Martin Pring's Introduction to Technical Analysis, 2nd Edition

By Martin J. Pring

"The technician’s technician" (Barron’s), Martin Pring gives new traders the tools and insight they need to draw greater profits from today’s markets

This new edition of Introduction to Technical Analysis explains how to evaluate trends, highs, lows, price/column relationships, price patterns, moving averages, and momentum indicators for a contemporary audience, using fully new, updated charts, diagrams, and examples.

Pring uses his trademark expertise and engaging writing style to simplify concepts for traders. Links to an exclusive downloadable video featuring original content and in-depth explanations of the material is also included.

You'll learn how to:

• Research and construct instantly valuable charts of stock and market activity
• Interpret the basic concepts of momentum, and apply the theory to actual trades through a common sense set of trading strategies
• Use price and volume pattern to identify breakouts
• Analyze and act on peaks and troughs that can signal a change in the prevailing trend
• Calculate moving averages and gauge their impact.

Martin J. Pring is the founder of Pring Research and publisher of Intermarket Review, a monthly market review offering a long-term synopsis of the world's major financial markets. Martin pioneered the introduction of videos as an educational tool for technical analysis in 1987, and was the first to introduce educational, interactive CDs in this field.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Feb 20, 2015
• ISBN: 9780071849388

Book preview

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INTRODUCTION

This book is designed for people who have no knowledge of technical analysis and want to quickly come up to speed on this fascinating subject. Those who have already accumulated a smattering of knowledge on chart interpretation should also find this explanation beneficial, as familiar ideas may be experienced from a new perspective.

I have always thought of technical analysis as an art form that uses scientifically derived indicators to identify a trend reversal at a relatively early stage and riding on that trend until the weight of the evidence leads to the conclusion that it has reversed. The weight of the evidence refers to the many indicators described in this book. They are far too numerous for the average trader or investor to simultaneously follow them all at any one time, but my job here is to present them to you by explaining their strengths and weaknesses. Your job is to pick out those indicators and approaches that you feel most comfortable with. Then, once you have made your choice, apply them in the weight of the evidence approach. The trick is to hone your favorites to perhaps four or five techniques that you have confidence in. Selecting too many will lead to confusion, and choosing too few will not provide you with enough evidence to make wise investment decisions. Remember, it’s going to be your money on the line, not mine, and if you are not fully confident in your approach, you are likely to be shaken out of a position at exactly the wrong time.

Technical Analysis Deals in Probabilities

Technical analysis never deals in certainties, only probabilities. If you think that following it will lead to instant financial gains, you are better off looking elsewhere, because this approach, and any other that I have ever followed, cannot help in this objective. I often equate technical analysis with religion, the objective of which is to discover the truth, the meaning of life if you will, and how we can eventually move to a state of omniconsciousness or a vibration-free existence. In technical analysis, the goal is to harvest profits. Just as human beings follow different paths in their choice of religion, so it is equally appropriate for traders and investors to carefully choose their favorite techniques and approaches in that search for profits. You will notice that I used the word harvest profits because that’s what successful trading is all about. It’s about taking a little here and a little there, not about going for broke and trying to get rich quickly. Don’t forget that as a trader you are trying to take money away from professionals. Would you ever dream of trying to beat a professional golfer without extensive practice and training? Of course not. Why then would you expect to beat professional traders without sound and extensive preparation? I am talking specifically about trading here because in a long-term bull market it’s a win-win situation as the buy-and-hold process works for everyone.

Psychology Drives Prices

It’s important to understand that the driving force behind prices is a psychological one. To be sure, business cycle and monetary factors are important, but the attitude of market participants to these emerging fundamentals holds more significance than the fundamentals themselves. That means that technical analysis studies the action of the market rather than the goods in which the market deals. The objective of this book is to guide you in the art of understanding what that market action means and how you can use that knowledge to forecast future price trends. Fortunately, the attitudes that determine prices move in trends, and once a new trend begins, it tends to perpetuate. This is all revealed when you study charts. If you try to interpret them from the point of view of what they are saying about the sentiment and mood swings of market participants, you will be further ahead than if you just apply a series of robotic rules.

Major Technical Principle At all times use common sense in your interpretation and keep it simple.

