What every spread bettor needs to know about Technical Analysis

By Michael Hewson, Digital Look’s Technical Analyst. Michael regularly speaks at seminars and conferences including Digital Look’s regular Introduction to Technical Analysis seminar. You can read his Analysis article every Wednesday at www.DigitalLook.com.
This article is taken from the Investor's Guide to Spread Betting. Download your free copy here.

Spread Betting and Technical Analysis

One of the most popular arguments amongst market commentators is what works best – the Fundamental or Technical approach? So if you’re a spread bettor which should you look at?

While there’s room for both views, I feel that the technical approach is extremely useful when it comes to spread betting. By understanding how charts work and by recognising the patterns they contain, you gain fascinating insight into where and when to enter trades. While timing is always important, it’s essential with spread betting.

It's all in the price

There’s one common tenet underlying the technical approach and plenty of evidence to support the fact that it works. It operates under the basic premise that “everything is discounted in the price”. The technician takes the view that the “price reflects all fundamental information currently available to everyone”. This means therefore that the price should be a fair reflection of the underlying fundamentals. This also allows the spread bettor to trade a vast array of different markets without having to have an economics or accountancy degree.

And it’s not just Fundamentals that are in the price, it’s emotions too; markets work on 3 emotions – hope, greed and fear. All of these can have a predictable effect on the price.

It’s also worth noting that this method of analysing markets has been around since the 1880’s in the west - even longer in Japan. Even though they evolved independently of each other they use the same rules of thumb when looking at trading strategies.

Defining objectives and selecting your market

An important question to consider is do you want quick profits, or do you prefer to wait and see a gradual profit accumulated over time?

If you’re looking at quick profits then you’re looking at fairly active markets with a quite high daily range in comparison to the price spread. A tight bid/offer spread and a fairly good trading range should equate to a reasonable chance of making good money on a day to day basis. A tight bid/offer spread also equates to a good amount of liquidity; helpful if things do go wrong as it gives you greater opportunity to get out of the position if needs be.

Evaluate the past – history repeats itself

As well as understanding that “everything is discounted in the price”, another key tenet of the technical approach is to evaluate the past. Dow Theory works on the premise that “history repeats itself”.

Looking at past price action on an asset can give clues as to how the price will behave in the future based on previous experience. Human behaviour can to a certain extent be predictable given a defined set of circumstances. This is how the technical approach can work. Seeing where previous highs and lows have occurred in the past and how the market has behaved previously when at these levels can give clues as to what might happen next and allow the trader to set rules in relation to a particular set of circumstances.

Trend, Support, Resistance

Another important rule in charting is to trade with the trend – if the market is going up, buy it. If it is going down, sell it. A common mistake investors and spread bettors tend to make when placing a trade on either a recommendation or when a stock meets their criteria, is to buy blindly without looking at the current trend of that particular stock. Using price charts as part of your investment arsenal can be extremely useful when looking at placing a 'buy' or ‘sell’ trade.

Most technicians look closely at the overall trend of the stock in question before timing an entry into a trade. Why buy a stock at 150p when the trend indicates it may be 120p a week later? You might be able to pay a cheaper price if you wait. Alternatively as a spread bettor you can go short – something that isn’t easily available to the private investor through traditional means. The other thing you can do on most platforms is to place a ‘limit’ order at the price you think the stock will go – effectively pre-ordering the stock at the resistance level. This is why the concept of trend is so important in any market and for spread betting in particular.

Using Support and Resistance and trend lines to identify which way a market is moving is a tried and trusted method.

Remember our previous assumptions that “History repeats itself” and that all markets are driven by human emotions? Both are important when it comes to the idea of support and resistance.

The basic idea behind support and resistance theory lies in the fact that in understanding the future we need to look at the past. Price levels that were significant in the past will be of importance to the price action in the future. Usually a support or resistance level is identified by previous lows or previous highs and is a level beyond which prices may have difficulty in moving.

Should the price break the support or resistance line, we often see an acceleration of the price movement. And then, as you can see in the chart below, the role of the line itself reverses – hence the resistance line below becomes the support line. Horizontal support and resistance levels are the most basic tool used by the technician to identify market breakout points and can offer the quickest profits if traded prudently. The example below illustrates this point perfectly.

Conclusion

The use of technical analysis is a useful tool which allows the spread bettor to be able to identify trends, support and resistance levels, and price targets for profit and loss levels as well as getting a feel for the liquidity and volatility in a market. The price is the barometer or the heartbeat of the market. Learning how to interpret this information is at the core of modern day technical analysis, something that the fundamentals cannot give you.

To learn more about Technical Analysis, go to www.DigitalLook.com/events and come along to one of my training sessions or online demos.

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