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By Eleni Apostolidi
Senior Financial Consultant, Saxo Bank
Prices fell below the 50 day average during October. This sell signal is stronger when the moving average also turns down. What’s the difference between a simple moving average, a weighted moving average or the exponentially smoothed moving average and which is better to use in order to derive the correct signals in the market?
Maybe it is better to use the reversal and continuation patterns in this case. Bars are really helpful but candlesticks incorporate more information. Oscillators, patterns, trends, cycle theory, Dow Theory, Elliot wave theory are terms that are abundant in the financial industry and are taught in Universities and other institutions with the ultimate goal to create successful traders. Even people that had no idea about what those terms meant are studying in order to reach the dream: "become rich".
But what does it take to become a successful trader? Is it luck, study of the macroeconomics, observation of the charts or something more than that?
In order to answer these questions and decide what the most effective rationale is, we need to analyse the actual techniques and tools used in each approach. In recent years, two different philosophical premises created two schools of thought: Fundamental Analysts and Technical Analysts.
Fundamental analysts study the factors that affect the price of a market, so, they are focusing on the forces of supply and demand. Controversially, the technical analysts argue that anything that can possibly affect the price either fundamentally or politically/psychologically is reflected in the price of a market. Thus, the technical analysis itself has the purpose of forecasting the future price trends by studying the market action, primarily through the use of charts. Fundamental analysis, in contrast, uses the intrinsic value and the current market price, to estimate if a market is overbought or oversold and give selling or buying signals, respectively.
The above chart represents the stock of Apple, on a weekly basis. A technical analyst could anticipate a reversal in the prevailing uptrend since mid-September 2012. His signal was a reversal pattern, called evening doji star, the red box on the graph. ( ). The name is not of any big significance but the way those candlesticks were formulated gave a selling signal and also a signal for the reversal in the existing trend. This signal was also confirmed by the MACD line (Moving Average Convergence/Divergence), the blue and orange lines under the chart. This MACD is the difference between two exponentially smoothed moving averages of closing prices. This terminology still is not really significant. What matters is that the blue line (fast MACD line, Base) crossed the orange line (slower MACD, Signal) from above, and fell below it, which indicated a sell signal and a reverse in the existing trend. This downtrend was tested many times until now but still remains valid.
A fundamental analyst instead would have checked the balance sheet, the income statement, the cash flow in order to determine the company΄s health and growth prospects. If he was studying a currency, he would need to take into consideration interest rates, GDP growth, trade balance, inflation levels and other microeconomic factors. A fundamental analyst would also take into consideration that the competition is on the move, Samsung/Nokia. Apple is to a big extent a hardware company with an outstanding ability to capture the essence of easy use. But for how long is this enough to sustain above normal profits? Finally, after the announcement of the yearly results that were not even close to the right level of revenue in Q1, the prices dropped dramatically.
All in all, technical analysts are indirectly studying the fundamentals, meaning the forces of supply and demand that cause the markets to fall or rise. They reflect the psychology of the market but they cannot themselves cause the markets to move up or down. In contrast, their principles can apply to all the markets so they can follow a variety, in contrast to the fundamentalists who tend to specialize in one only group.
But what does it take to become a successful trader? It is a combination of both approaches. What each investor needs is access to data and professional tools to create his own strategies and implement his ideas.
* Saxo Bank is a Danish investment bank specializing in online trading.
