The basics of technical analysis are explained by trader Tom Hougaard, including price action, volume and the various kinds of trends to watch for when trading Forex and Stocks.

Transcript:

Introduction:
We had a look at fundamental analysis, and now we turn our attention to, my favorite topic, technical analysis.
I'm a full time day trader and every moment of the day I will be relying on my charts to define my entry and exit criteria in the market.
And it doesn't matter whether i'm trading forex, gold, oil or even shares.
I will be taking you through some of my favorite trading setups later on, but for now we'll have a closer look at the fundamentals of technical analysis.

Scene 1:
Despite all the components that make up what we today know as technical analysis, there are really only 4 core elements:

• Price
• Time
• Volume
• Momentum

Price is considered the “be all – end all” of the markets. That is the only truth there ever will be; the current price.
If you ever watch CNBC or Bloomberg and you listen to someone say that a certain stock will reach a certain price – just remember it is their opinion – the only thing that really matters is the current price.
Time is another important topic, which very few traders ever consider as a concept to take into consideration when trading.
Volume is considered an important tool in many a trader’s analyses. You might even have heard analyst say that big moves in the market require big volume. That is not my experience, if you look at how bull or bear markets start, they often start on very little volume and finish on big volume.

Finally, there is Momentum, which is an incredibly important tool, at least in my own trading. It measures the velocity of the price move, and later on I am going to show you how I use momentum in a short term trading strategy.

Scene 2: Discard the “Informed” Opinion
When a CEO is interviewed on TV and he or she states that the current share price undervalues the company, they are really showing their ignorance about the market. You cannot argue with the market. It is non-negotiable.

The price is it. There is no “cheap” stock and no “expensive” stock. There is just demand and supply.
Remember that and remember it well. You will eventually find yourself in a situation where you think a stock you want to trade has gone “too far”. There is no such thing. Do not confuse the top of your trading monitor with support or resistance in the market. A stock will go as far as there is demand or supply.
One of the legends of technical analysis once said: “there is no stock too expensive to buy, and there is no stock too cheap to sell short”. (W.D.Gann)

Scene 3: The Laws of Price Action
We will be looking at price and the laws of price action shortly, but before we do, we need to look at the characteristics of trends; in particular major trends, that last for months and months.

Once a trend has established itself, it takes considerable power and time to turn it around. Primary trends are visible when the market is upwardly or downwardly mobile. These trends, often referred to as ‘Bull Markets’ or ‘Bear Markets’ can last for several years. Whilst you will inevitably experience both good and bad days within a bull market, the overall trend is going in a single direction.
A major trend rarely reverses without warning signs. The warning signs are increased volume activity, or a volume and/or price spike. The sign can also be a loss of momentum followed by a period of sideways market.

Once the initial trend reversal is complete, a decrease in trend volatility tends to follow. A strong trending market slowly eats away of the overhead supply, or as is the case in a downtrend, it steadily deteriorates the price.

Trends tend to begin after a market has reached an extreme. These extremes, also known as points of support and points of resistance, illustrate points in the market which provide a possible indication of the future direction thereof. Market participants are likely to act on this information, which will in itself partially influence market direction.

Scene 4: CNBC NASDAQ Wall Story
I remember during the bear market of 2000 to 2002, how CNBC reporters would take a camera to the street at times square and they would interview people who had lost a significant amount of their wealth having invested in dotcom stories. And I think it’s very easy to say to ourselves that we would have reacted differently if it was ourselves sitting with a stock that had lost 80% of its value in a year or less. But unfortunately it’s more likely that we would have uttered those words like the young man who said about Amazon.com: “Amazon.com is a good company, and it will turn around – it has to turn around”.
The bottom line is that a stock doesn’t have to do anything, a stock will do whatever it will do, demand and supply will dictate that, and as you venture into the world of trading, it is a good idea to know those facts before you start putting your money on the line.
The hardest game to learn is learning how to control your emotions when trading.

Scene 5: Dow Theory – the Father of Technical Analysis
It would be plain wrong to run a course on technical analysis without telling the story of its origin. Aside from Japanese Candlestick trading, which can be traced back thousands of years, the real rule based foundation was laid around 1900, by Charles Dow. Today “Dow Theory” remains the foundation of much of what we know as technical analysis.

Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment.
Much of what we know today as technical analysis has its roots in Dow’s work. For this reason, we will now cover the basic tenants of Dow Theory.

Scene 6: Basics of Dow Theory
The basic premise of Dow Theory states that all information - past, current and even future – is already discounted into the markets and reflected in the prices of stocks and indices. This information includes everything from the emotions of investors, and inflation and interest-rate data, to pending earnings announcements to be made by companies after the close.

