11/06/2018 |

How Technical Analysis is Used in Both Trading and Investing

The finance industry loves to separate traders and investors, treating them as two separate things. That can mean different terms at the broker, different support, or even different approaches to evaluating the markets. But here’s the thing, while there are differences in how traders and investors assess risk and put money into markets, both in essence are trying to predict the future direction of the asset they are buying.

If you see traders using tools that can identify market direction accurately, why would you, as an investor, ignore them? You wouldn’t, which is why investors really should be looking at technical analysis more closely to stay ahead of the game.

Types of Investors

Let’s start with investors and what they are seeking to do when buying into a financial instrument or asset. The obvious answer is to see the investment increase in value, but there are different ways to achieve this, and these are seen as different types of investment strategies or styles.

There are 4 distinct styles of investing, these are:

  1. Growth: Here, investors are looking for businesses that show the potential to grow faster than the market. This can be small companies or large organizations, and that growth can come from market domination to market changing innovation.
  2. Value: A value investor is looking for businesses where the stock is undervalued compared to the financial performance of the business itself. This could be for a variety of reasons, from high dividend payout ratios to having brand image issues, but crucially, the underlying financials and technical indicators show continued success.
  3. Momentum: While the traditional ‘buy low, sell high’ approach has stood the test of time, momentum investors look instead to find businesses that are already outperforming the markets. The idea behind this is that success breeds more success, and the good results will keep coming, investors riding that momentum to profits.
  4. Income: An income investor is looking for businesses that reliably provide high dividends. This can be a great option for those seeking to enhance a fixed income, as they provide a regular yearly payout without having to divest from the stock. Utility stocks are a popular option for this type of investment.

It’s important to remember that like traders, investors often look at more than one, or even all styles to manage risk and create a growth strategy that delivers on their goals.

Trading Versus Investing

Clearly defining investment or trading is not as simple as some would suggest, and in some cases, the lines between the two can blur significantly. Essentially, an investor is seeking to grow their investment by choosing the assets they buy carefully and then holding them for an extended period. As we have discussed, there are several approaches to building wealth as an investor, but the basic principle applies to them all.

A trader, however, buys and sells with more frequency, looking for assets of various kinds, from stocks to currencies, seeking to grow their wealth at a much faster rate. An investor may see 10% per annum a good return, a trader could be aiming for that every month. As with investing, there are various approaches to trading and three of the most popular styles are explained below.

1. Day Trading

The trader looks for very short duration trading positions that seek to make profits within the day, often in just minutes. These trading choices can be driven by fundamentals, such as government financial announcements, or technical analysis, such as support and resistance levels.

Figure 1: This image represents the time frame chart that a day trader would likely be looking at. In this chart, the FB 1-minute candle is getting close to breaking out of a symmetrical wedge which is something they may try to trade for a quick 30 cents to the previous high above shown on the chart. 

2. Swing Trading

Here traders seek to ride the momentum of the market, buying on an uptrend, selling on the downtrend. These trades can last a few days or even weeks, and they use technical analysis to identify trend strength and likely turning points.

Figure 2: This image shows the FB daily candle with a very strong downward sloping price channel. In this case, a swing trader could have traded the channel support up to the SMA (20) which is shown by the green and red circles above. 

 

3. Position Trading

Here is where trading and investing can blue a little. Position traders look for long-term trades that can last months or even years, to make their profits. Choosing low-risk instruments that gain over time, using a mix of fundamentals, such as the historic business performance, and technical analysis, again, support and resistance, long-term trends and so on, to identify potential trades. Position trading can seem very much like investing. However, there is one key difference that position trading has in common with all trading styles, and that is, unlike, investing, traders seek profit in markets that are trending downwards as well as rising.

Figure 3: This image shows the FB weekly candle chart which is what a “position trader” may be looking at. The position trader may use the shorter term charts above to look at entries on a longer-term trade. In this chart, Facebook is more oversold than it has been in 5 years on the RSI and is also trading right at the channel support that acted as a hard support in the past. 

Investing Long-Term

Long-term investing, whatever style it may be, requires a lot of planning. Buying a stock or other asset in the hope it will simply rise in value over time is not going to be successful over the long-term. While traditionally fundamentals of a business have been the deciding factor, you can never have enough data when making investment choices. Technical analysis offers further insight into any investment vehicle by looking at price conditions rather than how the company is actually doing on the balance sheet.

Figure 4: This is a technical chart of the SPY showing historically oversold conditions that did represent times to buy the dip in the SPY over the longer term. The number 1 on the chart represents the price falling right below the channel support and price nearing the next level of trendline support below. Numbers 2-4 show the lower indicators becoming historically oversold and the MACD nearing new lows which could suggest this time may not bounce back as quickly as the previous technical bounces. 

 

Technical analysis is not just a way to confirm other analysis about a potential investment, it can also provide continued analysis of the performance of the stock or asset throughout the investment, highlighting any potential underlying weakness or strength in the asset. In that way, a long-term investment becomes a more controlled, active approach, rather than a sit and wait-to-see-what-happens style that investing is often, wrongly, viewed as.

