SFO Personal Investor Series: Technical Analysis

11/01/2007 12:00 am EST

Focus:

Thomas Aspray

, Professional Trader & Analyst

Though this month’s selection is a bit different from our normal choice it is an interesting compilation of articles by a variety of well-known analysts. Though many of the contributors have their own books where you can explore their approach in more detail, these snapshots I feel will be especially useful to the person who is just getting started in technical analysis.

The book is divided into five sections and includes 28 different articles that cover a wide range of topics from: the origins of technical analysis, different types of charts, specific chart patterns, technical indicators as well as specific trading strategies. Though I could never do justice to each article, I thought that if I selected one article from each section you might be better able to assess the book.

Of course for many investors or traders the primary questions is why should I use technical analysis? This is addressed by Michael Kahn, a well-known technical analyst who writes for Barron’s, in his article “Profiting from Probabilities: The Value of Technical Analysis”. He defines technical analysis as “ simply the study of the markets using only data generated by the market itself” and that charts give you a true picture of supply and demand. Michael also focuses on determining the trend and stressing the point that patterns in the market repeat themselves. Though many traders seem to think of technical analysis only in terms of telling you when to buy and sell, he reminds that it can also give you a clear indication when you are wrong. Since money management is such an important part of profitable trading, using technical analysis to determine your stops can be very important.

Candlesticks are by far the most popular form of trading but this was not so in 1991 when Steve Nison released his book Japanese Candlestick Charting Techniques that introduced this method to the US audience and eventually most of the world. His article “Secrets of the Orient” gives one a brief history as well as a good introduction to candlestick charting. Also discussed briefly are how candlesticks can be combined with other methods to confirm the signal from the candle formation.

From Section Three: Interpreting Trends and Patterns it was a tough choice since chart analysis is one of my favorite topics. I decided to focus on “Find High–Probability Entries with Flags” by Adam Grimes, which explains the basics of this popular continuation pattern and then provides some interesting statistics that one could use as part of a trading system. He identifies one of the main benefits of trading flags, that is the ability to easily determine both a stop-loss point and a profit objective, key ingredients to a trading plan.

Section Four is all about technical indicators and the first article in this section is called “Trading The Indicators: Understanding Volume” and is written by Kira McCaffrey Brecht, a technician who is the senior editor of SFO Magazine. She includes some quotes from several legendary market technicians including John Murphy and Phil Roth, who advise that “big volume in an up-trend, but no price progress. That could be a signal that you’ve hit resistance”. She also reminds the reader that in a classical uptrend, volume should increase on up-days and decline on down days. Balance volume and Equivolume are two of the studies she discusses along with the importance of identifying divergences between price and volume.

The final section of the book is called Technical Trading in Action and the article by John Murphy, an old friend, titled “Take Off Your Blinders and Peer at Other Markets” is an update on what he calls intermarket analysis. His groundbreaking book on the subject was released in 1991 and is titled Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets. The premise of this book was that it is important to look at the relationships between the various markets because understanding these relationships can give you valuable insight into the market’s direction. As an example he looks at is how a falling dollar has historically been bullish for gold and other commodities. The chart he provides to illustrate this point shows that in 2003 the CRB Commodity Index was up over 13% while the dollar was down over 18%. Over long periods of time some of these relationships do change and as John notes “the threat of deflation” changed some of the relationships in the late 1990s, resulting in an update of his book on intermarket analysis in 2004. The validity of this approach has become evident to most in recent years as the spectacular growth in many of the emerging markets has had a dramatic impact on many sectors and commodities. The list on page 234, where John lists the main intermarket relationships, is worth the price of the book.

In summary, I found this book interesting to read as it reminded me of things I had forgotten as well gave me some new ideas. I think this book has something for everyone as the experienced trader will come up with a few new ways to look at an indicator or trading while the novice, who knows nothing about technical analysis, will be given a good introduction to the subject.

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