Technical analysis can be one of the fastest and smartest ways to make money in the financial markets. There are various arguments for the use of technical analysis. One theory says that everything that matters to a company is already contained in its stock price. Another says a stock price has nothing to do with the balance sheets and all to do with investors' emotions. Therefore a chart is just a reflection of the cyclical nature of these mass emotions.

Technical analysis is also often relegated to short-term trading rather than long-term investing. Daryl Guppy, one of Australia's best known technical traders and teachers, thinks the tools we use to make decisions for long term and short term trades should broadly be the same, because both approaches are all about managing risk.

"A trader wants to know if they buy today, is this stock likely to keep going up for the next three, five or 20 days, and an investor wants to know if the stock is likely to be higher in three, six or 12 months," Guppy says. "It is simply not good enough to say 'I am a long term trader, I don't need to manage my risk'."

When choosing a charting package, the tendency is to look for the one with as many indicators and features as possible. However, once you develop your own technical trading approach, like Guppy's, it may only include one technical indicator. Therefore paying through the nose for extra features will be a big waste of money. Your starting point for an education in technical analysis should be a thorough understanding of the two key tenets of charting.

The first is known as trend, and it is simply the direction of the price. A fundamental approach may recommend buying a share despite a downward trending price, if a stock is undervalued. However, applying the basic rules of charting would never prescribe buying shares if a stock is falling.

The second tenet is "support and resistance". A level where the price stalls or reverses is known as support if it is underneath the current price or resistance if it is above. These levels may not have any logical significance in fundamental terms. However, for a technical trader, identifying support and resistance provides a benchmark for the strength of a trend as well as areas on the chart where he or she can enter or exit a stock with greater certainty.

One of the biggest pitfalls for new technical analysts is to attempt to master a complex technical approach before they truly understand the basics. Venturing into the realm of Gann or Elliott Wave theory before you can confidently pick a trend can be a deadly mistake. Bill McLaren is one the best known Gann educators in Australia. "When I started in this business in 1965 I was on the floor of the Chicago Mercantile Exchange in the pork belly pit and I ran around asking all these old guys with grey hair, 'what advice can you give me? Do you have any techniques?'" says the trader and author. "I thought they'd give me a formula, but three fellows I asked all told me the same thing; they said 'the trend is your friend'. I thought, oh great, what kind of advice is that?" McLaren says it took 20 years to work out the significance of that advice.

The KISS principle of "keep it simple, stupid" should be your guiding principle in your technical analysis education. "Generally making money in the market is a simple task and it is achieved with simple tools," says Guppy. His approach includes identifying support and resistance, drawing old-fashioned trendlines and a multiple moving average.

A moving average is known as a technical indicator. A step up from the basics, but still a relatively simple tool, it takes the recent closing price data and averages it. "An indicator is designed to reveal something about price activity that isn't immediately obvious from the price chart," advises Guppy. "So we are trying to get behind what is happening in price."

McLaren thinks technical indicators can also be a trap for new players. "I was using RSI [relative strength index] and I lost $25,000 without even blinking an eye. How could this be? It worked so well in hindsight, but when I traded it, it doesn't work," he reveals. "These oscillators are really good learning tools, but to trade them is like trading shadows on a wall." He thinks indicators can work up to 60 per cent of the time and the other 40 per cent of the time they "kill you".

"A little knowledge is dangerous and a lot of knowledge is just the same," says Ken Henderson, president of the Australian Technical Analysts Association (ATAA). "When you have a very expensive software package you will go through every type of indicator and it leads to 'analysis paralysis'. Too much knowledge becomes overwhelming.

"I look back in horror at what little knowledge I had and how much I had exposed myself to risk financially," he says of his early days of trading with technical analysis.

ATAA runs regular monthly meetings in most capital cities with local and international experts in the field. It also publishes a monthly newsletter and a bi-monthly journal with articles on the topic. Henderson recommends including technical analysis is your investment decision-making process even if your primary approach is fundamental. "A lot of private investors I know use software programs to screen out the stocks they are not interested in based on fundamentals such as p/e ratios and net asset backing etc," he says. "Then they apply technical analysis to those stocks that have not been eliminated to determine which they will invest in, and once they enter those stocks they use technical analysis to determine which stage they exit."

Most fund managers and institutional traders publicly eschew the value of technical analysis. "We don't tell investors we use charts because people thinks it's voodoo," a slightly tipsy fund manager admitted to me at a party recently. "But the truth is the majority of us are using it to some degree." An understanding of charting does not guarantee to make you a successful trader, but it will give you the same knowledge many other participants in the market are using.

Guidelines

There are three books that technical analysis societies and associations have as recommended reading for their courses:-

Technical Analysis Explained by Martin J Pring is another classic covering the basics but also has more advanced topics like automated trading systems and a new indicator that identifies market cycles.
The Murphy and Pring texts also come with study guides.

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