Based on this tenet, the only information excluded is that which is unforseeable, such as natural disasters. These risks are however priced into the market.
Like mainstream technical analysis, Dow Theory is mainly focused on price. The two differ in that Dow Theory is concerned with the movements of the broad markets, rather than specific securities. An important consideration for Dow’s theory is to distinguish the overall direction of the market. To do this, the theory uses trend analysis.

Scene 7: Examining Dow Trends
According to Dow theory there are three main types of trends:
Short-, Intermediate- and Long-term.
Trend analyses attempt to predict a trend, identifying opportunities to ride the trend until data suggests that it has reversed.
Before we can get into the specifics of Dow Theory trend analysis, we need to understand trends. First, it's important to note that whilst the market tends to move in a general direction, or trend, it doesn't do so in a straight line. The market will rally up to a high (peak) and then sell off to a low (trough), but will generally move in one direction

Scene 8: Dow Theory – Trend Analysis
An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be considered an uptrend, both lows and peaks must be higher than those experienced in the previous rally.
A downward trend is broken up into several sell-offs, in which each sell-off also has a high and a low. To be considered a downtrend in Dow terms, both lows and peaks must be lower than those experienced in the previous sell-off.

Now that we understand how Dow Theory defines a trend, we can look at the finer points of trend analysis.
Dow Theory identifies three trends within the market: primary, secondary and minor.

A primary trend, which we briefly discussed earlier in this module, is the largest trend lasting for more than a year. Secondary trends on the other hand extend between three weeks and three months, and they are often associated with a movement against the primary trend. Finally, minor trends typically last less than three weeks. These are associated with movements in the intermediate trend.

Scene 9: Primary Trend Analysis
In Dow Theory, the primary trend is the major trend of the market, which makes it the most important trend to establish. This is because the overriding trend is the one that affects movements in stock prices. The primary trend will also impact the secondary and minor trends within the market.

Dow determined that a primary trend will generally last between one and three years, although this can, on occasion, vary. Regardless of trend length, the primary trend remains in effect until there is a confirmed reversal. For example, if during an uptrend the price closes below the low of a previously established low point, it could be a sign that the market is headed lower, rather than higher.

When reviewing trends, one of the most difficult things to determine is how long the price movement within a primary trend will last before it reverses. The most important aspect is to identify the direction of this trend and to trade with it. You should not trade against the trend until the weight of evidence suggests that the primary trend has reversed.

Scene 10: Secondary Trend Analysis
In Dow Theory, a primary trend is the main direction in which the market is moving. Conversely, secondary trend movements tend to oppose primary trends, moving in an opposite direction. This may alternately be a correction to the primary trend, for example:
An upward primary trend will be composed of secondary downward trends. This is the movement from a consecutively higher high to a consecutively lower high.

In a primary downward trend the secondary trend will be an upward move, or a rally. This is the movement from a consecutively lower low to a consecutively higher low.

This correction is evidenced in the chart image shown on screen now. Notice how the short-term highs fail to create successively higher peaks, suggesting that a short-term downtrend is present. Since the retracement does not fall below the previous low, traders would use this to confirm the validity of the correction within a primary uptrend.

In general, a secondary, or intermediate, trend typically lasts between three weeks and three months, while the retracement of the secondary trend generally ranges between one- and two-thirds of the period of primary trend movement. For example, if the primary upward trend moved the Dow Jones Industrial Average (DJIA) from 10,000 to 12,500 (2,500 points), the secondary trend would be expected to send the DJIA down at least 833 points (one-third of 2,500). Another important characteristic of a secondary trend is that its movements are often more volatile than those of the primary trend.
Scene 11: Minor Trend
The last of the three trend types in Dow Theory is the minor trend, which is defined as a market movement lasting less than three weeks. The minor trend is generally the corrective move within a secondary move, or those moves that go against the direction of the secondary trend.

Due to its short-term nature and the longer-term focus of Dow Theory, the minor trend is not of major concern to Dow Theory followers. This doesn't mean that it is completely irrelevant; the minor trend is watched with the larger picture in mind, as these short-term price movements are an element of both primary and secondary trends.
And as short term traders very often our focus is on those minor trends.

Scene 12: Summary
Most proponents of Dow Theory focus their attention on the primary and secondary trends, as minor trends tend to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational trading, because traders become distracted by short-term volatility thereby losing sight of the bigger picture. Stated simply, the greater the time period a trend comprises, the more important the trend.

This is Dow Theory. As you will learn in this course, it can be immensely profitable to trade the minor trend.
It would be wrong to say that you should simply focus on the primary and secondary trends.
As a private trader almost all my time is spent on the minor trend. And most day traders and swing traders focus on the Minor Trend.