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Definition of technical analysis
Technical analysis as defined by the Market Techncian's Association is: "..the study of data generated by the action of markets and by the behavior and psychology od market participants and observers. Such study is usually applied to estimating probabilities for the future course of prices for a market, investment or speculation by interpreting the data in the context of precedent."

Evidence that the U.S. Federal Reserve Board uses technical analysis in policy making decisions
In a recent speech Alan Greenspan noted that: "But, although there doubtless have been profound changes in the way we organize our capital facilities, engage in just-in-time inventory regimes, and intertwine our newly sophisticated risk-sensitive financial system into this process, there is one important caveat to the notion that we live in a new economy, and that is human psychology.

'The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions... To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears.
' Hence, as the first cut at the question 'Is there a new economy?' the answer in a more profound sense is no. As in the past, our advanced economy is primarily driven by how human psychology molds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past."

So, the Fed Chairman's speech suggests that the root of technical analysis, crowd behavior, is also the root cause of actions by humans in general that lead to price movement in the markets. If there ever was a reason to believe that you should be using technical analysis in your market forecasts, then I suggest you study Mr. Greenspan's speech, for it is obvious that in one form or another, the Federal Reserve Board uses it in its own policy decisions. This is exactly why I was able to forecast the 15-October-1998 rate cut before anybody else!

The Directional Movement Index
This is actually a suite of indicators meant to measure whether or not the market is in a trending mode. It is a fairly slow indicator and one must be careful in applying it in that it takes time to adjust to market moves. Whipsaws are possible, and in fact likely if the market is in a wide trading range.

The components of the index are:

Directional movement (+DM and -DM) represents the largest part of today's move that is outside the previous day's range. So, for example, if yesterday's price range was 18-22 and today's is 17-24, then +DM is two and -DM for the day is zero. On an inside day, there is no directional movement. This system does not care where the close is, so in the example above, even if the close was on the low, the directional movement is considered to be positive because the largest part of today's range is above the previous session's range. Note that -DM is always positive, so if today's range is 17-20 and yesterdays was 19-19 1/2, the -DM is 2 and +DM is zero.

Directional Movement Indexes (+DI and -DI) ) are computed by using the daily +DM and -DM discussed above and taking a ratio with the daily true range. The daily true range is the largest of the following: The absolute value of:
A. The distance from today's high to today's low.
B. The distance from today's high to yesterday's close.
C. The distance from today's low to yesterday's close.

What the true range does is adjust for gaps, in essence adding them back in to today's trading range. We then compute today's +DI and -DI as the ratio of the DM's to TR, so:

+DI =+DM/TR and -DI = -DM/TR.

This is then telling you how powerful today's move was in comparison to the day's range. On a day that prices gap higher, and close at the high, that day's +DI would be 1.00. Remember, on an inside day, both DI's will be zero and if there is positive directional movement there can be no negative directional movement.

Smoothed DI's are then computed. The standard computation is to do a 14-day moving average of the individual DI's (exponential preferred, but it does not make that much of a difference).

Directional Indicator (DX) is the ratio of the difference between the smoothed +DI and -DI and the total directional movement. That is:

DX = [+DI(14) - -DI(14)] / [ +DI(14) + -DI(14)]

Note- +DI(14) is the 14-day smoothed positive directional movement index and -DI(14) is the 14-day smoothed negative directional movement index. These are the standard numbers.

Average Directional Index (ADX) is just the smoothed DX (again typically a 14-day exponential smoothing factor).

What does it all tell you?

First of all, remember that this is a very slow indicator, so it is not going to turn at tops or bottoms. I mostly use ADX as a secondary indicator to tell me whether we are in a trend. Then I will look at the +DI and -DI to see what the components look like. The classic rules are that a move past 20 in ADX says that the trend is real and that moves above 40 should be treated suspiciously and might mean that the move is stretched. Some people get into a directional move on a run past 20 in ADX.

