Technical Analysis (Part 2): Rules you need to know

Last week I began our blog series with a look at the history, theory and philosophy of technical analysis. This week we move on to look at 20 rules that you should build into your technical analysis. It is by no means an exhaustive list; there are many more technical analysis rules than this and there will also be rules that you create yourself. However, those presented here are a good foundation that you can apply to your analysis and build on. Some rules may appear, at this possibly early stage in your interaction with the subject, as both peculiar and confusing. Stick with it though, because during the remainder of this blog series, the use of these rules will become a lot more apparent and understandable.

One of the reasons I believe technical analysis can be such a great tool for traders and investors is its subjectivity and flexibility. It allows the user to come up with their own opinions, angles & thoughts on a particular market very easily and allows for the development and enhancement of existing and new tools to reflect their own trading approach. Some may argue that this could also be a weakness, but with a solid grounding in the subject it can be quickly seen how you can turn this tool to your advantage. It's subjectivity though, does allow for a wide scope of potential outcomes from any individual piece of analysis but underlying this analysis can be found a set of technical analysis rules that you need to know.

Rules you need to know:

Remember from the Part 1 blog where I said that technical analysis is built on 3 pillars? Well, these should always be the first three generic rules you take with you into your technical analysis:

1. The price is the price - market forces have got it to this point - supply and demand are built in in real-time, saving you the need to do a lot of fundamental analysis leg work. As a 100% pure technical analyst that is all you need to know.

2. History, to a certain extent, does repeat itself - look for patterns (ones that continue or reverse), trends that happen time and time again. Certain markets have more obvious repeatable historic patterns and performance. Use the appropriate tools to measure and forecast this activity.

3. Determine the trend and trade with it. In Spain's Pamplona bull run, when they open the gates, you run with the flow of the bulls (unless you're really stupid). Even then you can still get hurt if you don't have a strategy. The same should be done in your technical analysis forecasting and trading - trade with the flow.

Trading and investing is a risky business. Put the odds on your side by running with the money....

After factoring the previous three assumptions into your technical analysis rule set, you can start to look at more specific rules:

4. Setting up your charts - time is normally represented on the X axis and price the Y axis. Note that for Japanese charts such as Kagi, Renko, 3 line Break and Western approaches such as Point and Figure, time is disregarded and they focus just on price. Price can be represented either linearly (its most popular approach) or logarithmically, which is very good for the longer term trader or investor.

5. Use chart types that suit you. There are many different types of chart: Line, Point and Figure, Candlestick, Market Profile, Equivolume, Kagi, Renko, Line Break and more besides. Discover them all, then filter out the ones that work best for you. Each have their own nuances that may suit your personality, but not someone else. I, for example, prefer the Japanese style charts; in particular Renko, Heikin Ashi and Kagi.

6. Price, I believe, should not be used as a stand alone measure. Confirmation of price action should be married up by using volume, open interest and sentiment tools (Commitment of Traders numbers, Currency Strength Indicators etc) and analysis. Dow Theory also subscribes to this train of thought.

7. From my experience, the more liquid the asset you're trading the better the technical analysis works. Markets such as forex or indices work very well in technical analysis due to the vast daily traded volumes. More caution should be applied to equities and commodities though. Using the same approach for say, Amazon Inc vs a FTSE small cap stock, WTI crude Oil or Lean Hogs, can be dangerous.

8. Trend line measurement and drawing. We will find out exactly what a trend is in more detail in later blogs. For now, all you need to know is that the trend is the general direction of a market or of the price of an asset. There are trends within trends and these are classified into short, medium and longer term periods and you should construct your analysis around these time zones. The rule on measurement of a trend is, if price touches the trend line twice then this is a tentative trend confirmation, three times or more then this is a signal of a strong trend. 45 degree trend lines are the ultimate trend shape. Trend lines should be drawn under the price action for an uptrend and above the price action for a downtrend.

