CHAPTER 1

Introduction to
Technical Analysis
Pursuing Profit in
the Financial
Markets

After reading this chapter, you will be able to:

Understand the general concept of technical analysis.

Discern the basic differences between technical analysis
and fundamental analysis.
Recognize some of the key tools and methods of technical
analysis.
Know what concepts will be discussed throughout the rest
of this book.

1
 Introduction to Technical Analysis

W hat Is Technical Analysis?

Technical analysis is the study of how past and present price action
in a given financial market may help determine its future direction.
At the same time, however, technical analysis should not be consid-
ered a crystal ball. Rather, the skills of a technical analyst are used
primarily to help determine the highest-probability reactions to past
and current price movement, as well as likely future price move-
ment. Therefore, technical analysis is less about actually predicting
the future and more about finding high-probability potential oppor-
tunities to trade in the financial markets.
The primary tool used by technical analysts is the ubiquitous
price chart, which generally plots prices over a given period of time.
The various major chart types are discussed in detail in Chapter 4,
which covers the basics of technical analysis. Different analysts/
traders may choose to use different types of charts at different
times, whether it is a line chart, a bar chart, a candlestick chart, a
point-and-figure chart, or any of a number of other chart types.

T echnical versus Fundamental

When many people in the financial world refer to technical analysis,
it is often in direct contrast to the other major school of market
analysis, fundamental analysis. The contrast between the two is clear
and distinct.
Fundamental analysis focuses on what the underlying reasons
may be for market movement. In the stock market, this would con-
sist of news and financial information (e.g., earnings) that are directly
associated with a particular publicly traded company. In the futures

2
 Technical versus Fundamental

market, it would consist of substantive market information regarding

a specific commodity (e.g., wheat or oil) or financial market/index
(e.g., S&P 500). In the foreign exchange, or currency, market, fun-
damental analysis would be primarily concerned with international
economies, central bank policy, interest rates, and inflation.
Fundamental analysis stands in stark contrast to the world of tech-
nical analysis. Instead of concerning itself with the underlying reasons
for price movement, technical analysis focuses on the price movement
itself and how mass human behavior is manifested in price action.
Technical analysts believe that all fundamental information and eco-
nomic factors that can cause price movement are already reflected in
price action. Therefore, technical analysis purists generally avoid look-
ing at earnings or crop reports or international economic conditions.
Instead, the two primary tools of price and volume as depicted on a
financial chart are sufficient for most analysts of the technical persua-
sion. Of these two tools, price is universally more important.
Here is another way to describe the distinction between funda-
mental analysis and technical analysis: While fundamental analysis may
concern itself with the myriad reasons “why” price moves, technical
analysis is single-mindedly focused on “how” price moves and the way
in which that might affect future price movement. Technical analysis
consists of a broad methodology through which traders can identify
trading opportunities and make all of their most important trading
decisions. This includes trade entries, trade exits, stop-loss placement,
profit target placement, trade sizing, risk management, and more.
While some traders and investors are strict adherents to either
fundamental analysis or technical analysis, and completely exclude
consideration of the other, many use a combination of both.

3
 Introduction to Technical Analysis

EXECUTIVE INSIGHT

Robert Prechter, Jr., CMT

In a written interview with the author, Robert Prechter, Jr., publisher
of The Elliott Wave Theorist since 1979 and founder/president of
Elliott Wave International (elliottwave.com), discusses being a
pure technician. Legendary for his market timing and trading acu-
men utilizing Elliott Wave principles, Prechter has won numerous
major accolades from the media and financial community over an
illustrious, decades-long career. He has authored many books, sev-
eral of which were instrumental in bringing Ralph Nelson Elliott’s
groundbreaking Elliott Wave Principle into the forefront of financial
market analysis. More about Robert Prechter, Jr., and his consider-
able contributions to the development of technical analysis can be
found in Chapter 2.
Prechter states:
Most analysts are not technicians. But it is also true that most
self-described technicians are not pure technicians. They talk
about Federal Reserve policy, political action, economic news
and other such events as causal to the market’s movement. If
such events are causal, then technical indicators would not be
potent, because randomly occurring outside events would be cre-
ating the supposed patterns, making them spurious. Any new
event could make the market go contrary to what a pattern or
indicator suggested. To be a hybrid analyst is to be theoretically
inconsistent. Either outside events move the market or market
behavior is patterned. One cannot have it both ways.
A pure technician is someone who believes that the stock market’s
causality derives from unchanging aspects of human behavior.
Only if this is true can a head-and-shoulders pattern, a trend line,
or a wave form be reliable. Otherwise such things are simply
artifacts of random movement. True technicians are those who
rely solely on technical indicators and models such as price trends,
cycles, volume patterns, momentum readings, sentiment indica-
tors, Elliott Waves, Edwards and Magee patterns, and Dow theory.

4
 What to Expect

Fundamentalists look for outside causes and try to predict

them, reasoning from those predictions to market predictions.
Technicians study patterns relating to market behavior and
make decisions on that basis alone. Fundamentalists study
everything but the behavior of the market. Technicians study only
the behavior of the market.

M ethods
The methods of utilizing technical analysis are many and varied.
They include such ubiquitous concepts as head and shoulders, sup-
port and resistance, trends, moving averages, and double-tops. But
they also include concepts that are less popularly known, such as
linear regression, bullish engulfing patterns, Elliott Wave, and point-
and-figure charts. All of these elements of technical analysis, and
much more, are discussed in the pages of this book.
The main focus of this book is to provide the essential knowl-
edge about technical analysis that is necessary to begin serious analy-
sis of any major financial market. With that goal, this book outlines
and describes the primary tools used by technical analysts and trad-
ers. Of course, technical analysis is a huge subject that is growing
every day, and no book could ever hope to cover all of the informa-
tion within the field adequately. Therefore, this book provides sub-
stantial coverage of the essentials, as the title suggests, while
necessarily omitting some of the more esoteric concepts in the field.

