Different types of technical analysis

I like to think that the risk of each range of investment products is the same, like I mentioned in an earlier article on technical stock analysis. Each share has the same (high) risk level and savings on bankaccounts have a low risk level. Allthough the risklevels are the same within ranges of investmentproducts, this does not mean that the risk of each share is the same at every point in time, based on the price-earnings ratio or dividend yield. Expensive shares do have a higher risklevel and a lower chance on a high return. Another method that is often being used to determine the risklevel and possible return is technical analysis.

Trend defines risk and return

Determining the trend of a share is the most important purpose for technical analysis. When a trend has been identified, the possible upward or downward space of a share can be determined. The risk and return can be extracted from this movement space of a share. To be complete: when a trend shows a lot of space for downward movement, the risk and possible return can be turned around by going short. Lots of downward movement space can result in a positive return.

Not all types of technical analysis are useful. To understand technical analysis well, I make a division of different types of methods for technical analysis. I also discuss the usefulness of the technical analysis and the goal of for which the method can be used.

Objective versus subjective technical analysis

The first division that can be made, is the division between objective and subjective technical analysis. Looking at a chart of a share and trying to make something up from this chart is subjective (or interpretative) technical analysis. The interpretation of the chart depends fully on the person who is looking at the chart. One technical analyst trying to interpret the chart can draw a totally other conclusion from the chart than his colleague who sits next to him (or her). An example of 'chart-viewing' and a possible conclusion is the head-shoulder pattern. An analyst can see this pattern, while another analyst can interpret the same chart as an up-going trend. Both can be right, but not at the same time for the same chart.

Objective (or mathematical) technical analysis cannot be interpreted in a different way by different persons. The basis of objective technical analysis are fixed numbers, like the price, or fixed calculation models, like the moving average. Formulas for objective technical analysis are agreed upon by scientists and investors, so no difference in interpretation between different technical analysts should be possible.

Because objective technical analysis is measurable and objective, this is the most useful type of technical analysis. In my opinion, subjective technical analysis is only useful for people who only want to look at pictures.

Indicator versus price driven

Objective technical analysis can be split up into to types of technical analyses, namely indicator driven and price driven technical analysis. Both types are well applicable and are widely used and can be used in combination, because both indicator driven and price driven technical analyses have different purposes. The indicator driven technical analyses is based on indicators and the price driven technical analysis is based on the price of a share. The ultimate purpose of technical analysis is determining the risk and possible return of investments, and indicator and price driven technical analysis can help you with that.

When the price driven technical analysis is used, the resistance and support price levels of a share are important. The closer the price of a share approaches this line, the less possible movement space of the price to that line exist. The chance of a counter-movement keeps on growing when the price approaches the support or resistance line.

A logic of the resistance and support lines can be found. Each time a support or resistance line is not broken, the support or resistance price level gets stronger. Investors get more and more convinced of the reality of the resistance or support and will use this information in their trades. When a resistance level is reached, investors will not buy the share any more, but want to go short in this share. This is why a resistance will not be broken easily. Of course the possibility always exists that a resistance or support will be broken. This should tell you that using the resistance and support levels can lower your risk, but a certain level of risk will always be present.

The indicator driven technical analysis uses trends that are present in the progress of a share. Upward and downward trends, as well as turnarounds in trends, can be recognized using indicator driven technical analysis methods. An example of an indicator driven technical analysis method is the 200-day simple moving average. With this indicator, the trend of a share can be found. In a next article I will discuss the most important and used indicator driven technical analysis methods.

Turnaround of the trend or correction

Besides determining the risk and possible return, technical analyses can also be used to identify a correction or turnaround in the trend. When a correction takes place, you really would like to know what the possible size of this correction is. Past data provides us the knowledge that the size of a correction often shows a back test of 38, 50 or 62% of the trend. I will give an example: When a share has shown an upward trend in which it advanced in value from 50 to 100 dollar, the correction will bring it back to price levels of 81, 75 or 69 dollar. However, you should take into account the important support and resistance levels.

Why does technical analysis work?

Technical analyses works because of two reasons: one is psychology and the other the use of technical analysis.

When lots of people think they have identified a trend, support or resistance price level, they will act like it is a reality. When more investors have identified the same trend, support or resistance levels, the more likely it is that these trends and levels will strengthen. This way, technical analysis (and psychology) will provide investors with a self-fulfilling prophecy.

Not only the psychological affects the trends and price levels of shares, also the number of people using the technical analysis is important. And I do not mean technical analysis as a whole, but certain methods of technical analysis. Technical analysis methods have the most effect when a lot of people use the same method. This way they are more likely to get to the same conclusions. And when they get to the same conclusion, they will act (and trade) what this conclusion tells them to do. And this way, the trends will strengthen as well as the resistance and support levels.

Trend or sideways movement

As I explained in this article, technical analysis can be used to identify a trend. With this trend, the risk and possible return can be determined. Unfortunately, not all shares trend all the time. What's more, 70% of the time shares will move sideways. The other 30% of the time, shares are likely to trend. Luckily not all shares will trend at the same time, therefore it is likely that you will be able to find a trending share at any time. So, go out and try to find these trends!