If you’re hoping to make a profit on your ASX investments, then grasping “the mind of the market”—that is, interpreting price movement of stocks in the ASX and constructing effective investment strategies based upon that interpretation—is of the utmost importance.
One method used by top investors is technical analysis, which looks to a security’s price charts and historical information to shape investment strategies.
This article will introduce to you some of the concepts and techniques utilised in technical analysis such as:
- Supply and demand in financial markets
- Technical metrics
- Market indicators
- Psychological factors
- Trends determination
- Reading trading volume
Market efficiency and the limitations and strengths of technical analysis
As stated before, technical analysis is the methodology behind analysing and interpreting price charts and historical information in order to design and implement appropriate trading strategies for upcoming changes in the market.
One important aspect of technical analysis is the efficient market hypothesis (EMH), which states that it is impossible to sustainably extract abnormal profits from the market once search and transaction costs are taken into account. EMH classifies the market into three general forms of market efficiency, differing by the type(s) of information reflected in current market prices:
> weak form > semi-strong > strong form.
Weak form market efficiency implies that all past information is fully reflected in the current prices of the market.
Semi-strong efficiency implies that—in addition to past information—all present and public information are reflected in current prices as well.
Strong form market efficiency implies that all past, present, public, and private information are fully reflected in current prices.
According to the theory prescribed by market efficiency, technical analysis cannot effectively analyse a weak form efficient market. This is because technical analysis targets the same historical information which is, by definition, already embodied in current prices. According to EMH, therefore, technical analysis cannot be used to identify mispricing or to extract abnormal profits in weak form market efficiency.
Despite this implication, technical analysis remains a popular paradigm and is well-praised by its advocates. Supporters of technical analysis allude to the many successes of technical analysts in the market as anecdotal evidence that the EMH is not entirely true. Of course, many technical analysts do not beat the market for huge gains, yet there is a meaningful proportion of technical analysts who have earned profits that seem to defy the implications of the EMH.
One explanation for this is the belief that pockets of inefficiency reside in the market that can be exploited through observation, identification, and implementation of suitable trading strategies. Commonly, technical trading strategies are coupled with beliefs about market participant behavior and its collective underlying psychology. This combination of analysis and psychology is traded upon when available information is used to ascertain ‘the mind of the market’—and design new trading strategies accordingly.
Basic concepts in technical analysis
Technical analysis is made up of economic and analytical concepts applied to the market. Technical analysis makes use of a variety of concepts, each designed to exploit differing market behaviors and inefficiencies.
Resistance and support
Any high school economics course would have introduced you to supply and demand, which applies the same to financial assets as it does to goods and services traded in the real economy.
In financial markets, sellers control the supply of stocks and buyers control the demand. The interaction of these forces ultimately determines the equilibrium price of a stock. The terms “resistance” and “support” help define the dynamic between supply and demand by denoting the upper bound of a stock’s price path and its lower bond, respectively. Thus, resistance represents what the majority of buyers are prepared to pay and support represents the lowest price at which sellers are willing to sell.
Both support and resistance are based on a static equilibrium representing only a single given point in time. By nature, then, they only provide a snapshot of the market and leave all other variables as given.
Resistance and support, of course, are not the only variable that affects stock prices. Many variables in a dynamic equilibrium can affect stock prices, including sentiment and fundamental factors. When it comes to the stock market, relevant fundamental factors include both macroeconomic variables such as GDP growth, inflation, and interest rates; and microeconomic factors such as an individual company’s unique capability to preserve and grow its cash flow, revenue, and profit.
Since the concepts of support and resistance assume a particular level of all other factors, their levels can and will react to variations in sentiment or economic factors and change or even disappear. Still, their importance as a tool in illuminating prevailing market psychology to investors is great—even if peripheral conditions occasionally shift the level of support or resistance.
Moving averages
Though support and resistance are the cornerstones of technical analysis, other metrics help investors take a look at the peripheral conditions which shake up the market.
To construct appropriate investment strategies, analysts must examine market psychology. One popular, long-standing means of doing so is by assessing a security’s moving average. To find the moving average of a security at a given time, daily prices during a specified time period (for example, 30 days) are added together and divided by the total number of days, resulting in the moving average.
To provide a more detailed example, imagine you must calculate a 90-day moving average. First, add together the closing prices of a security for the most recent 90 days; then divide that sum by 90. The result, also known as the moving average, will be the security’s average price over the last 90 days.
The bulls and bears of stock
This average is meant to show investors underlying trends and show the impact of bulls and bears on a stock price. All stock prices result from the interactions between bulls, who hold a positive outlook on a stock based upon sentiment and economic considerations; and bears, who interpret the same conditions negatively. Bulls tend to impact the market by pushing stock prices higher; bears usually push stock prices lower. Both bulls and bears exist on a continuum, and the moving price shows the transition between bullish and bearish states over time.