Since the technical approach involves the study of psychology, we are also dealing with human nature. Fortunately for technical analysis purposes, human nature remains more or less constant. That holds true whether we are analyzing nineteenth-or twenty-first-century price action or corn traders in Chicago, day traders in Shanghai, or currency traders in Mumbai. Consequently, the principles of chart and indicator interpretation can be applied in any country for any time period in any age. That means that if you are a day trader and see a monthly chart in this book, it is just as relevant as if it were an hourly chart because the principles of interpretation are identical. The only difference is that a new trend on a monthly chart will last much longer than a similar signal from an hourly chart. The same would be true in reverse for a long-term investor looking at an hourly chart. So whether you trade intraday, are a swing trader (three or four days’ time horizon) or a long-term investor, remember the interpretive principles and apply them to your own specific time frame. People often ask me if I have written or know of a good book on forex. Naturally I reply that there are no specific technical rules for forex because we are studying people in action, and human nature is more or less constant regardless of the security in question. Of course there are some differences; there are no published volume figures in the interbank currency market, for example. Nevertheless, a sell signal from an indicator in one market is just as valid as in another.

The technical approach to investment, then, is a reflection of the idea that prices move in trends and that these trends are determined by the changing attitudes of investors toward a variety of economic, monetary, political, and psychological forces.

People Continue to Make the Same Mistakes, and This Shows Up in the Charts

Human nature remains more or less constant and tends to react to similar situations in consistent ways. By studying the nature of previous market turning points, it is possible to develop some characteristics that can help identify market tops and bottoms. Technical analysis is therefore based on the assumption that people will continue to make the same mistakes they have made in the past. Human relationships are extremely complex and never repeat in identical combinations. The markets, which are a reflection of people in action, never duplicate their performance exactly, but the recurrence of similar characteristics is sufficient to enable technicians to identify juncture points. Since no single indicator has signaled or indeed could signal every top or bottom, technical analysts have developed an arsenal of tools to help isolate these points.

Markets Are a Discounting Mechanism

All price movements have one thing in common: they are a reflection of the trend in the hopes, fears, knowledge, optimism, and greed of market participants. The sum total of these emotions is expressed in the price, which is, as the legendary analyst Garfield Drew noted, Never what they [stocks] are worth, but what people think they are worth. His observation can, of course, be applied to any freely traded security

The implication is that investors are looking ahead and taking action so that they can liquidate at a higher price when the anticipated news or development actually takes place. If expectations concerning the development are better or worse than originally thought, then through the market mechanism, investors sell either sooner or later, depending on their particular circumstances. Thus, the familiar maxim sell on good news applies when the good news is right on or below the market’s (i.e., the investors’) expectations. If the news is good, but not as favorable as expected, a quick reassessment will take place, and prices (other things being equal) will fall. If the news is better than anticipated, the possibilities are obviously more favorable. The reverse will, of course, be true in a declining market. This process explains the paradox of equity markets peaking out when economic conditions are strong and forming a bottom when the outlook is most gloomy.

As I hinted at earlier, anyone expecting to apply the principles outlined here to make a quick dollar should avoid this book. There are no hidden secrets. There are no magic formulas. Hard work, diligent study, patience, discipline, and the avoidance of greed and fear are the weapons of successful trading and investing. Remember, there is no holy grail. In fact the real (financial) holy grail is knowing that there is no holy grail. Many before you have found the subject of technical analysis to be a fascinating one. I hope you will too.

In the meantime, good luck and good charting!

Part I

BASIC CONCEPTS

1

BASIC BUILDING BLOCKS

Some Ground Rules

In the beginning of a great novel, the author often grabs the attention of readers with some pretty exciting stuff. This, though, is not a novel, and we are going to begin with some seemingly dry material, later working into the more interesting stuff. We will start with some basic but nevertheless important pointers. Please bear in mind that this approach is not perfect. It can and will fail from time to time. As stated in the Introduction, technical analysis deals in probabilities. That means that even if the odds are 95 percent in your favor, there are 5 percent that are not, so it’s still possible that things will not work out as we would like or expect.

1. Technical analysis can put the odds in your favor, but only if you have the patience and discipline to objectively apply the basic principles. That word objectively is emphasized since emotion control is a key to success in the financial markets.

2. There is no surefire system. You may see commercials on TV promising consistent, easy, or fast profits. I guarantee you they are patently false. Consider the fact that if the advertisers had found the ultimate system, they would be quietly collecting millions in the marketplace adopting them, not wasting their time and money on promoting their ideas.

3. With the use of computers and computerized trading it is now quite easy for the average person to develop or purchase some sophisticated systems and methods. My experience is that people often use complexity as a substitute for thinking. The better approach is to keep things as simple as possible and let common sense rule at all times.

4. In this book, stocks, bonds, commodities, and currencies or any other freely traded entity will be referred to as securities. The use of this generic term will avoid repetition and make the discussion less cumbersome. It also underscores the idea that basic technical principles can be applied to all freely traded markets.

What Is Technical Analysis?

