Investment Analysis can be divided into two basic types: Fundamental Analysis and Technical Analysis. This section will discuss the important issues in understanding Technical Analysis. With the aim of predicting future trends, Technical Analysis incorporates price charts and/or technical indicators for analysing previous trends to predict future market prices.
Before delving into Technical Analysis applications and techniques, investors should understand the following assumptions.
1. Price reflects all market behaviour.
2. Prices will occur in patterns.
3. History will continue to repeat itself
Three Major Analysis Techniques:
1. Candlestick Charts
2. Chart Patterns
3. Trading Indicators
Trading Indicators are used in Technical Analysis as an analytical tool which utilizes specific mathematical equations to calculate and analyse price movements. In response to market environment, various analytical tools can be modified accordingly with other tools in order to help investors develop strategies and determine the best trading opportunity. There is a great variety of trading indicators and the most popular indicators include Simple Moving Average (SMA), Relative Strength Index (RSI), Stochastic (STC) and Directional Movement Index (DMI).
Simple Moving Average (SMA)
Moving averages are usually used to show the mean price over a certain number of previous prices. For example, a 10-bar simple moving average of the closing price would show the mean closing price from the most recent 10 bars. Moving averages can also be applied to other data such as volume or other indicators, but are most commonly used in prices. There are several different types of moving averages which are all slightly calculated in different ways, but they all have similar smoothing effect on the data, so that any unexpected price changes are removed, and the overall direction is shown more clearly.
Moving averages can be used to identify a trend by using the slope of the average (or lack of slope in a ranging market). They can also be used in trend trading systems to enter and exit trades by waiting for the price and moving average crossovers, or for multiple moving average crossovers.
Relative Strength Index (RSI)
The Relative Strength Index (also known as RSI) is a momentum indicator which was developed by J. Welles Wilder in 1978. It is calculated by using the price, and is used as an oscillator showing the overbought and oversold levels. The RSI compares the upward price movement with the downward price movement over a specified timeframe, and displays the result as a momentum line oscillating between 0 and 100.
The RSI can be used in both ranging and trending markets, and therefore can be used in several different ways. The RSI can be used to identify an overbought level when it is above 70, and an oversold level when it is below 30. The RSI can also be used as a divergence indicator, with entries based upon the divergence between the RSI and the price bars.
The Stochastic Oscillator (usually known just as Stochastic) is a momentum indicator that was developed by George Lane in the 1950s. The Stochastic Oscillator is based upon the theory that prices move in waves, which means moving back and forth between an overbought level and an oversold level (even in strong trends). The Stochastic Oscillator is usually displayed as a stochastic line, and the signal line is the moving average of the stochastic line.
As the Stochastic Oscillator is both a momentum indicator, and an overbought / oversold indicator, it can be used in both trending and ranging markets, and can be used in both short and long term timeframes. There are several ways to interpret the Stochastic Oscillator during trading. One of the most popular ways is to enter a long trade when the stochastic line crosses above the signal line, and enter a short trade when the stochastic line crosses below the signal line. A common variation of this technique is to only make entries when the crossover occurs below or above specific thresholds (usually 30 and 70).
Directional Movement Index (DMI)
The Directional Movement Index (also known as DMI) is a momentum indicator which was developed by J. Welles Wilder. It is calculated by comparing the current price with the previous price range and displays the result as an upward movement line (+DI), and a downward movement line (-DI), between 0 and 100. The DMI also calculates the strength of the upward or downward movement, and displays the result as a trend strength line (ADX).
The Directional Movement Index can be used in both ranging and trending markets. In general, when the +DI line is above the -DI line, the market is moving upwards, and when the -DI line is above the +DI line, the market is moving downwards. The ADX line shows the strength of the move, and the market is considered to be trending when the ADX line is above 30, and ranging when the ADX line is below 30. There are several trading systems using the DMI, so there are several alternative uses of both the DI lines, and the ADX line.