Alexander Elder, in his book Trading for a Living suggests going with the trend whenever ADX breaks from a low level and from beneath both directional lines and then ratchets up four points, it is a sign of a new trend starting. It warns that when ADX is above both DI lines, the trend is ahead of itself. He suggests getting out of a trade when ADX turns lower from such a position.

ADX in bonds has been falling since 8-October. It continues to fall, but right now it is beneath both DI's. (I am glad you asked me about this because somehow my ADX settings had gotten clobbered and I was giving you bad data on the ADX.) +DI is still above -DI, so as long as we do not fall too much more, ADX will continue to slip. Given the smoothing constants, it will probably take a move toward 121 or lower to get ADX to ratchet strongly higher in a down move, which is another reason to believe that the long term trend remains higher. Short term though is certainly down, though ADX is not useful for that determination.

I mostly use ADX to see the direction of the three lines as compared to the current trend. When ADX starts to turn from an extreme level, that can be a warning of a change in the trend for the next several months. It is often late, as it was in October, but it did indicate range trading for a while, which is what we are getting right now. ADX is never a determinant in my thinking because it is slow, but I do use it to see how well my larger wave counts fit with the indicator.

In the coming weeks I will be adding further educational materials on technical analysis.

Suggested Reading List In association with Books.com


Technical Analysis of the Financial Markets: John Murphy

This is the updated version of the classic, Technical Analysis of the Futures Market and is one of the most easy to read and comprehensive guides to technical analysis.


Schwager on Futures:Technical Analysis: Jack Schwager

Though most technical analysts I know prefer the Murphy book, this one also spends a good deal of time on how to trade, something missing from the Murphy book. There is no coverage of Elliott Wave Theory though.


The Disciplined Trader:Mark Douglas

Though this is not a book on technical analysis at all, it is the best thing that I have ever seen on how to trade. It gets into the psychology of trading and how to be flexible in your analysis. This book might be even more important than the technical analysis books and you should not consider trading without reading and studying this book first!


Intermarket Technical Analysis: John Murphy

This book talks about how various markets can effect one another. While some of the conclusions are wrong in my opinion, I think the basis of the book is very important. To follow bonds without having an opinion on stocks can be dangerous to your health.


Trading Systems and Methods - Perry Kaufman

Kaufman's book spends a good deal of time talking about trading systems and shows how to compute many of the indicators that we all talk about. It is important to understand the math behind these indicators when you are using them. This is a tough book to follow, but is worthwhile if you want more depth of systems.


Technical Analysis of Stock Trends: Edwards and Magee

The true bible of technical analysis. It is something like 50 years old and not as complete as Murphy, but if you follow stocks, it is the best.


Aerodynamic Trading: Connie Brown

Ranks right up there with the Mark Douglas book on how to maintain the proper mindset for trading. Excellent exercises and fascinating writing style make this book an absolute must buy.


Trading for a Living: Alexander Elder

Not as good as Douglas, but also reviews many indicators. Covers money management.


Japanese Candlestick Charting Techniques: Steve Nison

A great book on visual charting. Steve is the expert on this and the book is very well written too. He does an awesome job of explaining how to combine Japanese techniques with standard Western technical analysis.


Extraordinary Popular Delusions and the Madness of Crowds: Charles Mackay

Written by a historian over 100 years ago. Read this before you buy any idiot.com stock! It really is the raison d'etre behind technical analysis.


The Elliott Wave Principle: Prechter/Frost

Though Bob Prechter has not been on target in calling the stock market, he is the expert on Elliott Wave Theory. It is my favorite of the Elliott books and what I used to learn Elliott Wave analysis. If this is your bent in analysis, push this book much higher on your list. If you are not interested in Elliott, then it belongs anyway as a secondary reading so you know what all those wild-eyed Elliotticians are talking about!


Options, Futures and Derivative Securities: John Hull

Only for people who are into the greeks. Very theoretical but truly explains futures and options theories.


Others:
I have not included books on point and figure (many have suggested trying Tom Dorsey's book) or Gann, because I am not a big user of these methodologies and would not want to recommend on that basis. You may use the Amazon search link below to order other books from Amazon.

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