Using technical analysis as a basis for action

Updated: 2010-11-22 14:19

By Daryl Guppy (China Daily)

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Using technical analysis as a basis for action

Does technical analysis provide a method to predict the market? It's a question I am often asked and the answer is always "No". Technical analysis provides a framework for assessing price movements. It helps to identify in advance the price points that will confirm or invalidate analysis. The objective is to know the price behavior that confirms the trend has changed, or if the trend remains the same.

The analysis distinguishes between price activity that is normal and carries no significance in terms of trend change and significant price activity.

This is price activity that increases the probability of a substantial trend change. Technical analysis provides a series of trigger points. When one of these points is crossed then investors and traders must actively re-assess their approach to the trade or investment.

The behavior of the US Dollar Index is a good example. When major events occur in markets, such as the confirmation of the second round of quantitative easing in the US, we anticipate the result. Our conclusion, like many others, was the US dollar would continue to fall and the price of gold would continue to rise. In fact the exact opposite happened, with a rally in the US dollar and a substantial retreat in the price of gold.

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The gold price developed a small rise to $1,420. This rally was short-lived and the price quickly retreated to below $1380. The price continued to fall rapidly and the close price below $1,357 was also a close below the value of the long-term uptrend line.

Are these movements temporary or do they indicate a more significant change in the trend? If they are temporary then there is no need to sell gold. In fact the retreat would be a buying opportunity. If the retreat is something more significant, then, like legendary trader George Soros, we may decide it is time to sell gold because a major trend change is developing.

The fast rally and retreat behavior is normal activity in a rising trend. The close below the trend line value at $1,357 is more significant. This price activity suggests there is a high probability the uptrend is ending. This confirms it is time to protect profits and that it is not a good time to buy gold in the hope the uptrend will continue.

The US Dollar Index chart also developed significant price activity. The rally from $0.76 to $0.78 was not expected, but it was not unusual. Many people expected the US Dollar Index to fall. The move to $0.78 was consistent with the normal rally and retreat behavior in the downtrend for the index.

When the index moved above $0.785 the price activity became more significant because this was a move above the downtrend line. This price move confirmed the rally had developed into a potential trend breakout. A move above resistance near $0.79 would confirm the trend change and investors will need to take action to protect their profits.

This is the most important role of technical analysis. It does not tell us what will happen in the future with the price of gold, or oil or the US dollar. The analysis identifies the price levels where we need to take action at some time in the future. Gold trading above the all-time high of $1,420 signals one type of investment decision. Gold trading below the uptrend line at $1,357 signals a different type of action. Good analysis tells the investor when it is time to take action.

The author is a well-known international financial technical analysis expert.

Using technical analysis as a basis for action

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