Technical analysts interpret moving averages and determine whether investors are moving towards bullishness or bearishness. When prices rise above their moving average, investors are acting as bulls and pushing prices higher—warning that it could be a good time to purchase. When prices fall beneath their moving average, however, investors are acting more bearish—and it would typically be wise to sell.
The sole purpose of a moving average is to infer the transition of bullish or bearish sentiments in the market over time and determine the relative level of bullish or bearish outlook in the market. As with support and resistance, the metric of moving averages relies upon other market variables, including sentiment and economic conditions, as being given during the time examined.
Although technical analysis techniques rely on historical information, economic occurrences in the present will impact the inferences drawn. One recent example of this is the global financial crisis which began in 2008 and resulted in unexpected modification of market sentiment and global expectations in years that followed.
If you’re familiar with the mathematical concept of chaos theory, then the element of chance in the market should come as no surprise. In the market, even minor incidents can create a great impact by changing market sentiment or expectations of market performance. In turn, unforeseen developments can arise and change the result of our technical analysis, making it exceedingly more difficult to prepare trading strategies based on historical data.
Indicators: lagging and leading
Both moving averages and support/resistance are basic metrics in technical analysis—and both are what are called “lagging indicators,” meaning that the signals they send—whether to buy or sell— have a lag in relation to a stock’s price trend.
This isn’t necessarily a bad thing: lagging indicators are useful to investors and analysts when stock prices are moving in long trends. They don’t, however, tell us about upcoming changes in price. Because lagging indicators encourage investors to buy or sell late, they can prevent investors from grasping early opportunities. Converely, they help reduce the risks inherent in being on the wrong side of the market.
But there are indicators that predict changes in price. Leading indicators work by measuring the extent that a security is overbought or undersold. Overbought securities are assumed to mean-revert, or raise in price, letting investors peek into the future.
Trending vs trading prices
Many trading systems and indicators focus on determining whether stock values are moving strongly in one direction (trending) or simply moving back-and-forth (trading). Whether the market is trending or trading makes a world of difference to the technical analyst, for they determine how lagging or leading indicators can be utilised. Lagging indicators, for instance, are more effective in trending markets. Leading indicators tend to work better in trading markets.
Think back again to the global market collapse. In 2009, the market became a trading market after previously being an upwards-trending market. Technical analysis held that leading indicators would serve as the most effective indicators during this period—and the best at creating trading strategies which would accurately predict the next market trend.
There’s more to the effectiveness of lagging or leading indicators than just this. Many factors converge to create the real-life ultimate outcome, the market’s new trajectory. To better measure these, a wide variety of metrics exist—and each day more are developed by investors and back-tested against market history.
Trader’s remorse
Psychology plays into the world of economics. One such way is with trader’s remorse, where a trader must mourn either selling too early or buying too late. Rooted in mankind’s natural risk aversion, trader’s remorse can lead to a loss in profits after selling a security too early or an over-expenditure due to buying an overpriced stock.
This phenomenon affects not only individuals but the market as a whole and analyst have developed price charts that alert investors to periods of trader’s remorse.
From the perspective of technical analysis on the ASX, the idea of trader’s remorse can be best utilised in relation to two opposite traps that result when there is a situation of sustained remorse: i.e. bull and bear traps.
Bull and bear traps
If there is a resistance level in a security, a breakout above that level occurs, and that breakout is followed by trader’s remorse, traders may decide that the increased price is not warranted. If so, a classic bull trap forms.On the other hand, if a stock has a support level, its price falls beneath that threshold, and this change is followed by trader’s remorse, a bear trap could form—if investors do not agree with the lower price that results from falling below a support level.
On the other hand, if a stock has a support level, its price falls beneath that threshold, and this change is followed by trader’s remorse, a bear trap could form—if investors do not agree with the lower price that results from falling below a support level.
Technical analysts try to predict these false breakouts and the traps that come from them. One measure that is often consulted in making future predictions is the interplay of volume. The level of volume can help analysts to better signal where the market is headed: if prices break through a support or resistance level and increase greatly in volume while the period of trader’s remorse shows relatively low levels of volume, then new prices will likely be accepted by the market. If the opposite occurs, however—a breakout is accompanied by a small increase in volume while the trader’s remorse period brings a bigger increase in volume, then prices are likely to rise back to their initial levels.
In short, volume acts as a signal of what the market is thinking when it comes to sentiment and expectations. A combination of high breakout volume and low remorse volume shows that the market harbors strong sentiment and is most likely to revert back to previous support and resistance levels. Low breakout volume matched with high remorse volume, however, means that a bull or bear trap is the more likely outcome. Accurately foreseeing what lies ahead is the goal of any investor, and implanting these tenets of technical analysis helps to develop appropriate and lucrative strategies for trading.
