III. Tools of the Technician
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Type of Charts
The daily bar chart has already been acknowledged as the most widely used type of chart in technical analysis. There are, however, other types of chart also used by technicians, such as line charts, point and figure charts, and more recently, candlesticks.
Charts can be plotted using arithmetic or logarithmic price scales. For some types of analysis, particularly for very long range trend analysis, there may be some advantage to using logarithmic charts. On the arithmetic scale, the vertical price scale shows an equal distance for each price unit of change. On the log scale, however, the percentage increases get smaller as the price scale increases. For example, a move from 5 to 10 on an arithmetic scale would be the same as a move from 50 to 55, even though the former represents a doubling in price, while the latter is a price increase of only 10%. Prices plotted on ratio or log scales show equal distances for similar percentage moves. For example, a move from 10 to 20 would be the same distance on a log chart as a move from 20 to 40 or 40 to 80.
Chart patterns are pictures or formations, which appear on the price chart. There are two major categories of price patterns - reversal and continuation. As these names imply, reversal patterns indicate that an important reversal in trend is taking place. The continuation patterns, on the other hand, suggest that the market is only pausing for awhile, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of patterns as early as possible during the formation of the pattern.
A technical indicator is a mathematical calculation that can be applied to a security's price or/and volume fields. The result is a value that is used to anticipate future changes in prices.
There are two types of indicators: lagging indicators and leading indicators. Lagging indicators or trend-following indicators are superb when prices move in relatively long trends. They don't warn you of upcoming changes in prices; they simply what prices are doing (i.e. rising or falling) so that you can invest accordingly. Trend-following indicators have you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce you risk by keeping you in the right side of the market. Another class of indicators are 'leading' indicators. These indicators help you profit by predicting what prices will do next. Leading indicators provide greater rewards at the expense of increased risk. They perform best in 'sideways' or trading markets. Leading indicators work by measuring how 'overbought' and 'oversold' a security is. What type of indicators you use, leading or lagging, is a matter of personal preference.
Indicators that help you gauge changes in all securities within a specific market are called market indicators. These indicators gauge the entire market and not just an individual security. Market indicators add significant depth to technical analysis because they contain much more information than price and volume.
These approaches to trading are directly dependent on human behavior and cannot be represented by pure mathematics. The way in which traders respond to market moves, and the remarkable similarity that can be found in Nature, give serious underlying substance to these methods. Because not all of the assumptions upon which these systems are based can be quantified, they are substantiated by the performance of the systems themselves. The principal works of Elliott and Gann are included in this category, as well as that of Fibonacci series and ratios, which form a significant part of their technique. Both are fascinating and open areas of creativity essential to broad system development. They are grouped together with discussions of natural phenomena and the rapid growing area of financial astrology, all of which should leave your grey matter stimulated.