13.5.2 Commonly Used Tools In Technical Analysis

Commonly Used Tools In Technical Analysis

Introduction

Technical analysts use four primary methods to identify trends and possible trend turning points, either alone or in conjunction with each other: chart analysis, quantitative analysis, analysis of sentiment indicators, and cycle analysis.

Chart Analysis

Chart analysis involves interpreting graphic representations of market data. The most common chart type is the bar chart, displaying high, low, and close prices along with trading volumes. Other charts often used in technical analysis include candlestick charts, line charts, and point-and-figure charts.

Example of a Bar Chart

Here’s an example representation of a daily bar chart for the S&P 500:

    graph TD
	    A[Daily Bar Chart – S&P 500]
	    A -->|February 7| B(Bar 1: High, Low, Close, Volume)
	    A -->|February 8| C(Bar 2: High, Low, Close, Volume)
	    A -->|February 9| D(Bar 3: High, Low, Close, Volume)
	    A -->|...| E(...)
	    A -->|June 7| F(Bar n: High, Low, Close, Volume)
	
	    classDef high fill:#90EE90;
	    classDef low fill:#FF6347;
	    classDef close fill:#FFD700;
	    classDef volume fill:#87CEEB;
	
	    B:::high
	    C:::low
	    D:::close
	    F:::volume

Quantitative Analysis

Quantitative analysis involves the use of mathematical and statistical models to identify trading opportunities. This includes the use of indicators and oscillators like Moving Averages, Relative Strength Index (RSI), and MACD.

Example of Indicators

    graph TD
	    G[Quantitative Analysis]
	    G --> H(Moving Averages)
	    G --> I(Relative Strength Index - RSI)
	    G --> J(MACD - Moving Average Convergence Divergence)

Analysis of Sentiment Indicators

Sentiment indicators reflect the mood or psychology of market participants. This can include surveys, market indices, and other measures like the VIX (Volatility Index).

Example of Sentiment Indicators

    graph TD
	    K[Sentiment Indicators]
	    K --> L(Market Indices)
	    K --> M(Surveys)
	    K --> N(VIX - Volatility Index)

Cycle Analysis

Cycle analysis aims to identify recurring cycles in the market, which could be related to economic factors, seasonal effects, or other repeating patterns.

Example of Cycle Analysis

    graph TD
	    O[Cycle Analysis]
	    O --> P(Economic Cycles)
	    O --> Q(Seasonal Effects)
	    O --> R(Other Repeating Patterns)

Support and Resistance Levels

• Support level: The minimum price level where demand generally exceeds supply, preventing further price decline.
• Resistance level: The maximum price level where supply exceeds demand, preventing further price increase.

Chart Formations

Chart formations reflect behavioral patterns that recur and signify trend reversals or continuations.

• Reversal Patterns: Signals a sizable advance or decline in prices (e.g., head-and-shoulders formation).
• Continuation Patterns: Indicate a pause in the trend with likely future continuation.

Head-and-Shoulders Formation

Visit Investopedia: How to Trade the Head and Shoulders Pattern

Symmetrical Triangle

Visit Investopedia: What Is a Symmetrical Triangle Pattern? Definition and Trading

Quantitative Analysis

Quantitative analysis relies on statistics and tools like the moving average. A moving average smooths out price data by creating a constantly updated average price.

Calculating a Moving Average

Buy and Sell Signals

• Buy signal: Occurs when price breaks through the moving average line from below.
• Sell signal: Occurs when price breaks through the moving average line from above.

Sentiment Indicators

Sentiment indicators measure investor expectations. Contrarian investors use them to anticipate market moves by acting contrary to the majority.

Example of Sentiment Indicator

A service showing 80% bullish sentiment likely indicates an overbought market, suggesting caution.

Cycle Analysis

Cycle analysis forecasts market movements’ timing, assessing various cycles:

• Long-term cycles: Exceeding two years.
• Seasonal cycles: Per one-year period.
• Primary/intermediate cycles: 9 to 26 weeks.
• Trading cycles: 4 weeks.

Key Takeaways

• Technical analysis helps in forecasting price trends through various tools.
• Use Chart Analysis for visual representation and Quantitative Analysis for statistical smoothing.
• Sentiment Indicators offer contrarian investment insights.
• Cycle Analysis helps pinpoint movement timings.

Frequently Asked Questions

Q1: What is a support level in technical analysis? A: A support level is the price point below which a security does not fall as demand exceeds supply.

Q2: What does a head-and-shoulders formation indicate? A: It indicates possible trend reversals, either topping out in a bull market or forming a bottom in a bear market.

Q3: How is a moving average calculated? A: A moving average is calculated by summing up closing prices of a given period and dividing by the number of periods.

Q4: How are sentiment indicators used? A: Sentiment indicators gauge investor sentiment, often used by contrarian investors to predict market movements by taking an opposing view.

Q5: Why is cycle analysis important? A: Cycle analysis forecasts the timing of market movements and differentiates them for effective trading strategies.