W hat to Expect
After this introduction, Chapter 2 begins with a concise history of
the most pivotal events in the development of technical analysis—

5
 Introduction to Technical Analysis

from the Japanese rice markets in Osaka; to the revolutionary tenets

of Dow theory; to the development and mainstream adoption of
charting; to the advent of Elliott Wave theory; to the emergence of
trend following; and finally to the automated, systematic trading
of today.
Then the most important aspect of technical analysis, price action,
is described in detail in Chapter 3. Price action, or the patterned be-
havior of price that can give clues as to potential future direction, is
truly the basis for the study of technical analysis as we know it today.
The book then jumps straight into the primary basics of techni-
cal analysis—charts. These are the primary tools of technical analysts
and traders, whether the chart of choice is a line chart, a bar chart, a
candlestick chart, a point-and-figure chart, or some other manner of
graphically depicting price action. All of these chart types are pre-
sented and discussed in Chapter 4, including their structures and
methods of interpretation.
After these basics are covered, Chapter 5 is devoted entirely to
what is arguably the single most important concept within technical
analysis and the heart of the discipline: trend. The definitions and
characteristics of uptrends, downtrends, and no trend are covered, as
well as methods to identify trend conditions.
After the heart of technical analysis is discussed, Chapter 6 talks
about another vital aspect of the field that can be considered the soul
of technical analysis: support and resistance. These twin concepts are
the basis for much of the technical analysis that is published in the
media as well as for many technical trading methods and strategies.
The chapter on support and resistance is followed by a discussion
of the practical drawing tools necessary for depicting both trends and

6
 What to Expect

support/resistance levels. These important drawing tools include

trend lines, trend channels, and horizontal support and resistance
lines. Chapter 7 covers how these lines are customarily drawn and
interpreted by technical analysts and traders.
Moving on to Chapter 8, the discussion then turns to the key
topic of chart patterns. This includes the most prevalent and impor-
tant bar chart shapes, such as triangles, wedges, flags, pennants, head
and shoulders, and the like. The chapter also includes descriptions of
the most common Japanese candlestick formations, such as ham-
mers, shooting stars, doji, engulfing patterns, and the like.
Chapter 9 covers the world of moving averages, those wavy lines
that can reveal so much about a market’s trending conditions and sup-
port/resistance areas. Moving averages also play a pivotal role in many
technical trading strategies, as well as in market analysts’ commentaries.
Besides moving averages, many other important technical indi-
cators are mathematically derived from price. The most common
and important of these indicators, which include a special subcate-
gory called oscillators, are presented and described in Chapter 10.
From there, this book moves into the more advanced concepts
of Fibonacci and Elliott Wave theories in Chapter 11. These unique
perspectives on market price action are often used by more sophisti-
cated technical traders, and they can provide extremely valuable
insight into the structure of price and how to reap potential benefit
from it.
Chapter 12 covers yet another unique perspective on price ac-
tion: point-and-figure charting. Significantly different from its line,
bar, and candlestick cousins, point-and-figure analysis concentrates
exclusively on the market’s price action, excluding all other factors,

7
 Introduction to Technical Analysis

including time and volume. Because of this fact, many consider

point-and-figure trading to be the purest form of price action
trading.
Although volume is customarily excluded on point and figure
charts, it is the star of Chapter 13. Used primarily by stock market
traders, volume is considered both a leading indicator as well as a
confirming indicator. When trading equities, volume can be a vital
tool for providing important confirmation of price action. Confir-
mation is a key concept within technical analysis.
Chapter 14 brings together all of the tools, methods, and con-
cepts of technical analysis discussed up to that point and describes
specific trading methods and strategies used by professional technical
traders. This discussion includes information on both manual and
automated trading and on how each strategy covered is suited to
either mode of trading. The strategies and methods described in
Chapter 14 comprise the culmination of all the building blocks of
information found throughout the rest of the book.
Finally, Chapter 15 discusses one of the most important aspects of
any trading plan: risk control and money management. Although it
is not nearly as enthusiastically embraced a topic as trade entry
strategies, at least with many novice traders, most successful and pro-
fessional traders/investors would likely agree that risk control and
money management are the keys to consistent success in the financial
markets. Without these vital components of a sound trading plan,
failure can almost be assured. Chapter 15 covers some of the most
important aspects of a good risk and money management plan.
By the end of this book, the goal is for the reader to be well on
his or her way to becoming well rounded and knowledgeable on

8
 Summary

the art and science of technical analysis. To truly master any of the
concepts discussed in this book will require further study and a lot of
practical, hands-on experience. But once that mastery occurs, one
invariably finds that it is always well worth the effort to get there.
This book is meant to serve as an essential guide pointing the way
to eventual mastery of technical analysis concepts and applications.

S ummary
This chapter delved into the basic concepts of technical analysis,
including a core definition and the differences between technical
analysis and the other main school of financial market study, funda-
mental analysis.
The sharp contrast between technical analysis and fundamental
analysis is useful in helping those who are new to the financial mar-
kets understand how each discipline may fit into one’s overall mar-
ket outlook. Fundamental analysis is more concerned with “why”
price may move, while technical analysis focuses on “how” price
moves. Technical analysis helps traders and investors to identify
trading opportunities, which include trade entries, exits, risk man-
agement, and more.
This introductory chapter then went on to describe what is cov-
ered in each subsequent chapter. All of the essentials of technical
analysis for financial markets are covered in these chapters.