03 Oct 2017 Intro to Technical Analysis
In the previous edition of the Stock Exchange Handbook we busted a few misconceptions about share valuations and explained how the Price/Earnings (P/E) ratio is a valuable indicator of how expensive or cheap a share is. In this edition of the Investor Education Series by Sanlam iTrade we introduce Technical Analysis of share price movements, once again busting a few misconceptions.
Fundamental Analysis vs Technical Analysis
Fundamental Analysis involves analysing a company’s financial statements to determine the fair value of the business, while Technical Analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the analysis of price movements (according to Investopedia, a great website to use). Technical analysts will study price movements on charts and try to forecast future price movements and trends based on market sentiment and human behaviour.
Technical Analysis can be divided into two parts: Pattern Identification and Mathematical Models, mostly oscillators. Trend Pattern Identification includes:
- Reversal Patterns (Head & Shoulders, Double Tops & Bottoms)
- Continuation Patterns (Triangles, Wedges, Flags)
- Minor Trend Change Indicators (Key Day Reversals, Inside Range Days).
Mathematical Models include:
- Moving Averages (MA), MACD, RSI, Stochastics and many more.
Bull trends and bear trends
An up-trend or bull trend is defined by higher and higher highs, and higher and higher lows. A down-trend or bear trend is defined by lower and lower highs, as well as lower and lower lows. Reversal patterns usually indicate an end to a trend while mathematical models, also called oscillators, give even earlier indications that a market or share is overbought or oversold. See the example of the JSE Index below.
The bull and bear trend names are derived from the way they fight or kill. A bull strikes upwards with its horns and a bear strikes downwards with its paws. Bulls also stampede, a trend that makes most investors and brokers happy, a bit like the adrenaline-filled Running of the Bulls in the Spanish town of Pamplona. But – beware the injuries.
Busting misconceptions about Technical Analysis
- Technical Analysis is only for day traders.
It is true that short-term traders and day traders rely on Technical Analysis for most of their decisions and don’t use Fundamental Analysis much. However, even long-term investors make use of Technical Analysis to decide whether a share is overbought or oversold. Portfolio managers often use it to time their entry or exit points on shares selected with Fundamental Analysis. In practice the two types of analysis are used side by side to produce the best results for individuals and portfolio managers in making investment decisions.
- You need to be a professional to use Technical Analysis.
It is true that large hedge funds and investment banks make ample use of Technical Analysis and have dedicated trading teams that use it, but there are also many individual investors making use of the tools. There are many free online courses, webinars and books to study. In today’s world many online brokers like Sanlam iTrade provide excellent charting tools at no extra cost to clients. For example:
JSE All Share Index candlestick chart with trend lines, MA, MACD, Stochastic and volume
- You must be correct more than 50% of the time to make money.
This is not true. Disciplined traders can be profitable even if they are correct only 40% of the time. Profitable trading requires the discipline to stick to stop losses. Most traders lose money because they ride their losses and cut their profits. Many find it psychologically difficult to take a loss and admit a wrong trade. The disciplined trader will only enter trades with a 2:1 reward-to-risk ratio and stick to their stop losses.