Technical Analysis and Coverage Guide

The field of Technical Analysis (TA) is as broad and complex as fundamental analysis. The aim of this guide is not to give a full rundown of the field, the aim is to explain the logic behind the main approaches we will be using in our coverage. The short version of all the text below is that when using TA always try to remember the underlying logic that the method is attempting to capture, rather than get caught up in the minutiae of the measure itself, as this circular logic can get you get caught up in a tangle..

The main approaches we will be covering are in the table of contents below:

Table of Contents

Candles/Heikin Ashi

There are many different options for price action, from line, OHLC Bars, Candles and Heikin Ashi. Candles are the most popular method for many traders, although to assist in seeing the underlying trend we prefer Heikin Ashi chart types.

Heikin Ashi is the most appropriate measure for most charts as it takes the average of the previous period and graphically represents whether the move in the current period has been above or below this, by the colour. So it does not simply take the price action at the close of the previous period, the timing of which is somewhat arbitrary. As traders we really want to know what was the average price over the previous period. So the Heikin Ashi chart takes the data from a standard OHLC bar chart, while also showing you the underlying trend. Many of our charts will use the Heikin Ashi format, and this will be highlighted in the headline of the chart.

Trends

Some market participants question the very notion of trends. Below is a monthly chart of Halma (HLMA). So we believe the issue with Technical Analysis is not that markets can move in trends, as quite plainly then can, the issue is can you push this fact too far in your analysis? With this second point the honest answer is most certainly, yes. However it very important to point out that there are followers of Technical Analysis that simply follow the one basic premise of TA “The trend is your friend”, very profitably.

This one approach alone, used properly, can produce superior returns for the patient, over the longer term. Although with short term trends, or even intraday “trends” the use of this logic is more questionable, especially when used on its own.

When considering trends it is also very important to look at varying timescales, at least one up and one down from your current chart. So on a standard Daily chart for example, at the very least you should have a view on both the Weekly and Hourly trends. 

Trends Summary

Unless you are knowingly opening a Contrarian position always be aware of the underlying trend, and go with it. If there is no clear trend ensure you are using indicators and trading logic that works in a non-trending market. 

Moving Averages

Moving Averages are very simple technique. Moving Averages (MA) can be considered as being a rolling trend calculator. So using the Halma chart above, as the price action has been in such a strong bullish trend, the 21 period moving average on that chart is nearly a straight line higher, blue line on chart.

Beyond being a simple trend calculator the most common use of Moving Averages is with the Moving Averages Crossover. On the chart below we have drawn 20, 50 and 100 period moving averages, again on Halma, this time on the Daily time period. The Blue arrow highlights how in mid May, both the 20 and 50 day Moving Averages, moved up through the 100 period Moving Average.

In this case the 100 period MA was indicating a positive trend, as it was moving higher. When the short term moving averages have enough force to push up and through an already positive longer term MA, this is called a Golden Cross.

As mentioned above it is always important to remember what underlying logic the Golden Cross is highlighting rather than get caught up in the indicator itself. For a Golden Cross to occur the long term trend has to be positive (according to the 100 period MA) the medium term and short term trends also have to be positive and have to be accelerating to push up through the long term trend. Phrased this way it is clear to see that buying into markets under these conditions could be profitable for the long term.

Where TA can run in to trouble is when practitioners attempt to somewhat reverse engineer signals like this and suggest that every Golden Cross by definition has to be a great buy indicator, this is not true. Under the right conditions the Golden Cross and its bearish counterpart the Death Cross can be a great signals to keep an eye out for.

Momentum & Failure Swings

Momentum is another simple concept which can get over used and over complicated. Essentially it is a measurement of the rate of acceleration or deceleration of the price action. So staying with Halma, the chart below shows how price action moved up to post fresh highs in July. Which on the face of it sounds very positive. Upper Blue line on chart . But the Relative Strength Indicator (RSI) showed that the speed of the trend had slowed. Lower Blue line.

The RSI is one of the most widely used momentum indicators, with MACD also another widely used momentum indicator. The RSI oscillates between 0 and 100, and tends to stay within the 30-70 range. Moves above 70 are considered overbought, and under 30 oversold.

One of the most widely followed signals is the RSI Failure Swing. This occurred with the chart below. Price action posts a higher high, but the RSI (while overbought) fails to post a higher high. This creates a divergence between the price action and the momentum. Usually it is the momentum that is proved “correct” and price action needs to consolidate, as occurred in this case.

As with all TA signals it remains extremely important to remember the underlying logic this signal is attempting to capture, as you can spot RSI Failure Swings everywhere if you look, but that DOES NOT mean that the underlying logic it is attempting to capture is everywhere.

These signals are just that signals, and you need to do more digging before you can be sure that the signal is accurate.

