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TIPS ON TECHNICALS
BUILDING YOUR
TECHNICAL
TOOLBOX

A COMMODITY RESEARCH BUREAU PUBLICATION

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Tips on Technicals: Building Your Technical Toolbox

Tips on Technicals:
Building Your Technical Toolbox
By Michael N. Kahn

Like quality carpentry, quality technical analysis requires the right tool
for the right job. While a hand saw can cut wood to build a table, a power
saw with built in guides can do it with a much higher degree of precision.
Conversely, the back end of a screwdriver can pound a nail but choosing the
right tool, a hammer, protects both the carpenter and the tool. In this issue
of “Tips” we’ll outline what tools should be in a good technical toolbox. In the
next issue, we’ll discuss more about when to use them.

Technical tasks

Technical tasks are simply the four main area of analysis that technicians
consider. These are price, volume, time and sentiment. Many of today’s
widely used indicators focus on only one of these areas. Further, many
of today’s technicians use only a few indicators, leaving out one or more
sectors of analysis completely. It’s like building a table with two or three legs.
It may stand up for a while but it won’t be solid enough to deal with shifting
or heavy loads.

Since the goal of any market analysis is to enable one to make money in
the differential between price paid and price received, price is necessarily
the most important factor. It is not a surprise that most market analysis
revolves around this element. Price patterns, such as triangles and gaps,
are used extensively. Measures of price momentum, such as the relative
strength index and rate of change are popular. Methods of smoothing out
market noise, such as exponential moving average systems, are created all
the time.

Volume is the next area and is important in gauging public participation

in any market move. Liquidity, open interest and breadth are all terms used
here. Liquidity measures how easy it will be to trade (turnover) and how
much catalyst is needed to cause a price change. Open interest, while
usually confined to the futures markets, measures how many participants
have put their money on the line by establishing either long or short
positions. “Shares outstanding” in the stock market is not quite the same but

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Tips on Technicals: Building Your Technical Toolbox

it does indicate how much stock is available (short sales excluded). Available
stock is the potential supply that can be offered for trading. Breadth covers
such areas as how various market sectors participating in any price moves
and how much money is flowing into or out of the market.

The next area of analysis is time. Accumulation, distribution, bull phases

and bear phases are common to all markets and each stage takes a
certain amount of time to complete. Together they form the market cycle
and knowing where the market is in its cycle aids in making the investment
decision. Further, the relative lengths of each cycle component and their
durations yield clues to market direction. Seasonal analysis began with
the agricultural commodities as they progressed through their growing,
harvesting and selling seasons but can be seen in all markets. Economic
and political cycles affect the financial markets as capital flows and
productivity change.

The least understood area of analysis is sentiment analysis. This covers

such areas as degree of speculation, public opinion and consensus. It is
measured by relative activities in speculative instruments, such as options,
and polls of bullish opinions. Both rely on the “burning match” theory in
which the flame is passed from investor to investor until there is nobody
left to take the match. They last one holding it gets burned, literally. In the
markets, as bullish opinion spreads, eventually everyone will have bought.
There will be nobody left to whom the last investors can sell. No demand
means the end of the rally. This can also be measured subjectively in the
media as glowing bullish news is reported only when the newspaper buyer
and TV viewer are ready to receive it. Again, when the public has an overall
bullish consensus, there is nobody left to buy.

Tools for each technical task

The most common tools in each area are outlined in the table below:

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Tips on Technicals: Building Your Technical Toolbox

Price Trend Identification • Trendlines , channels

• Smoothing, Moving averages
Patterns • Triangles, flags, gaps
• Candlesticks
Momentum • Single line oscillators (Relative
Strength Index, Departure,
Momentum
• Multiple line oscillators
(Stochastics, MACD)
• Directional Movement, Parabolics
• Bollinger Bands, Percent Bands
Relative levels • Benchmarking
• Log scaling
• Spreads and Ratios
Volume Participation • Volume, Cumulative Volume
Liquidity • Open interest, Shares issued,
Turnover
Breadth • Up-down volume
• Advance-Decline
• Dow Theory, Sector Analysis
Time Cycles • Form (translation)
• Seasonal
• Economic, political
Time Frame • Short, medium, long
• Cyclical vs. Secular
Extent • Length of trend or base
• Relation of correction to trend

(continued on next page)

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Tips on Technicals: Building Your Technical Toolbox

Sentiment Speculation • Options activity, put-call ratio

• Junk bonds, initial public offerings
• Margin levels, mutual fund cash levels
• Commitment of traders report
• Effects of good and bad news
Consensus • Percent of newsletters bullish or bearish
• Public opinion
Anecdotal • Magazine covers
• Hem lines, Superbowl

Combination tools

Some indicators were designed to cover more than one analysis area, as
follows:

Price and Time • Market Profile (shows time spent at each price
during the day, forms a value area on the chart)
• MESA (maximum entropy spectral analysis, finds
cycles in the data and projects them forward)
Price and • Money Flow (price times volume summed per
Volume trade, used as a supply/demand indicator)
• Equivolume (bars have width in proportion to
volume, used to allocate significance to price bars)
Price and • Elliott Waves (wave structure follows public
Sentiment emotions, can identify ebb and flow of trading
activity)

There are many variations of each study available but there is a limit
to how much data one can reasonably combine into a trading strategy.
Mechanical systems and artificial intelligence can go beyond this limit but
in return for better analysis, they require greater expertise, computer power
and discipline to set up and use. While the latest gadgets may be available
to the carpenter, most practitioners will do fine work with a basic set of tools.
As long as each is matched to the job at hand, the resulting quality is limited
only by the skill of the craftsman.

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Tips on Technicals: Building Your Technical Toolbox

About the Author

Michael N. Kahn is a columnist for Barron’s Online based out of Florida.

He also writes a free technical newsletter. To subscribe to this service,
please visit www.midnighttrader.com. The complete collection of Michael
Kahn’s “Tips on Technicals” is available in Real World Technical Analysis at
http://www.crbtrader.com/pubs/rwta.asp.

About Tips on Technicals

Each edition will cover one aspect of analysis; some being simple and
some being a bit more advanced. The accompanying charts were taken from
relevant CRB products.

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Tips on Technicals: Building Your Technical Toolbox

Other Commodity Research Bureau Publications:

»50 Rules of Futures Trading

»Charting Tools for Professional Traders

»Guide to Technical Indicators - Volume 1

»Guide to Technical Indicators - Volume 2

»Guide to Trading

»How to Spot Profitable Timing Signals

»How to Use Charts to Forecast Futures Prices

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