Technical analysis — also known as charting — has been used by traders in all sorts of assets, not just in equities, for centuries.
But how can you tell if technical analysis actually works for the sharemarket?
Charting to track the sharemarket is still a relatively new area compared with fundamental analysis. However, recently more studies have come to light that support the idea that technical analysis or using charts can outperform against the sharemarket.
One study found that there are 26 technical trading rules that when applied correctly could actually outperform a buy and hold strategy. Brock, Lakonishok and LeBaron (1992) looked at 26 technical trading rules over almost 100 years, from 1897-1986. They looked at the Dow Jones Index, then evaluated a buy and hold strategy on particular stocks versus using two trading methods: moving averages and trading range breaks. By comparing the results of buy and hold versus these two main technical analysis methods, they found that the 26 technical trading rules outperformed.
In a related study, Levich and Thomas (1993) provided more evidence that moving averages produced profitable trading signals. The data was for the foreign exchange market for the period 1976-1990.
And in a third study, Gradojevic and Lento (2007) looked at different moving average combinations: 1 day/50 day, 1 day/200 day, 5 day/150 day. The study applied the combinations to the S&P/TSX 300 index, NASDAQ composite index and Canada/US spot exchange rate. The researchers found that excess returns were generated using moving average crossovers.
A moving average is the average price over a time period. For example, a 200 day moving average is the average price of a stock or index over 200 days. This type of analysis is useful because it generates a trend-following mechanism.
Generally if the price of a share moves above the 200 day moving average line, it's a buy signal and if it moves below, it's a sell signal. 200 days is quite a long line on the market and it's thought of as a long-term indicator, suitable for a trader looking to catch long-term trends.
If on the other hand, you're a short-term trader looking to trade a couple of times a month, you would use a shorter time frame such as 15 days to watch moving averages.
You can even use two moving averages of a shorter and a longer time period to generate buy and sell signals.
For example, if you chart a 1 day and 200 day moving average, and you see that the two lines cross over (called a 'moving average cross over') it indicates a buy or sell signal.
A buy signal is generated when the shorter period line (like the 1 day moving average line) moves above the longer period line. Conversely, a sell signal is generated when the shorter period line moves below the longer period line.
The moving average crossover tends to work well when there is a strong uptrend or downtrend in the sharemarket, but not when prices are moving sideways. The problem with a sideways market is that it causes 'whiplashing', that is buy and sell signals appear at the same price.
Let's have a look at an example:
In this example you can see the shorter time period in black and the longer time period moving average in red. When the black line moves below the red line it generates a sell signal.
While moving averages have been shown to have been effective in the past, it is not a fool-proof system. Other technical analysis indicators can be combined to increase your chances of success in the market.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.