determine what all of its components mean and how to apply them in actually executing a trade.
Charts offer traders a transparent one-to-one correspondence with market prices; indicators do not, and that is the primary problem with them. Indicators are second-level techniques. They use the primary market data such as prices but manipulate it to attain a new level, hopefully, of understanding. Information theory tells us that such translations or manipulations are fraught with some risk and danger. Without being 100 percent certain how the indicator relates to the underlying data, we can be easily misled. Markets move in prices, and using indicators requires that we constantly shift levels to make trading decisions. Each shift can cause an error, and because the markets move very swiftly, errors compound quickly.
Indicators also tend to be curve-fit. That is, you must somehow select time frames and other parameters to calculate the indicator value. As the markets change, these parameters may need to be constantly altered and updated. Trending markets evolve—sometimes rather quickly—into trading markets, and vice versa. Some indicators do this internally, after a fashion. For others—you guessed it—you need another indicator to make those decisions.
Indicators are opaque to varying degrees. The more complex the indicator the more difficult it is to determine what it is really measuring. In the meantime, the markets are marching onward and upward or downward. Another consequence of this opaqueness is that it is difficult to develop rational money- management tools using most indicators because the primary-level connection to prices has been severed in the calculation process. Stops, for example, are a function of prices, and your indicator needs to convert its findings back to price levels to determine a stop. Of course, you can always build another indicator to do that for you. If you’ve guessed that I’m not a big fan of indicators, you are correct.
Cycle Analysis
If the technical market paradigm is correct, then prices have a memory of some sort. Cycle analysis accepts this as an axiom and takes the idea a small step further: Prices behave in cycles. There is certainly logic to this, I think. But
whether the markets are cyclical in nature or simply exhibit cyclical behavior from time to time is the big question.
Components of a Cycle
All cycles are defined by four parameters:
1. Amplitude—the distance between the maximum or minimum
value and the mean value of the cycle; half the vertical range.
2. Wavelength—the period of the cycle as measured from one peak
to the next peak or from one trough to the next trough.
3. Phase—the horizontal shift left or right for a cycle.
4. Decay/expansion—cycles may decay or expand for the above
values over time, either linearly or nonlinearly.
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