Tips on Technicals - Let the Market Talk
Most beginning technical analysts, and probably a few experienced ones, look at a chart with preconceived notions about what the market will do. This usually narrows the analysis and often provides incorrect results. The theme for this chapter is "you cannot impose your will on the market." The market will always tell you what it is doing. The secret of technical analysis is to wait for the market to talk before trading and continue to listen in case it changes its mind.
Finding order
Some charts, like those of the major stock markets, seem to travel up or down for long periods of time. Finding the trend there is easy. Figure 1 shows the long trend in the US stock market interrupted in 1994 by a well-defined triangle consolidation pattern. A breakout from the pattern gave a very obvious signal. Late in 1995, a small down flag occurred followed by a push towards new highs.
The Australian Dollar, Figure 2, moved both higher and lower against the US Dollar for the full 7 years on the chart so finding a relevant trend is a little more difficult. The first thing to do is to find short-, medium-, and long-term trends. From 1989 through 1993, the decline in this market was resisted by a well-defined trend line (A). When it was broken to the upside in 1994, a new long-term trend began (B).
However, this supporting trend line was broken in 1995 as the market fell from 77 to 71 cents. Looking back, the 1994 rally could be considered an accelerated medium-term rally within a more sustainable long-term uptrend.
This really cannot be determined with reasonable certainty until the market breaks the 1994 high, thereby validating the new long-term uptrend line (C).
Making a trading decision
Given that the market is an long-term uptrend, the next step is to determine support and resistance. There is a long-term horizontal support line from the 1989 and early 1992 lows (not drawn). The intermediate-term uptrend line from the 1995 low (D) successfully supported the rally several times. Further confirmation comes from a momentum indicator, such as the Relative Strength Index (RSI), which is more bullish than bearish on daily charts (not shown).
The next step is to determine resistance. The reason to do this is that it establishes a likely price target which is critical in determining the risk/reward scenario. Should the major resistance be only a short distance away, it would be prudent to wait for that level to break rather than risk that it does not break. The latter event could send the market down to major support and a significant loss.
Resistance is relatively easy to spot at the late 1994 highs near 77.80 cents. Confirmation comes from the top of an intermediate trading channel (E) which will cross that peak in the near future. When a trading channel bottom successfully holds, the likely price target is the top of the channel.
The final step is determining your own trading horizon. A position trader, holding a position for several days to several weeks, might buy at this point. A day trader or short-term trader would look at a shorter time frame, such as hourly (Figure 3), to find the best entry point. The chart shows that RSI has fallen somewhat and the market has traded sideways from the channel top to the channel bottom twice already during this short-term move. It might be better to wait until the market reaches the channel bottom before buying. In fact, a break of this channel might actually become a short-term sell signal within the intermediate-term rally.
Summary
The market reveals many things as the data are manipulated through various times frames and spans. Once the overall direction of the market can be found, trading decisions can be made in line with your own trading style. The secret is to let the market talk. If you have difficulty finding trends, it is better not to trade than to force trend lines and patterns onto the chart. The market usually does the opposite of what you would expect.