Bull/bear ratio
One market sentiment indicator is the bull/bear ratio. The bull/bear ratio is designed to gauge the overall bullish or bearish outlook of influential market participants such as stockbrokers, investment advisers, market analysts, and journalists in order to show the relationship between bullish or bearish investors participating in the market.
As it is a ratio of bullish investors compared to the combined number of both bullish and bearish investors, any neutral investors are ignored. Thus, the bull/bear ratio is a qualitative, not quantitative, measure of market sentiment.
The bull/bear ratio is found simply by placing the number of bullish investors over the combined number of bearish and bullish investors.
Bullish investors/(bullish + bearish investors)= bull/bear ratio
The bull/bear ratio serves as an indicator for optimism or pessimism in the market. In general, extreme optimism on the part of market professionals and the public coincides with market tops and extreme pessimism coincides with market bottoms. High readings (indicating a bearish market with not enough bulls) ten to go hand-in-hand with market tops, while low readings (indicating a bullish market with not enough bulls) pair with market lows. Analysts tend to view bull/bear ratios above 60% as a marker of extreme optimism and ratios below 40% as indicative of extreme pessimism. Investors may look at these figures to make inferences and act accordingly to accumulate undervalued stocks.
Fibonacci studies
You may recall the Italian mathematician Leonardo Fibonacci, born around the year 1170. He is best remembered today as the developer of the Fibonacci sequence, a sequence of numbers in which each successive number is the sum of the two previous numbers. For example:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.
The numbers in the Fibonacci sequence are more complex and interrelated than they seem. For example, any given number in the sequence is approximately 1.618 times the number preceding it and any given number is approximately 0.618 times the following number.
When it comes to market analysis, this intriguing sequence is not the sole use of Fibonacci’s work. There are four popular Fibonacci studies, each of which help anticipate changes in trends as prices approach lines created by Fibonacci studies:
1. arcs
2. fan lines
3. retracements
4. time zones
The upcoming sections will explain how Fibonacci arcs, fan lines, retracements, and time zones are used to analyze the market.
Fibonacci arcs
Fibonacci arcs are an extension of the basic technical principles of support and resistance in the market. To create a Fibonacci arc, a trendline is made between two extreme points, such as a peak and a trough. From the second extreme point, three arcs are drawn to intersect the trendline at Fibonacci levels of 38.2%, 50.0% and 61.8%. The arcs provide investors with an indication of support and resistance levels in the market.
Fibonacci fan lines
Fibonacci fan lines begin just as Fibonacci arcs: by finding a trendline between two extreme points. To create Fibonacci fan lines, however, a hypothetical vertical line is drawn through the second extreme point. From the first extreme point, three trendlines are drawn so as to pass through the invisible vertical line at the Fibonacci levels of 38.2, 50.0 and 61.8. Within the bounds of the fan lines created are points of support and resistance within the market. Fibonacci fans differ from similar, but more basic, horizontal bounds of support and resistance by accommodating trends in the price of a security.
Often, Fibonacci arcs are paired with fan lines in order to better anticipate support and resistance in the market.
Fibonacci retracements
Just like the previous two Fibonacci studies, a Fibonacci retracement is made by first drawing a trendline between two extreme points. From there, a series of nine horizontal lines are drawn intersecting the trendline at 0.0, 23.6, 38.2, 50.0, 61.8, 100, 161.8 and 261.8%.
After significant price moves, security prices retrace. Using Fibonacci retracements, analysists can see where support and resistance levels are likely to occur—at or near to the Fibonacci retracement levels. Many technical traders utilize Fibonacci retracements to identify strategic places for transactions to be placed or to target prices or stop losses.
Fibonacci time zones
Fibonacci time zones are simply a series of vertical lines drawn at different points in time, given by the sequence shown earlier: 1, 1, 2, 3, 5, 8, 13, 21, 34, etc. These lines mark out “time zones,” making it easier to reveal significant price events occurring at Fibonacci time intervals. In the case of this study, there is no exact reasoning behind marking intervals according to Fibonacci’s sequence. Still, many analysts utilize these time zones to develop their trading strategies.
Chart formations: head and shoulders plus the double top
Fibonacci studies are not the only way to analyze the market. Two other popular technical measures are head and shoulders and the double top chart formations.A head and shoulders pattern will show a price rise to an intermediate level before rising yet higher to a peak. From that peak, the price will decline for a short period before rising again to form a second peak, occasionally of a slightly greater height than the first, and then ultimately decline to a second intermediate peak.
A head and shoulders pattern will show a price rise to an intermediate level before rising yet higher to a peak. From that peak, the price will decline for a short period before rising again to form a second peak, occasionally of a slightly greater height than the first, and then ultimately decline to a second intermediate peak.
