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Using Technical Analysis to Interpret Economic Data

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This chapter is from the book
This chapter covers the technical analysis techniques that are used later in determining the success or failure of market timing systems based on economic data. They do not include the standard chart pattern analysis, but instead they include the analysis of trends using moving averages and other methods.

Trends

As any chart of market prices will show you, prices have a predilection toward traveling in trends. The trend, of course, can be upward or downward at various slopes or sideways. Most investors in trading markets make money following the trend of an investment price. The fact that prices trend makes it possible to make money. If prices were purely random in their movement, no one would profit. But people do profit, and very handsomely, because prices travel in trends. From a technical perspective, a trend is a directional movement in prices that remains in effect long enough to be identified and still be playable. Not all trends last long enough to be recognized and then acted on. Profiting also depends on the investment horizon of the person analyzing trends. If his outlook is for long-term trends, day-to-day price motion is irrelevant. If his outlook is to swing trade over a few days, the long-term trend is unimportant.

Regardless of the trend length, prices do not follow a straight line. Around the trend, prices tend to fluctuate. When that trend changes direction, it is first evident in one of the fluctuations. However, not all fluctuations are changes in trend. They may be just countertrend oscillations about the trend that will return to the direction of the trend.

The small vacillations around a trend sometimes make the trend difficult to identify. Shorter trends are parts of longer trends. Though trends may be obvious in hindsight, ideally, we would like to spot a new trend right at its beginning and spot when the trend has ended. This ideal, however, never happens, except by luck. No magic indicator exists to spot precisely the beginning and end of a trend. Looking at a graph of prices, an analyst can spot many trends of varying length and magnitude, but such observations are observations of history only. A trend must be recognized early and last long enough to profit. If you spot it too early, your chances of failure are greater; perhaps it was just an aberration or a smaller, countertrend move, or perhaps it was a new trend but not long enough or large enough to profit. If you allow more time to prove that the trend exists, the chances of failure are less but potential profit is lost when the price continues in the new direction without your position. There is always a trade-off between potential risk and potential reward. This is why so much effort goes into accurately recognizing the beginnings and ends of trends.

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