Volatility

Volatility measures the historic dispersion of price action around its mean. There are numerous mathematical ways to calculate this and many ways to visualise this on a chart. Perhaps the easiest to grasp is the Bollinger Band, or with Linear Regression channels.

Sticking with Halma, and the Daily chart below, the 20 period, 2 Standard Deviation Bollinger Band is calculated. The Bollinger Band can be considered to be the normal distribution range of the historical data around its mean. A two standard deviation band is mathematically drawn to capture 95% of the price action.

Meaning that “if things stay broadly the same”, big if, but if things stay broadly the same it would be fair to assume that future price action is 95% likely to remain within this band in the near term.

So had you monitored the RSI Failure Swing above, but did not place the short trade, then you saw Halma post support numerous times around the 1980 level, Blue channel, it would have been fair to assume that if things stay the same, there was a 95% chance price action would remain in the channel and therefore give you a profitable trade to buy the stock at the Blue arrow, at around 2000.

As we see, in August there was a break lower, this could have stopped you out. What would you say to yourself at this point? “That was so unlucky” or “there was always a one in twenty chance that was going to happen”. Traders say the latter, punters say the former. Had the price dropped down to 1700 then you could consider yourself unlucky, but a move to 1830 was always possible, 19/20 outlier yes, but not a true longshot. Volatility measures, whichever one you select, attempt to show you what ranges it would be fair to expect in the days ahead, which understandably is crucial.

Another method we frequently use is Linear Regression with standard deviation channels. This is a mix of Trend analysis and Volatility. In that it automatically calculates the trend of the data being analysed, and then throws up a channel around that, based on the volatility (standard deviation) of the price action.

Hopefully you can also start to see how, combining signals and approaches from Trends, Moving Averages, Momentum and Volatility can give more profitable trading strategies.

Fibonacci Retracements

This is another technique where it is pivotal you understand what the underlying logic the method is attempting to capture.

The Covid pandemic created a perfect scenario to describe this. In February 2020 the FTSE 100 was trading around 7600, then news broke of a pandemic which threatened to be as serious as the Spanish Flu, which wiped out over 50 million people. The index understandably collapsed to be under 5000 within a matter of weeks.

At this point how do we forecast price action? Prices have just obliterated support levels that have held for the previous decade. If the pandemic is as bad as the Spanish Flu the global economy will be decimated and 5000 is a fair price with future losses expected ahead, if it is not the Spanish Flu and Paracetamol is found to be an effective cure then we can expect to be back at 7600 very quickly. So at these lows a simple but effective first guess is to take the mid point of this previous significant move, 6300 in this case. The 50% Retracement level.

Can we be confident that price action will immediately snap back to the 50% level, no, does this 50% level suddenly get bestowed with some mystical magical powers, no. It is simply stating that all things being equal it is the mid point of the chaos that has just ensued, and so is a decent place as any to start.

As this 50% level is so vague and is just a mid point of the previous range it is standard practice to throw a range around the 50% level. Traditionally this is 61.8% and 38.2%. 

What then often occurs, as seen by the FTSE 100 through the summer of 2020, is that price action does recover to the 50% area, and does then get contained within the 61.8%-38.2% range around the 50% for the medium term.

So at the time of writing December 4th, 2020, the FTSE is nudging up towards the 61.8% level at 6626. Moves above here suggest that the UK market is pricing in a full Covid 19 recovery and this immediately opens up the serious upside target of 7600, the previous highs. That is the logic of retracements. They can help to describe the underlying market after a significant market move, these levels by themselves do not drive market action.

This is where TA can get into trouble, when practitioners start to act as if the technique drives the markets, rather than simply describing the underlying situation. “Pure” TA practitioners are only concerned with the price action. In this sense we are not “True” Technical Analysis practitioners, as we use a blend of TA signals in combination with fundamental analysis and market awareness to guide our decisions, and use TA when we believe it provides justifiable and understandable support and resistance levels.

Pairs, Ratios and Alpha's (α)

Above we outlined how it is essential that you are aware of the trend, over all timescales. it is also imperative that you are aware of the trends and relationships the asset has with other more dominant markets and how Pairs and Alphas come in to play.

Below is a Daily chart of the FTSE 100, candles chart , with the S&P 500 price chart overlaid in grey. Over this timescale you can see how the two indices move in lock step.

However when you zoom out of this chart , as per the lower image below, it becomes clear that the S&P 500 has considerably outperformed the FTSE 100 over this period, trading up to fresh all time highs, while the FTSE remains well under its all time highs. To trade the FTSE 100 or even any FTSE 100 individual stock without having an appreciation o the relationship with the more dominant S&P 500 and its trend, is a making your life much harder than it needs to be.