With the preliminaries out of the way, let’s take our description of technical analysis to a higher level. In a sense, the word technical is a bit misleading, since we are really concerned with studying various forms of pricing information as displayed in graphs. The idea is to get a better handle on the underlying psychology of traders and investors as reflected in the price action itself. If we can obtain clues from the charts to what’s going on in their heads, we stand a better chance of understanding what’s going on in our own heads vis-à-vis the fear/greed pendulum, since mastering our own emotions is actually just as important as figuring out what the charts are saying. From time to time I’ll be emphasizing what I think are the key points that I would like you to remember. They will show up in this format:

Major Technical Principle The price of a specific security at any one time is affected by the knowledge, hopes, fears, and expectations of all those people who already own it or who might be thinking of buying.

If I am sitting with cash, I am affecting the price just as much as anyone who has bought the security—for by holding back from making a purchase, I am keeping the price lower than it otherwise would be. It’s the attitude of people that is important. As stated in the Introduction, it is important to understand that market participants look ahead, anticipate future developments, and take action now.

If you are on the railroad tracks and see a train coming, is it likely that you will wait until the last moment before getting off the tracks? No. You anticipate that the train is going to run over you, and you get off the tracks right away. Market participants are the same. The difference is that not all participants get the news at the same time. An institutional investor, for example, may get a call from an analyst and then take action. This same news or development may take several days or weeks to filter down to the individual investor, who then reads it in the financial press or a favorite blog. It’s not that the individual is less smart than the institution since they both take action on the news. It’s that one gets the news sooner than the other. Some receive it from a different angle, and different people have different attitudes toward the same anticipated developments. For example, if you are an investor and anticipate that some forthcoming bad news will create a short-term reaction in an ongoing bull market, you probably won’t take any action. On the other hand, if you are a highly leveraged short-term trader, you would be foolish not to sell. Otherwise you would stand to lose all your profit and probably your account. The same news, then, can affect different people in different ways. The sum of the attitude of all participants, and potential participants, is reflected in one thing and one thing only—the price. This discounting mechanism is the reason that markets bottom when the news is bad and peak when it is good. At such points of extreme emotional activity, participants have already factored today’s headlines into the price and begun to anticipate tomorrow’s.

This is fine. But it would be of little use except for the fact that prices move in trends, and once a trend begins it tends to perpetuate. The art of technical analysis, then, is to try to identify trend changes at an early stage and maintain an investment or trading posture until the weight of the evidence shows or proves that the trend has reversed. In technical analysis, the evidence is provided by the numerous indicators and principles that will be covered in this book. They include price patterns, trendlines, moving averages, momentum, and so forth.

One principle that emerges from this definition of technical analysis is that once a new trend emerges, it should be assumed that it is still in force until enough indicators have given reversal signals. In other words, always assume the prevailing trend is intact until proved otherwise. Technical analysis does not promise that you can identify the actual top or the bottom, merely the area of a top and the area of a bottom.

Since trends tend to perpetuate, it’s still possible to do quite well in most situations. However, it’s best to remember that technical analysis, like other art forms, is far from perfect, even when correctly interpreted. It can certainly help in identifying the direction of a trend, but there is no known method of consistently forecasting a trend’s magnitude or duration.

Time Frames

The principles of technical analysis can be applied to any time frame, from one-minute bars to weekly and monthly charts. The interpretation is identical. The only difference is that the battle between buyers and sellers is larger the greater the time frame under consideration. That means the same technical event appearing on intraday charts is interpreted in the same way as that on a monthly chart. However, since the time frame on the latter is so much bigger, so is the implication of that specific event. On an hourly chart it would be measured in a day or a fraction of a day, whereas on a monthly chart the effect would likely last between 5 and 10 months, and so on. As we proceed, you will see a huge variety of examples featuring many different time frames.

Major Technical Principle For the purpose of interpretation, the period really doesn’t matter—it’s the character of the pattern that matters.

For example, if you are a long-term trader and see an event featured on a 10-minute chart, you would never take action based on such a short-term signal. However, if that same event appeared on a weekly or monthly chart, you should draw on your experience with the 10-minute chart and apply it to the longer-term one.

Methods of Plotting Charts

Over the years, technicians have devised a number of different ways of physically representing market data on charts. The following discussion covers the more popular methods.

