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In financial securities, there are two main types of player. The first is the Warren Buffett-type, value investors that usually always go long, looking carefully at the fundamentals of a business to decide whether it is going to be profitable and grow in the long term.
The second is the Charles Dow-type, someone who looks for inefficiencies in market forces to sport (often short term) opportunities to profit from. They’re more open to using exotic instruments like CFDs and options contracts, and have a greater propensity to go short.
There is often a great debate between these two sides of the financial community. Value investors often see technical traders as flamboyant risk-takers that spend their time manipulating individual instruments or entire markets. On the other side, many traders regard value investors as sedate and risk-averse Luddites that are unwilling to embrace modern tools to derive bigger returns.
In reality, neither of these perceptions are fair. There is a time and a place for both value investing and technical analysis, but it is important to understand which of these you’re taking part in before you actually commit any of your capital.
Value investing is a topic that is discussed a lot and often aimed at the novice investor, but fewer resources are available for those looking at technical analysis. So let’s take a look at this second type of trading to get a better understanding of what it is.
What is Technical Analysis?
Technical analysis was invented by Charles Dow, a man whose surname should be very familiar to anyone who has paid even the slightest bit of attention to American stock markets. He is the first half of the Dow Jones index which he founded back in 1884.
As well as creating the first metric of American industry, Dow is regarded as being the “father” of technical analysis. He started by creating simple tools such as the moving average to see whether a company’s share price was trending up or down.
Over time, it has ballooned into a much larger discipline with traders using a myriad of algorithms, charts, and calculations to spot opportunities for “alpha” (profit).
What Skills Do You Need to Do Technical Analysis?
There are two sets of skills required for technical analysis. The first is an understanding of the discipline itself, how each calculation is performed, and how to interpret the results. This can be developed through training and practice, so beginners should be able to pick this up as they go. In fact, there are plenty of resources that you can use to teach yourself the necessary techniques, such as this free book.
The second is basic arithmetic, a skill that can be found in many other areas of life. For example, people who play games like roulette develop a strong understanding of probabilities because roulette numbers are different depending on the variant you play. In European roulette, there are 37 pockets, 18 red, 18 black, and one green, creating a house edge of 2.7%. However, in the American version, there is an additional green pocket, bringing the total to 38, and almost doubling the edge to 5.26%.
These skills can be acquired from other activities too, such as baking, where you’re required to multiply or divide the quantities of ingredients, depending on the size of the cake or pastry you want to make.
This is to say that most people have a large proportion of the skills necessary to undertake technical analysis and they can learn the rest as they go, meaning it is something that anyone can do.
What Types of Technical Analysis Are There?
Technical analysis is a collective term for several different techniques, but here are some of the most common ones you will come across on your journey:
- On-balance volume (OBV): This measures the difference between trading volume on rally/fall days, where OBV is high, it shows that buyers are willing to push prices higher. When OBV is falling but the price is rising, there could be an opportunity to go long.
- Accumulation/Distribution (A/D) Line: This is a measure of how close a closing price is to its daily high. A security that is consistently finishing near the high water mark suggests there is an upwards trend in its price.
- Aroon Indicator: The Aroon indicator measures whether an asset is regularly hitting new highs/lows, which could help to identify trends
