Trading and Technical Analysis: An Introduction
In this article, we will present and discuss some bullish and bearish patterns in financial markets for both cryptocurrency and stocks. In Section 1, we introduce Charles Dow, considered as the father of Technical Analysis. In Section 2, we present his 9 basic principles for trading. In Section 3, we present some trading techniques for Technical Analysis such as Moving Average (MA), Triple Moving Average (TMA), Bollinger Bands (BB) and Moving Average Convergence/Divergence (MACD) . Last but not least, in Section 4, we conclude about the importance and usefulness of Technical Analysis as an investment tool. Also, there is an extra session with suggested reading to improve your knowledge on Technical Analysis and Trading.
Section 1 – Meet Charles Dow
If you believe that the market discounts everything, then you must know Charles Dow, an american journalist, one of the founders of Dow Jones & Company and also The Wall Street Journal. Mr. Dow, as we may call him during the article, developed some principles that guide trading based on Technical Analysis and are known as the “Dow Theory”.
We all know prices fluctuate and investors are influenced by everything around them. According to Dow, the price will always reflect all available and relevant information to drive future results. That said, you don’t have to bother about specific news or fundamentals. The price will get the job done for you.
We have relevant information to make decisions every day. Latest relevant news on cryptocurrencies like the Ethereum Merge and Polygon – Disney partnership, or on the stock market like the surge of Oil prices and its impact on Energy companies like Crescent Point Energy, or on the markets itself through FED (Federal Reserve) movements to fight inflation are clear examples that will affect prices.
So, the main idea, according to Mr. Dow, is to anticipate the market movements based on historical price charts.
Section 2 – Dow’s principles
There are 9 principles on Dow’s theory, as follow. All of them can be directly applied to trading and Technical Analysis:
- Principle #1: The market has three tendencies
- Primary: Normally occur for long durations of more than a year. An upward primary trend has ascending tops and bottoms while a downward primary trend has descending tops and bottoms;
- Secondary: It represents a reaction that interrupts the main tendency momentarily. It can happen for 3 weeks to 3 months. Normally is correlated with the feeling that a specific investment is an opportunity that will lead to DCA (Dollar Cost Average);
- Terciary: It looks like the secondary, but it has a shorter duration of less than 3 weeks.
- Principle #2: Volume must follow the tendency. Yes, simple as that.
- Principle #3: Upward tendencies have three distinct phases
- Accumulate: This is the early stage where buyers believe that the asset is undervalued;
- Slow increasing: it represents a steady but not fast increase in prices;
- Excess: This is the time also referred to as “the pump” where many investors believe that the asset is undervalued and make a move at the same time for a given period.
- Principle #4: Downward tendencies have three distinct phases
- Distribution: It starts at the end of the “Excess” phase. The price tends to lateralize;
- Panic: Investors are driven by fear and doubt. These sentiments are fed with negative news from everywhere. Without certainty about the future, the investors start a big wave of selling;
- Slow decreasing: This is where the sentiment of “it has gone way down too much” takes place. Also known as “buy the dip”. Some investors start to buy the asset back.
- Principle #5: The average discount everything. The price represents the opinions of thousands of investors about the fair price of an asset. The average represents the result of this interaction over time.;
- Principle #6: Industrial and Transportation averages must move in the same direction. This happens because industrial production is related to the production of goods and transportation is related to its delivery. If they don’t confirm the same direction, then something must be wrong.
- Principle #7: The prices can often lateralize. This happens while the investors are not yet certain about a bullish or bearish tendency;
- Principle #8: The averages must be calculated in relation to the closing prices since they represent the final consensus after all the trading moves;
- Principle #9: The ongoing tendency is valid until a clear reversal signal appears.
Figure 1 shows the Ethereum weekly chart and possible patterns:
Section 3 – Trading Signals: Bull or Bear?
