By Damon Callaghan – It’s Monday night, 1:29am. The European market is about to close, but the New York market has a long five and a half hours till the 24-hour trading day ends – this is the foreign exchange market. Never in my experience trading currencies, have I spent so long staring at a computer screen, watching a chart tick up and down, trying to understand where the price is going. In fact, I’m not alone – thousands of traders, analysts, academics and businessmen spend hours, days, even weeks, trying to understand certain price movements in the financial markets. Some would even argue that analysing these markets is one of the most complex challenges that one will encounter in their career.
Technical Analysis and Fundamental Analysis
Financial market analysis can be viewed in two segments: technical and fundamental analysis. Most traders and analysts find that they favor one method over the other, however, they usually concur that both are complementary.
Fundamental analysis aims to help traders find the true value of a financial instrument, determine if it is either overbought or oversold and make their trades accordingly. It’s process is to survey the components that affect the supply and demand underlying a financial instrument, in order to define price direction. Fundamental analysts use economic calendars, companies’ accounting data and other information to make sense of price direction.
For example, when the recent mining tax was announced in Australia this year, many resource and mining companies saw its negative implications for net income, causing them to threaten Australia’s economy by potentially moving business operations overseas to avoid the tax. Many fundamental analysts would have shared this same view, bidding down the price over several weeks for many publicly-listed mining companies on the ASX (BHP, ABY, LEG), as the mining tax would have decreased the intrinsic value of the companies’ shares.
However, technical analysis focusses more on understanding market sentiment and its relation to price movements – it addresses the issue that a financial instrument’s price represents much more than it’s intrinsic value. Sometimes, financial instruments don’t move the way they are expected to, given their true value. This is because the market is not always rational – it may take days or weeks for a fundamental price movement to occur.
For example, between 9 and 13 July this year, the AUDUSD currency pair was trading in a tight range. From a fundamental perspective, this is not how the price should have been trading – it was expected that the Australian dollar was going to rise due to a mortgage rate rise favorable to the currency. However, it took four days (this is a long time in foreign exchange), since the rate rise, for the AUD to break out from the range and rise to a nine-week high, which was mainly due to poor US retail sales data.
The role of technical analysis is to gauge price movements like these. Many traders argue that the primary price direction of a financial instrument can usually be determined by fundamental analysis. However, technical analysis is important in understanding price movement – it uses patterns, designs and mathematical methods to make sense of price movement, even when the market isn’t acting rationally.
Dow Theory
While many technical indicators that help traders buy or sell financial instruments deductively exist, it is important to understand that the foundation of technical analysis stems from the basic assumptions of Dow Theory.
Charles Dow was a cofounder of the Dow Jones Average (DJA) and the first editor of the Wall Street Journal. His editorials contained a plethora of ideas and principles that he believed were identifiers of price direction in the DJA as well as individual stocks. These ideas were later collated and interpreted by William Hamilton and Robert Rhea [1] shaping them into what is now know as Dow Theory.
Dow Theory declares that markets have three movements. The first movement is the primary trend – it is identified as the bull (upward) and bear (downward) markets that last for several years. The second movement is the secondary reaction – it is the movement of price in the opposite direction of the primary trend that lasts from three weeks to several months. In other words, it is a noteworthy decline in a bull market or a correction in a bear market. The third movement is the daily fluctuation in price, which rarely affects the first or secondary movements.
A major part of Dow’s analysis involved identifying whether a market was either bullish or bearish and determining when a trend had reversed. A bullish primary trend is illustrated by a chart with higher peaks [2] followed by higher troughs [3] whereas a bearish primary trend is distinguished by lower peaks followed by lower troughs. In most circumstances, the period in a chart between a peak and the following trough in a bullish trend and the period between a trough and the following peak in a bearish trend are secondary reactions. The daily fluctuations are small price movements that meet the supply and demand for stocks in a particular day that do not detract from the main direction of the primary trend.
Dow explained that there are two ways in which a primary trend can reverse. Assuming that the DJA is presently in a bullish primary trend, one signal that might indicate a trend reversal is a large decline that decreases below the previous trough. The other indicator may be the formation of a lower peak after a higher trough, followed by a lower trough. In comparison, a bearish primary trend would reverse either by a large upward correction that increases beyond the previous peak, or a formation of a higher trough after a lower peak, followed by a higher peak.
In Dow’s analysis, he predominately observed price movements in the DJA. However, he later split the DJA into the Industrial and Transport Averages and applied his analysis to both averages. Even though the majority of the application of his ideas was based on stock market averages, many analysts have found that Dow Theory’s assumptions are still very relevant in other financial markets, even when analysing individual instruments.
However, by translating Dow Theory’s principles to other markets, it is important to consider altering the time-based parameters to the relevant market’s time-frame. For example, in the following diagram, I have applied Dow Theory to make sense of EURUSD movements. Since the foreign exchange market is very liquid, a primary movement will usually last for weeks or months instead of years; a secondary reaction lasts for days till weeks at a time; and daily price fluctuations are replaced by hourly exchange rate fluctuations.
Dow Theory explains that three different phases exist within each primary movement. (see the brilliant explanatory diagrams at student 2 trader dot com).
Each of these phases explain the psychology behind price movement within a primary trend – they help to answer the question: why are the prices moving in this direction over this time period? For example, phase one in a bull market implies that traders and investors are reviving their confidence in future business, signaling the transition from bear to bull market. The following table gives a brief description of each of the phases:
An example of these phases is present in the recent price movement of the Dow Jones industrial average. As shown by the following diagram, Phase 3: Distress selling explains the March 2009 low in the bear market, leading to Phase 1: Reviving confidence, shaping a new bull market that has formed from this multi-year low.
Technical Analysis in Practice
However, the formation of a higher trough on 14 June (confirmed by the higher peak on 15 June), was the first indication of a reversal into a bullish primary movement. The EURUSD continued its bullish trend after completing a secondary reaction from 21 June to 3 July.
In this example, the role of technical analysis in trading becomes much clearer. Assuming a trader opens a position to go short [4] EURUSD at 1.2700, the formation of the higher trough on 14 June would be a good indicator to close out his position and take his profits. After this trough is confirmed by the higher peak on 15 June, it may even prompt the trader to open a small long [5] position around the 18 June trough.
Furthermore, even though fundamental analysis may dictate the primary movement in a weekly or monthly chart, in this scenario, it failed to validate the short term price movements that eventually lead the EURUSD pair to trade above the 1.2900 level, emphasizing the importance of technical analysis as a process that can make trading the financial markets profitable. druv4
Damon is well known for beginning the first online trading resource for students around the world, aimed to give free education about trading to all his readers. You can find this and more, mind blowing interviews with trading professionals at www.student2trader.com