Bar Charts

Most charting methods plot the price on the vertical, or y, axis and the time on the horizontal, or x, axis. This is certainly true of the most widely used form of charting—namely, the bar chart (Chart 1-1), in which the portrayal of prices is achieved with vertical bars. The bars themselves usually have at least one horizontal tick mark. A bar’s height represents the trading range for the period in question. The top records the high and the bottom the low. A tick mark to the left represents the opening price, and a tick mark to the right the closing, or settlement, price. The bars also reflect the time period in question. If the data is weekly, the bar will reflect the Monday opening, the Friday close, and the intraweek high and low. In daily charts, the bars reflect the daily trading range, and so forth. The advantage of bar charts is that they visually provide a lot of information. The most important parts are the opening and closing prices. The opening is helpful because it reflects the psychology of market participants as they begin the trading session. Closing prices are valuable because they signify traders and investors who are willing to take home a position overnight. Of course this principle does not apply to intraday bar charts because the session is continuous and therefore no one is forced to sit with a position when the market is closed. Even so, closing prices still appear to form a useful function for this intrasession price activity. Later, in Chapter 8, we will see that the characteristics of a single bar can often provide clues to future market action.

CHART 1-1 Bar Chart (S&P Composite)

Underneath most price charts you will see more vertical bars in the bottom window or panel. These measure trading activity, or volume, for the particular time period in question. Most of the indicators and techniques used in technical analysis represent a statistical variation on the price, so it is extremely useful to monitor volume because it reflects a different variable, one that is independent of price. Unfortunately, most of the time volume does not speak to us, but when it does, it is very much worth listening to.

Line Charts

In the line or close-only style of charting (Chart 1-2), the highs, openings, and lows are ignored. Only the closing prices are considered. The continuous line joins the closing prices. The line chart does not provide as much visual information as the bar chart, but in many respects it is more useful. First, since the high and low are ignored, much of the random noise that occurs during the trading session is eliminated. Second, because of the cleaner chart look, it is much easier to visually spot the prevailing trend; this means that reversals are also easier to identify. Third, the closing price is important, since it reflects only those participants who are prepared to hold the security overnight or over a weekend. These are the people who have a greater conviction and are more likely to be in tune with the prevailing psychological trend. This factor does not apply, of course, to intraday charts, only daily, weekly, and monthly. Finally, close-only charts can be plotted for longer time spans, since bar charts require a space between the bars, and too many periods will visually clutter up the chart.

CHART 1-2 Close Only or Line Chart (S&P Composite)

Point and Figure Charts

The point and figure method (Chart 1-3) differs from all the others in that the horizontal axis does not measure time, rather the amount of trading within a specific price range. These charts consist of a series of O’s and X’s, which are called boxes. Declining prices are reflected by the O’s and rising ones by X’s.

CHART 1-3 Point and Figure Chart (S&P Composite)

Each box represents a set amount. For prices trading above $20, it is normal to set the box to $1 if that is the unit of trading, and if the price is less than $20 the box is set to 50 cents. As prices move to a new high, a new X is plotted for each $1 of gain. Were the price to move up by 99 cents—in other words, less than a dollar—no new boxes would be drawn. Reversals to the downside follow a predetermined rule: A new series of X’s or 0’s cannot begin until prices have moved by a specified amount in the opposite direction to the prevailing trend. This specified amount will be greater than the amount needed to record a new O or X. The use of the reversal technique, therefore, helps to reduce misleading or whipsaw signals and to greatly compress the size of the chart so that more data can be plotted. Since only price is recorded, it could take several periods before a new box is plotted. Hence a common practice is to record dates either at the foot of the chart or in the boxes at the appropriate points.

Price fluctuations for any given security are largely a function of time. That means that long-term charts are constructed with large boxes (i.e., higher dollar amounts) and short-term ones with smaller boxes. The point and figure chart takes a bit of getting used to, but its proponents are adamant that it is a very valuable form of charting.

Candlestick Charts

The candlestick form of charting (Chart 1-4) has gained in popularity in the last couple of decades. This method originated in Japan several centuries ago and basically offers the same information as bar charts. The difference is that candlestick charts can often make it easier to spot certain technical phenomena not readily apparent with a quick glance at a bar chart. Bar and candles charts are compared in Figure 12-1 (see Chapter 12).

CHART 1-4 Candlesticks (S&P ETF)

The candles consist of a vertical rectangle with two lines spiking up and down. The vertical rectangle is known as the real body and encompasses the trading activity between the opening and closing prices. For example, if for a daily candle, the opening price is higher than the closing price, it will be recorded at the top of the real body and the closing price at the bottom. The vertical line above the real body measures the distance between the high of the day and the higher of the opening or closing price. The lower line represents the distance between the low of the day and the lower of the opening or closing price. Days when the close is higher than the opening are represented by transparent (white) real bodies; days when the opening is higher than the close are displayed by a solid (black) real body. Even though candles can be plotted for any period in which information is available, days are used in the example because daily candle charts are the most common.

Candle charts place greater emphasis on the opening and closing prices than do bar charts. One disadvantage of candles is that they take up a lot of horizontal space, so it’s only possible to plot a small amount of data