Learn Trading: Basics of Technical Analysis

Traders are constantly searching for different trading systems,
refreshing
ideas, and new innovations to better refine their trading plans. By
investigating the works of the forefathers of technical analysis,
Traders can
gain an immense knowledge of the workings of the financial markets.
Technical
analysis is based on three basic premises. First, the market is a
discounting
mechanism, which means that every fact or information pertaining to the
market
is already been discounted in the price since there are individuals and
groups
with large interests and pockets, who are armed with the latest
research and
findings, and who can afford to stay on top of the latest developments
in the
market. Second, technical analysis involves the study of mass
psychology and
the repetition of price patterns or formations. Since crowds behave
similarly,
price patterns will repeat again and again. Third, markets are either
consolidating or trending. When the market is trending, the odds are
that the
market will continue to trend.

The forefathers of technical analysis wrote extensively about technical
set
ups relating to the markets and noted their own observation pertaining
to the
mental and psychological aspects of trading as well. Having the trading
plan
and technical set ups account for nearly ten percent of your success as
a trader.
Your ability to make timely trade executions and to stay head and
shoulders
above the crowd accounts for about 90 percent of your success as a
trader.
Charles Dow, a prolific author and a journalist pioneered the art of
technical
analysis. He wrote his own observations in a series of editorials and
articles
in the Wall Street Journal around 1901-1903. Robert Rhea, William
Hamilton,
and Samuel A. Nelson compiled and formalized Dow work into a body of
theories.
Each of these authors wrote books in his turn. Samuel Nilson wrote ABC
of stock
speculation. For example, among the basic tenets of the Dow Theory is
that there
will always be three different price fluctuations in the market. The
primary,
the secondary, and the minor trend, which is respectively synonymous to
saying
daily, weekly, and yearly fluctuations. Successful traders include more
than
one time frame in their analyses to have a full picture of the whole
structure
of the market. The hourly chart can be used in conjunction with the
daily chart.
The daily chart can be used in conjunction with the weekly chart.

Equally, Charles Baucker, Richard Wyckoff, Ralph Nelson Elliott made
significant contributions to the art of technical analysis. Richard
Schabacker,
The father of the art of technical analysis in principle, pioneered the
concept
of chart patterns. He introduced terms such as head and shoulders,
triangles,
flags. He is also the first individual to use trendlines to define
support and
resistance levels. Richard Wyckoff coined the concept of testing, and
examined
meticulously market actions and reactions. He observed and looked for
nuances
in chart patterns to analyze how a specific price pattern may emerge.
For
instance, he looked at how the market shook bulls (buyers) before a
major rally.
Elliott is credited with the concept of waves and that, not only
charts, but
also waves form patterns, which will repeat themselves again and again.
For
instance, he introduced the concept of impulse wave which tend to
happen in
the direction of the trend.

MOMENTUM INDICATORS

Momentum indicators, also called oscillators, are used in technical
analysis
to measure the velocity of price changes (momentum) both up and down.
Every
momentum indicator is an oscillator as it oscillates between two
extreme levels.
These extremes are commonly known as overbought and oversold levels.
When an
oscillator reaches the upper extreme level, it is said to be
overbought. When
an oscillator reaches the lower extreme level, this condition is known
as
oversold. The horizontal line in between these extremes is referred to
as the
equilibrium line. The Relative Strength Index (RSI), the moving average

convergence/divergence (MACD), and the stochastic index are widely used

momentum indicators.

RELATIVE STRENGTH INDEX (RSI)

Momentum oscillator developed by J.Welles Wilder in the late 1970s and
discussed in his book, New Concepts in Technical Trading Systems. RSI
measures
the relative strength of the present price movement as increasing from
0 to
100. There are many variations of RSI in use today although Wilder
emphasized
using a 14 period and setting the significant levels of RSI at 30 for
oversold
(signaling upturn) and 70 for overbought (signaling downturn). The
averages
of up days and down days for 14 day periods are plotted. If the
financial
instrument makes a new high but the RSI does not move beyond its
previous high,
this divergence suggests reversal. When RSI bounces down and falls
below its
most recent trough that signals a price reversal.

STOCHASTIC INDEX

Oscillator which measures overbought and oversold conditions in a
financial
instrument based on moving averages and relative strength concepts. In
its
simplest form, the stochastic index is expressed as a percentage of the

difference between the low and the high price of a financial instrument
during
the stochastic chosen period. For instance, if the stochastic period is
14days
and the high in that period was 50 and the low 40, the difference would
be 10.
If the price at the time of the calculation of the stochastic index was
40,
the stochastic reading would zero. At a price of 50, the stochastic
would be
100. At 45, the stochastic would be 50. The stochastic index normally
plots
a 5 day moving average of the stochastic. Lines representing the 25
percent
and 75 percent levels refer to oversold and overbought conditions
respectively.
If the stochastic index falls below the 25 percent line, that suggests
an
oversold condition. When the stochastic index rises above the 75
percent line
that indicates an overbought condition. An upward reversal through the
25
percent line is a positive breakout and a downward reversal through the
75
percent line is a negative breakout, indicating new uptrend and
downtrends
respectively.

MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)

Oscillator developed by Gerald Appel which measures overbought and
oversold
conditions. MACD, pronounced MACD, makes use of three exponential
moving
averages a short one, a long one, and a third, which is the moving
average of
the difference between the other two and represents a signal line on
the MACD
graph. (MACD is typically shown as a histogram, which plots the
difference
between the signal line and the MACD line. Trend reversals are signaled
by the
convergence and divergence of these moving averages. When the histogram
crosses
the zero line upward, that suggests a positive breakout (a buy signal).
If the
histogram crosses the zero (equilibrium line downward (a sell signal),
that
indicates a negative breakout. One of the most popular MACD indicators
in use
is the 8/17/9 MACD. On a daily MACD, the short moving average would be
8 days,
the long one 17 days, and signal line 9 days. On a weekly MACD, the
same applies
but those same numbers would refer to weeks rather than days.