Introduction to Technical Analysis

Here's is where we start to have some fun. Regardless of how you want to trade the markets you need an approach. It might be spinning a bottle, asking your Aunt Jenny what she thinks or just gut feel.

However you do it, even though you may not think so, you have an approach.

The majority of traders will eventually use some form of technical analysis (also known as chart traders, market technicians and chartists).

Just before we go down this road of mystical wonder I think it is very important that you hear both side of the argument of why technical analysis works.

For every book that there is on making money trading there is probably an opposite book explaining why it can't be done. Before you dismiss the last statement out of hand. Lets explore the argument that no matter what you do you can't beat the market.

Random Walk

The random walk theory dictates that a security prices changes randomly, with no predictable patterns. Now that's quite a statement but there are number of very respected statisticians who have a very convincing argument to prove it.

It all started in London with a man called Maurice Kendall who presented a paper to the Royal Statistical Society in 1953. The subject of the paper Kendall presented was the behavior of stock and commodity prices.

Kendall started out looking for predictable price cycles in stock and commodities prices. The problem was he couldn't find any.

Regardless of how he approached it, the price of a stock was just as likely to go up or down on any given day despite what happened on the previous day. Which is where we get the term Random Walk. Prices seemed to follow a random walk as he observed them.

The best way to demonstrate this is with a game. Let say we are going to make a bet on the toss of a coin. You start with $100. We will toss this coin once per day. If it comes up heads you win 3% and if it comes up tails you lose 2.5%.

At the end of the first day you will either have $103 or $97.50. At the end of the second day we repeat the process.

The probability of the coin landing heads or tails is exactly 50%. This is because regardless of how many times the coin is tossed each event is independent. The coin has no memory of what happened the toss before. This means that the results will be totally random.

Kendall's paper implies the same effect in the stock or commodities market. If each day is an independent event then the markets must be random. We shall talk about more probability's later.

Taking this idea slightly farther if the markets are random then the history of the price of a stock or commodity has no bearing on the future price. It wouldn't help to look at charts or data, as each day there would be a 50% chance of the market going up or down.

You may be thinking by this stage that this theory is rubbish. I can trade the markets and make money! Try this simple test. Have a look at the two charts below. One is a chart of 100 daily closes of the Dow Jones Industrial Average and the other is a 100 random coin tosses.

Makes you think doesn't it! If each day in the market were in fact an independent event then it would be impossible for you to make money from it consistently.

You see any succession of event's particularly independent events can have an aberrant run. This is what kills the trader.

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