Technical Trading

Technical analysis really began with Charles Dow. Not only did he found the Wall Street Journal, but he created the Dow Jones Industrial Index, which he used for articles explaining how patterns of highs, lows, and averages over time explained market events. However, Dow only looked at history, fitting chart analysis to events that had taken place. It was William P. Hutton who first used chart analysis to predict future market behavior. The concept of technical analysis may be known as Dow Theory, but it was Hutton that really defined what it meant. Hutton was able to call the 1929 crash using his analytical approach, as far back as 1927, but was largely ignored.

Figure 5: A photo of Charles Dow. Click here for the source of the image. 

Through the work of those who flowed, notably Robert Rhea, Edson Gould, and John Magee, technical analysis matured rapidly. By 1950, institutional traders and investors were using technical analysis as part of their strategies. However, at that time, technical analysis was a laborious, manual operation, every calculation, every plot on a chart being calculated and drawn by hand. While that period between the 1920’s and 1950’s saw the birth of technical analysis, and many of the analytical approaches we still use today were defined in that period, it is perhaps the easy availability of computers that is the landmark in technical analysis history.

Figure 6: The TrendSpider chart below is an example of how computers have revolutionized the way technical analysis is performed as well the speed at which it is done.  In this chart, the 120-minute Bollinger Band is overlaid on the 60-minute chart with an alert set to trigger if price closes within that purple area. To learn more, click here. 

Today, with simple to use charting software, and even web-based charts that don’t even require a software install and can be viewed on a mobile device, anyone can make use of the most advanced technical indicators in just a few clicks. That accessibility Has transformed how traders and investors can make informed decisions about their investments, with powerful tools that were once restricted to large institutions employing hundreds of analysists now available on your smartphone.

Technical Trading Strategies

Of course, having access to trading strategies and understanding how to use them most effectively are two different things. Hedge funds and others seek to minimize risk while maximizing investment performance, and while technical analysis has in recent years been closely associated with short-term trading that has not always been the case. In fact, due to the manual nature of analysis before computers, it really was only used in long-term investing to begin with.

Hedge funds use technical positions to mediate risk and exposure in both short- and long-term trading strategies. This is achieved in two ways:

Long/Short Positioning: Here the fund will analyze the market for stocks that are overvalued or undervalued, to trade. To minimize the risk of a trend going against them, they will have a planned exposure. This could be 75% in long positions, and 25% in short positions, giving them a total net exposure of 50%.

Market Neutral Positions: This takes the long/short strategy further, always seeking 50% long and 50% short positions within the portfolio for a 0% net exposure to market movement.

Technical analysis strategies

There are a few ways to incorporate technical analysis into your investment and trading strategies, these include:

1. Trading The Trend

Technical analysis is very useful for identifying trends. While traders tend to think of trends lasting days or at most months, by examining longer timeframes, you can establish trends that last years in the same way. As a strategy for both the short and long term, this approach is used by traders, hedge funds and investors alike.

Figure 7: This image shows the weekly MU chart over five and a half years. The trend here shows a two-year rally followed by an 18-month selloff. A position trader could have made money on both sides playing this trend. 

2. Trading the Price Channel

Support and resistance lines are some of the most commonly used technical indicators beyond trends, and highlight areas where markets are likely to change direction or break out of a range. There are many ways to establish support and resistance levels including Fibonacci levels and basic chart analysis.

Figure 8: This image shows a very strong downtrend on the FB daily chart. If a swing trader was looking to trade support and resistance levels, they could do so once the support and resistance levels had been established and a price channel had formed (shown by “1” and “2”). The green and red arrows show where the swing trader could have made money trading to top and bottom of the channel. 

3. Volume-Based Trading

Trading volume around a specific market move or trend can be a good indicator to the underlying strength and whether it is likely to continue or see a direction change, it is a key analysis that enhances the accuracy of other technical analysis.

Figure 9: This image shows how a trader looking at volume could have taken advantage of the SPY continuing down to test channel support (shown by the green circles) after the large uptick in selling volume in the middle of the channel. 

4. Trading Candlestick Chart Patterns

In most forms of trading, the candlestick chart patterns, from head and shoulders to engulfing patterns, are part of a trader’s strategy to understand market direction. They can be used with surprising accuracy to predict future direction. Being able to apply them to all timeframes, including yearly charts and beyond, meaning that they can be used for extremely short-term trading as well as long-term investing alike.

Figure 10: This image shows the TrendSpider “Pattern Recognition” feature picking up the bullish harami setup on the SPY weekly candle. Technical traders use these candles to look for areas of supply and demand based on how they close. To learn more about candlesticks, click here. 

Conclusion

In conclusion, technical analysis was for a long time out of reach of individuals and small traders and investors, but today any of us can access these tools simply and easily, often at no cost. There is a reason hedge funds and successful investors still use these tools today, because they provide a significant aid when making investment decisions, and as a result increase success rate.

Whether you are a trader or investor, or even both, technical analysis is accessible, effective and should be part of your approach to any investment decision.