Introduction to Trading Techniques-Technical Analysis, Fundamental Analysis, Trading System and Data Selection Criteria
The techniques applied by traders broadly fall into two main categories, technical analysis and fundamental analysis. The trading system that is described in this chapter falls under the technical analysis technique.
Technical Analysis
Technical analysis (TA) is defined as the study of market (price) action1 for the purpose of forecasting future price trends [Murphy 1986]. It is probably the most widely used decision making tool for traders who make multi-million dollar trading decisions. According to Davidson [1995], the Bank of England reported in its quarterly bulletin in November 1989 that 90% of foreign exchange dealing institutions uses some form of charting or technical analysis in foreign exchange trading with two thirds claiming charts are as important as fundamentals for short-term forecasting (intraday to one week).
He concludes that, since intraday traders account for 90% of the foreign exchange volume, technical analysis plays an important role in decision making in the market. One of the reason for TA’s popularity is that it forces a discipline and control on trading by providing traders with price and profit/loss objectives before trades are made. It is also a very useful tool for short-term as well as long-term trading strategies as it does not rely on any information other than market data. Another reason for its popularity is that, while its basic ideas are easy to understand, a wide variety of trading strategies can be developed from these ideas. Currently the major areas of technical analysis are:
1. Charting: The study of price charts and chart patterns; e.g. trendlines, triangles, reversal patterns, and Japanese candlesticks.
2. Technical/Statistical Indicators: The study of technical indicators; e.g., momentum, relative strength index (RSI), stochastic and other oscillators.
3. Trading Systems: Developing computerized or automated trading systems, as well as mechanical trading systems, ranging from simple systems using technical indicators with a few basic rules (to generate trading signals such as moving averages) to complex rule-based systems incorporating soft computing methods such as artificial neural networks, genetic algorithms, and fuzzy logic. The traditional trading systems are based on rigid rules for entering and exiting the market. The main advantage of these systems is that they impose discipline on traders using them to be discipline.
4. Esoteric methods e.g. Elliot Waves, Gann Lines, Fibonacci ratios, and astrology.
Murphy [1986] summarizes the basis for technical analysis into the following three premises:
· Market action discounts everything. The assumption here is that the price action reflects the shifts in demand and supply which is the basis for all economic and fundamental analysis and everything that affects the market price is ultimately reflected in the market price itself. Technical analysis does not concern itself in studying the reasons for the price action and focuses instead on the study of the price action itself.
· Prices move in trends. This assumption is the foundation of almost all technical systems that try to identify trends and trading in the direction of the trend. The underlying premise is that a trend in motion is more likely to continue than to reverse.
· History repeats itself This premise is derived from the study of human psychology which tends not to change over time. This view of behavior leads to the identification of chart patterns that are observed to recur over time, revealing traits of a bullish or a bearish market psychology.
Note:
1 Although the term “price action” is more commonly used, Murphy [1986] feels that the term is too restrictive to commodity traders who have access to additional information besides price. As his book focuses more on charting techniques for commodity futures market, he uses the term “market action” to include price, volume and open interest and it is used interchangeably with “price action” throughout the book.
Prof. Clarence N W Tan
Next: Fundamental Analysis
Summary: Index