Example using the weekly Heikin Ashi chart for Amazon Inc:

9. Trend target measurement - a loose rule in my opinion that you could apply, aka the 'measured rule'. The length of the previous trend can be used as a guide to add on to a correction in price.

10. The higher time-frame chart carries more weight to your decision making. Always start your analysis from the higher time-frame and hone in to the time-frame in which you trade. Take the next two higher time-frames as a guide. For example, if you trade in the 15 minute charts, use firstly the 240 minute then 60 minute charts to determine the market flow and trend. Once you've done that stick with that direction in your 15 minute chart window.

The table below could act as a guide to the time-frames you could use:

There's no point trading the 15 minute charts and setting your objectives around analysis you've carried out in the weekly charts. The two time frames are too far apart.

11. Improve candlestick or bar chart analysis by teaming up with oscillators or indicators. These indicators can be applied on top of the price action or below. They create a fabulous confirmation tool to your raw price analysis.

12. Always determine where support and resistance levels are. There are many tools to work out these levels: trend lines, moving averages, Ichimoku, Fibonacci, Pivots etc. These levels are crucial for understanding the price behaviour of the asset you are trading.

13. Use indicators for timing. Are you always getting into a trade too late or out too early? Can't understand why the market has reversed? Then use indicators such as MACD, Stochastics, RSI etc to improve your edge and find overbought and oversold levels.

14. Beware the round number! Market behaviour at its predictable best! It's all to do with psychology and laziness. These numbers are like bees to a honey pot. They attract the stop hunters, money flow, smart traders and losing traders. Use them to your advantage or stay away from them. Your charts will quite clearly show you these key numbers.

15. Co-linearity: When putting your indicators together on a chart, NEVER add ones together based on a like for like calculation e.g. MACD and RSI, which are both based on the closing price. Stochastics and RSI would be a better combination or RSI and Volume. Avoid the cardinal sin of multi co-linearity amid indicators i.e. the multiple counting of the same information.

16. Divergence is a great application for spotting markets when they go out of sync. When two indicators are not confirming each other, this can often signify a bearish or bullish divergence. For example, in oscillator analysis, if the price is trending higher while an oscillator starts to drop this can usually signify a trend reversal.

Divergence can highlight bullish or bearish correction taking place.

17. Measure volatility through ATR (Average True Range). If you don't know where to set your stops, you may not be factoring in the volatility of the underlying instrument you are trading. The ATR indicator can create a more quantitative approach to your trade management.

18. Use technical analysis for money and risk management. An often overlooked use of technical analysis is its ability to keep the shirt on your back. Using it for stop setting, target setting, entry, exit and risk & return numbers, will all aid your trading and investing. Using technical analysis in this space creates discipline and takes a large chunk of the psychological game out of the equation.

19. Measure behavioural analysis using technical analysis. Putting a number around behavioural analysis can be hard. If you want to gain an edge, then technical analysis, with its various tools and indicators, lets you interpret this action and can allow you to create unique trading strategies around your discoveries. Tools that could be used are Moving Averages, to discover price cycles in commodities, or Elliott Wave and Gann.

20. Are you too jumpy getting in and out of trades? Use Heikin Ashi charting to take some of the psychological weakness out of your trading. Heikin Ashi smooths out the price data keeping you in trends longer.

Understanding and applying Technical Analysis rules will make your trading and investing far more effective. You will be able to manipulate and construct technical analysis to suit you.

There are countless other rules, both hard and soft, that I could have listed by going into the minutiae of technical analysis. However, many of these will be addressed over the coming blog series. Hopefully, these 20 will start you off on the right track when applying technical analysis to your trading and investing.

Next time: "Technical Analysis (Part 3): Line and Bar Charts"

Stephen Hoad BA (Hons), MSc, MSTA is a lecturer with the Society of Technical Analysts and specialises in Japanese charting & trading methods.

Author of the book: #TradingThought: Mind Medicine for Traders & Investors

For more information on technical analysis or trading, please contact Stephen at [email protected] or visit www.thestophunter.co.uk.

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