Double tops are major reversal patterns that form after an extended upwards trend in price. With a double top, there are two consecutive peaks, roughly equal in height. An investor may observe an established trend with a first peak occurring, followed by a trough and then a second peak, usually with low volume and resistance from the previous price high. In the case of the double top, the market psychology inferred is that as the price falls from its first peak, trend followers in the market sustain their buying pressure until a second (double) top forms. With this second peak, however, volumes tend to be weaker and thus the peak cannot be sustained. The market is then alerted that a trend reversal is likely given the strong level of resistance marked by the chart’s second peak. (A head and shoulders chart is based on this same sort of market psychology but is expounded by the addition of two intermediate peaks before and after the simple double top.)
Both of these chart formations are based on market psychology rather than mathematical concepts, making them tools of technical analysis rather than fundamental analysis (which would gauge a company’s financial merits or an asset based on the quality of its operations, financial ratios, and cash flows).
Technical analysis infers these qualities by how market participants respond to fundamental analysis in financial markets. To technical analysts, all relevant information is conveyed by charts, price behavior, and other metrics—such as those resulting from the behavior of overlying derivatives, which will be discussed later.
Option analysis: two select examples
Insight into market sentiment associated with underlying stocks can be ascertained through developments in options and other derivative markets. The puts/calls ratio and open interest are two technical measures which provide investors this type of information.
Puts/calls ratio
Traditionally, options are traded by investors who seek the potential for huge profits with minor capital outlay. By examining the actions of these investors, signals for identifying market tops and bottoms may be found. One way to look at this is through the puts/calls ratio, a market sentiment indicator that shows the relationship between the number of puts to calls traded.
Most options are used for either hedging or speculating, the former of which is not important to option analysis. The speculating function sees call option buyers who expect to see an increase in the price of the underlying stock while put option buyers expect a decrease.
The relationship between the number of puts and calls illustrates the bullish or bearish expectations of options traders. The higher the ratio of put/calls, the more bearish these investors are on the market—and vice-versa: lower readings mean a high call volume and bullish expectations to match.
The puts/calls ratio serves as a contrarian indicator: excessive bullish or bearish ratios theoretically signal a trend reversal. Options buyers tend to be “unsophisticated,” and the put/calls ratio considers this in its design. When ineffective or unsophisticated investors join an ongoing bullish or bearish trend, more informed investors see this as a harbinger of a trend reversal.
Open interest
Open interest is the total number of open contracts of a given options contract. These open contracts are long or short contracts that have not been exercised, closed out, or allowed to expire. By itself, open interest reflects only the liquidity of a specific contract or the market as a whole. When combined with volume analysis, though, open interest can provide clues to the flow of cash both into and out of the market.
Rising volume and rising open interest theoretically confirm the direction of a current trend in the market while falling volume and falling open interest forewarn an end to a current market trend.
It is important to remember that any option contract involves both a buyer and a seller, meaning that one unit of open interest represents two agents.
Criticism of techniques in technical analysis
Beyond the techniques overviewed here, many others exist.
Critics of technical analysis warn of the potential for data mining, wherein an analysist digs through market data intentionally to find patterns which support a preconceived belief. Analysists without such biases may still find patterns implying a causality that does not actually exist in the market.
These dangers could be applied to any technical analysis metrics—those overviewed here and others discussed elsewhere. To defend against the dangers critics warn of, investors could ask themselves whether an observed double peak truly imply a trend reversal or whether a low puts/call ratio actually means a reversal between bullish or bearish sentiment. By calling into question the charts and figures of technical analysis, investors can better shield themselves and their money from harm.
As there are so many techniques to choose from, differing means of technical analysis will work better for some investors—and perhaps not at all for others. Those that can extract a profit from one or more of its approaches will continue to praise it, while critics discredit its findings as contrived, erroneous, or otherwise unsuitable for developing market strategies from. It is up to the investor to find the paradigm which works for them.
Compared to fundamental analysis, technical analysis takes a more distant interpretation of financial assets. Technical analysts see charts as the holders of information necessary to develop effective trading and investment strategies, despite arguments to the contrary. Individual investors must decide which approach or approaches they wish to take—whether self-designed or popularly used—and see for themselves how to grow their investment in an ever-changing market.
Wrap up
This article serves only as an introduction to technical analysis. Yet this brief overview of its most elementary techniques—especially as they relate to the “mind,” or psychology, of the market—could revolutionise your trading.
Knowing support and resistance and how they relate to supply and demand in financial markets, being able to calculate and apply moving averages, and being able to recognize economic factors and public sentiment as constantly changing and chaotic variables means that you are equipped to predict the actions of the market.
Through gauging the change in investor expectations and market sentiment, recognizing trending and trading markets, and understanding the impact of trader’s remorse on the trajectory of the future market, you can begin looking at the stock market with the eyes of a technical analyst—ready to apply their metrics to maximise profit on the ASX and other global markets.