For shorter timeframe positions, less than three months, always have a view on the dominant markets to your position. In equities for example, the S&P 500 is king, if you do not have a view on this index when you are trading any global equity frankly you are trading blind.

Alpha's (α)

Alpha trading is an advanced technique, and the positions are often denoted by the Greek letter alpha. α. As discussed above in the near term much of the price moves in equity prices are a direct result of the moves in the parent index, not on any company specific moves. Most novice traders assume, incorrectly, that when they buy RSA Insurance for example, they are getting exposure to moves related specifically to RSA. When in fact most of the moves in the short term can be explained by the moves in the wider market. . This mathematical relationship is called Beta. Many of the FTSE 100 stocks have a Beta that approaches 1, which means that on average if the FTSE 100 Index gains 2% in a day, then the stock will gain 2% on that day, on average. At the time of writing December 2020 RSA for example has a beta of 1.21. Meaning the majority of its near term moves can be explained by the moves in the FTSE 100.

Many amateur equity traders fail to grasp this point, and trade the individual stock purely on the individual stock story. Then when in the short term the stock moves are mostly dictated by the wider market the amateur trader gets confused. It is not possible to trade major listed companies in the short term without having a very strong view of the wider market, as that is a large part of what you are getting exposure to, in many cases it is even the majority of what you are getting exposure to, in the short term.

Over the long term the “Alpha” of the position has time to work out, so over the long term, Amazon has outperformed the S&P 500, in the near term the two markets will seem to move very much in line.

So what do you do if you want short term exposure to the Alpha, not the Alpha AND Beta?

Simple you buy the stock and then sell an equal amount of the parent index. Now you have exposure to pure Alpha. This approach also has the advantage of stripping out much of the wider market noise. So on the Covid pandemic for example, below is a chart of Apple divided by the S&P 500 over 2020 (the Apple alpha) and under that is a normal chart of Apple. The Covid crash barely appears, the Apple alpha dropped 11% over this period, as the pandemic largely affected Apple and the broader index the same, Apple’s share price over this period however dropped 35%. 

So trading the Apple alpha over this period gave you exposure to Apple’s expected outperformance of the wider market, but insulated against much of the market volatility.

*Bonus Pro Tip

For those wanting to replicate this chart, on their own free Tradingview profile, the code we used is (NASDAQ:AAPL*100/TVC:SPX). This way the Apple share price is multiplied by 100, this makes the Y axis more “readable” as it is a whole number. Without this multiplication function the Y axis on ratio/pairs and Alpha charts can often look quite confusing depending on the prices of the individual markets. Also Alpha trades at Research Squared are usually closed out on an end of day basis, not intraday, due to the complexity of subscribers gaining live intraday Alpha prices. 

We are not an affiliate of Tradingview.com and do not get paid for referrals, we simply believe that this is the best free Technical Analysis platform out there and so we our happy to recommend it to anyone interested in Technical Analysis.

Apple Alpha only dropped 10% from Covid in March 2020

Apple: dropped 35% ($81 to $53) from Covid in March 2020

Pairs Trading

Pairs Trading is another advanced technique and similar to Alpha’s it relates to the simultaneous buying and selling of two assets. But while an alpha relates to an asset versus an index, a Pairs Trade relates to one asset to another comparable asset, such as Tesco/Sainsbury, Gold/Silver, Brent Crude/Heating Oil, or even Nasdaq 100/S&P 500.

Like an alpha this has the advantage of being largely market neutral, stripping out much of the wider market volatility and focusing on the pure outperformance of one asset versus another. There are times when this is an exceptionally attractive strategy to follow.

Summary

We do not ‘believe’ in Technical Analysis, in the way that some practitioners do. We simply have decades of experience that demonstrate that on occasions, and when signals are blended properly, and when combined with basic market understanding, Technical Analysis can help improve profitability in trading. That is it, there is no magic to it beyond that, sorry!

It is most comparable to card counting in Blackjack. The house edge in Blackjack in normal play is around 0.5% The successful card counter can move this edge in their favour, so the game is then around 0.5% in their favour. That is it, no more than that. But that is enough to make a great deal of money in the long run with sound money management. Technical Analysis can give a comparable small edge, with sound money management and over the long run it can be profitable, sometimes very profitable. But like card counting it sounds simple and many try it, but the vast majority fail as simple does not mean it is easy.

You are most welcome to sign up for any other service that promises riches or access to “the great market secret”, that is not what we are selling here. We have a strong understanding of the markets, both fundamentally and technically, and using the basic principles of both we look to flag up potentially profitable positions.

Please feel free to contact us at any time, via the contact form in the menu, if you have any questions about our approach, or any other point you feel we may be able to help you with, please get in touch and we would be happy to assist wherever we can, and all the very best with your trading.

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