Tips on Technicals - Technician's License
The debate continues on whether Technical Analysis is an art or a science. Those of the latter belief work with equations, trading systems and models. Those of the former belief use trend lines, traditional technical patterns and an experienced eye. Just like writers who use journalistic license to bend the rules of grammar and facts, market technicians selectively ignore various chart points, to create a meaningful and, more importantly, useful analysis.
Rationale
Strict interpretation of technical rules can cause the technician to set seemingly accurate support and resistance levels that are weak and unrelated to true market conditions. Figure 1 below shows 350 days of LME Aluminum. At the 1740 level, a former support line has turned to resistance. However, it is unclear which exact price should be considered significant. The June low is 1738. In September it was 1730. In October, the highs were 1746 and 1737.
Spending too much time deciding which price to use in a trading system or model can let profitable trades slip away. The line drawn is at 1738 but can really be represented by a resistance zone of 1737 to 1748. When using a single price, extreme intraday reactions can be ignored and this automatically places greater significance on multiple price occurrences in the market analyzed.
The October - November support line is clearer at about 1655 but that means that at least two bars had penetrated support. These points can be ignored so that we may set up a support line that has been touched five times and is therefore a meaningful level.
Best Fit
Unlike regression analysis where a line is drawn to represent all the data, a trading channel places support and resistance trend lines at levels that correspond to the majority of the significant highs and lows. The Aluminum chart shows a short-term up-channel in mid-1995 with a technically precise support line (channel bottom) but a parallel resistance line (channel top) that has been penetrated at least one time. The channel top shown touches the tops of the bars on at least three occasions and is much more significant than a channel top drawn through the extreme top in May.
Similarly, the longer-term down-channel of 1995 shows a parallel channel bottom that touches three points while ignoring an extreme low set in February.
Figure 2 above shows 150 days of January 1996 NYCE Orange Juice futures. In mid-1995, a long-term downtrend was reversed and Orange Juice rallied in a clear channel. Strict adherence to the rules of trend line construction would have dictated that the supporting trend line be drawn from the market bottom through the first significant retracement (correction). That trend line, shown dotted, would be essentially meaningless. By using the next significant low as the start of the trend line, not only can a meaningful trend be identified but a resisting channel top can be added to contain the rally. Note here too the channel top was violated by an extreme trading range day but still touches price action a significant number of times.