There are thousands of trading signals and different patterns. In this section, we will list 5 trading signals for bullish and bearish patterns. Let’s go!
The idea to use moving averages for trading is to smooth the price volatility. By doing this, the investor has a better understanding of the prices at different periods using a certain delay. The most popular moving averages are:
- Simple Moving Average (SMA): This one is basically an arithmetic expression of a price based on its average that keeps being adjusted over time. It can be simply understood as the average price given a certain period;
- Exponential Moving Average (EMA): This indicator is used to reduce the price delay in relation to SMA, since it’s exponential, so recent prices will have a higher weight.
Ok, nice. But what are the buying trading signals here? If the market prices are above their moving averages, then it can be a selling trading signal. If it’s below, then it can be a buying trading signal. Of course, it’s not as simple as that, since the good trader will analyze a variety of indicators at the same time and not only a few. Let’s take a look at EMA (9,5) of a Polkadot cryptocurrency (DOT):
Now let’s apply the same analysis for stocks. Here is the daily chart for Crescent Point Energy (CPG):
Triple Moving Averages
This trading indicator is a combination of tree EMA with different periods. The shorter period represents accumulation (no price tendency). The selling allert happens when the lower EMA (Orange) crosses the medium one (Green) and it’s confirmed when it crosses the Black.
Let’s take a look at a simple example using S&P 500 index based on the weekly chart:
This indicator was developed by John Bollinger. Take a look here to find more about him. Also, it’s a great idea to visit this webpage about Bollinger bands. This indicator creates two bands that move along a moving average of 20 periods considering 2 standard deviations (default). These numbers can be changed by the analyst for other trading strategies.
The analysis of both bands are crucial and it must be done along with others indicators to decide about buying or selling. If the bands move on different directions, then it’s a sign of high volatility.
Let’s take a look at the example on Figure 5 that applies Bollinger Bands to the Bitcoin daily chart.
We can see that the investor was able to anticipate a period of greater uncertainty. This doesn’t mean that he needed to sell the Bitcoins, but he could follow a strategy to reduce the portfolio’s volatility. This theme has been covered here in the article “The power of diversification: Stocks Market vs Bitcoin vs Ethereum – a 5-year return analysis“.
Moving Average Convergence/Divergence (MACD)
Developed by Gerald Appel. This indicator is very simple and intuitive to use. The mathematics behind this indicator combines tendencies and moving averages into a momentum indicator. Depending on how the moving averages behave, the MACD indicator will fluctuate above or below the target line (formally known as zero line strategy).
Mathematically speaking, the MACD is a difference between moving averages. When this difference moves from negative to positive, then it can be understood as a buying trading signal. The opposite happens when the difference moves from positive to negative. This indicator can be even more useful when used along with its histogram, developed by Thomas Aspray, that measures the distance between MACD and the target line.
Let’s take a look on Figure 6 that shows the weekly chart of the cryptocurrency Ethereum
Section 4 – Conclusion
In this short article, we’ve presented Charles Dow and its basic principles applied to trading and Technical Analysis. The trading techniques demonstrated are just a few examples of possible tools to be applied to stocks and cryptocurrencies. It’s wise to recognize that an indicator can never be used alone. A well-designed trading strategy will combine a variety of indicators while trying to anticipate market movements in order to generate consistent gains overtime.
It doesn’t matter if you are a fundamentalist or a technical analyst or if you rely on stocks’ financial results or on their price charts. At the end of the day, all of us want to make money. Let’s do like Jesse Livermore once said: “There is only one side of the market and it is not the bull side or the bear side, but the right side.” I’m not sure on what side are you in, but go find it.
Extra session – Suggested reading on Technical Analysis/trading
- Technical Analysis of the Financial Markets [Alex Herold] – link here
- Technical Analysis for Beginners [A.Z. Pen] – link here
- Crypto Technical Analysis [Alan John] – link here
- The Handbook of Technical Analysis [Mark Lim] – link here