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This article was originally written for the trading and investment club's website at my university. Previously there were no articles on trading or technical analysis so I decided to write a brief introduction for people to get started. I think the article does a good job at introducing the ideas so I will re-publish it here. Most of the articles for the investment club's website were concerned with economics and long term trade ideas. Most reading that I've done has also been focussed on long timeframes and at fundamental analysis. First a brief recap of fundamental analysis then some of the more popular concepts in technical analysis will be explained.

Fundamental Analysis

Value investors like Buffett are quoted to have no use for technical analysis and, to the best of my memory, rarely looks at charts. Anthony Bolton of Fidelty said in his autobiography (Investing against the tide) that he was mainly a fundamental analyst but one of the first things he liked to do was look at the chart. If you are interested in trading then we'd recommend a mix of fundamental and technical analysis: use fundamentals to find your opportunities but then use technical analysis for timing. Any ratio that uses fundamental data of a company is, of course, fundamental analysis such as: free cash flow, liabilities etc. Any ratio that relies upon price is not fundamental, the market price of a stock can be thought of as the market agreeing upon the derived price given all the data.

Types of technical analysis

Technical analysis is the 'art' of looking at the price chart and trying to determine where the price is going next. The idea behind this is that history repeats so there should be a typical set of chart patterns that will recur often enough to give us predictive power of where the price will go next.  That is to say that human behaviour repeats itself so often as to be predictable. A pure technical analyst would believe that all the information about a stock is already in the price, this is often called 'pricing in'. Fortunately, Wikipedia has fairly good coverage of technical analysis in case you want to read further. Some of the most popular techniques are trend lines, candlestick patterns, Fibonacci ratios and the Elliott wave theory.

Moving Averages

The moving average is a line of the price that is averaged over some timeframe. That is to say that you create a line by averaging the price over the space of a few minutes, hours, days or whatever timeframe you like. The 20-day moving average is a line that takes 20-day windows of the price and averages over that timeframe to produce a smoother version of the price. Looking at a price chart may look random but using something simple like a moving average will show you how the price is trending. You can also calculate a least-squares fit of the price data, which would put a best-fit straight line through all the data. Fortunately, you there are websites that line you draw moving averages on top of your favourite price chart, such as BigCharts. You may have to download the price data from Yahoo finance in order to calculate the least-squares fit but that isn't wholly necessary. Take note that there are two favourite types of moving average: simple and exponential, the latter seems to be favoured as it puts more emphasis on the most recent data point. Have a look at the wiki article to see how the moving average looks.

Trend lines

Much like the least-squares fit I just mentioned that gives an indication of where price is heading one can also draw trend lines on the data using your best judgement. The least-squares fit is something that you can calculate so has less room for human subjectivity. In common use, though, are trends that human traders place on a price chart to get an indication of where price is going next. This is classic technical analysis in my mind. As the price moves you can see it make peaks and troughs, by drawing a line between two peaks or two troughs you can get some idea of what the price is doing. If you pull up the chart of the FTSE 100 over the last 2 months (8th August 2011 to 8th October 2011) you can see that the price has been trading in a range. There is an obvious straight line that you can draw underneath all the troughs and another that you can draw across all the peaks. The line under all the troughs is the line of support, that is a line which supports the price and won't allow it to drop further. On the other line that runs across the peaks is the line of resistance where it does not allow price to rise above it. These lines are only temporary and show where the market has decided to take a rest as it can't push any further. Eventually, these lines are significantly broken and we can something called a break out. Many traders want to be in on the action of a break out as it may mean that a big move is about to come. Caveat emptor: break outs can be false and may not lead in the direction you'd first think.

Some of the most popular charting patterns are created using trend lines, such as head and shoulders, bullish / bearish flag and pennant, double top, double bottom

Candlesticks

I find candlesticks to be a nice way of representing the price data but I pay little attention to the candlestick patterns as I've found they have little real predicate power beyond the usual technical patterns. A candlestick is a little bit like a moving average, as an example you can look at the price data over the space of a day and convert that into a candlestick chart: this would be a chart where each day is represented as a single candle on the chart. The candle has a body and, generally, two wicks. The top wick shows the highest price reached on that day while the low wick shows the lowest price reached that day. The body of the candle shows the open price and the closing price. Arguably this four prices are the most important, they show the most extreme data points for that day and how they relate to the open and closing price. The large the body then the larger the difference between the open and close price. Some traders believe that a candle with no body, called a doji, indicates a possible reversal in the price direction. A candle with no body means that the open and close price are essentially the same.

Fibonacci Retracement / Ratios

This is the last thing I want to say in this article on technical trading. There are many more patterns and theories out there, hopefully we will cover those in a future article. I will draw your attention to one last technical indicator which is that of Fibonacci ratios. These ratios are found all over nature and are quite common in the markets too. Part of the success of technical trading is that people believe it to be true so it is true. Whenever the price nears support or resistance traders will opt not to buy or sell as they don't want to be the ones to buy or sell, at least not without some significant piece of news. Fibonacci ratios allow you to identify future prices of support and resistance, it is for that reason that I include them here and have found them to be somewhat useful.

Whenever the price trends in a particular direction it is not uncommon for the price to change direction and retrace some of the distance it made. If the price has, say, been trending up for a while it may hit a peak as the market has decided not to bid the price up higher. Subsequently, the price will fall. This fall is generally not random but has a well known structure to it. The structure of the climbs and falls can be described using Elliott wave theory, which is something I'll leave for a future article. What I will point out is that when the price falls from a peak it falls towards a price level where it hits resistance this level of resistance is often a Fibonacci level. These levels can be found from ratios within the Fibonacci sequence of numbers. That is to say that the price will fall to some percentage of its height: place a horizontal line under the lowest price of the trend and then place a horizontal line at the peak. This is the range of the trend, the key Fibonacci levels represent a percentage of how far the price is likely to fall. These levels are 0%, 23.6%, 38.2% and 100%. The 50% retracement is not a Fibonacci ratio but is sometimes used as a convenience.