Book Reviews

Book Review: How Technical Analysis Works by Bruce Kamich

Rating: Mama desu.

Background: This is a follow-up from my interest in Technical Analysis after reading about the 3 tools (MACD, Slow stochastics, SMA) recommended by Phil Town to be used in conjunction with fundamental analysis.

Key Points:

  1. The logic of the technical approach
    • The market discounts everything (i.e. it is forward-looking) 
    • Prices move in trends
    • History repeats itself
  2. Trend line breaks: 1%/3% rule: If the security trades more than 1%/3% above/below the trend line, you buy/sell.
  3. Support and Resistance
    • Once broken, support becomes resistance, and vice versa.
    • The more times a level was tested, the more important that level becomes.
    • Finding support and resistance levels
      • % retracements – prices retraces 25%, 33%, 38%, 50%, 66% from the high of a move.
      • Price objectives – from patterns such as triangles, head-and-shoulders, etc.
      • Moving averages – 50-day and 200-day moving averages
      • Extrapolating trend lines
      • Price markups – e.g. double the low
      • Volume at Price – places where the volume was high
  4. Patterns
    • Head-and-shoulders – The height from the neckline to the top of the head is projected downward from the neckline to get the projected price. If the target is overrun, double the target (i.e. subtract the height again). 
    • Double tops – same as H&S.
    • Triple tops, saucers, lines, cup-and-handle, V tops – basically a list of patterns that seemed pretty useless, either that or the explanations were lacking.
  5. Reversals
    • Outside days (high-low range of current day is outside/eclipses the prior day) and inside days (high-low range of current day is entirely within that of the prior day) are signs of weakness – i.e. nobody (bulls/bears) is in control.
    • The stock has been on a downtrend and it makes a new low. If another new low is not made the next day, and the stock can close above the high set on the recent low day, then we have a short-term buy signal.
    • The stock has been on an uptrend and makes a new high. If another new high is not made the next day, and the stock can close below the low set on the recent high day, then we have a short-term sell signal.
    • Island reversal, and hook reversal – no info on how to use them.
  6. Consolidations
    • Flags and pennants – Go long/short on a break above/below the line across the highs/lows of the flag/pennant.
    • Triangles
      • Price target – Measure the length of the missing side that will ‘close’ the triangle. Project that length from the breakout point to get the target price.
      • Timing – Triangles typically break out 2/3 to 3/4 of the way through the pattern. If you mark the point in time where the triangle pattern would have reached its apex, that will often mark the peak or trough of the move out of the triangle.
    • Rectangle/box – Height of rectangle can be used to measure and project a target.
    • Rare diamond – very rare
    • Wedges (triangles where both top/bottom trend lines slope in the same direction)
      • A rising/falling wedge favors a downside/upside breakout.
      • Price target – If the wedge is a continuation pattern, the price range of the move before the wedge can be projected from the breakout point. If the wedge is a reversal pattern, the distance traveled by the wedge can be projected from the breakout.
  7. Gaps
    • Types of gaps
      • Breakaway gap – ‘nuff said
      • Runaway (measuring) gap – Gap in a continuing trend. Project the length of the move before the gap, to get the price target.
      • Exhaustion gap – Last ditch attempt before a reversal
    • How to trade gaps – Find the halfway point of the gap and assume it will trade back till there.
  8. Channels
    • Profit by buying/selling within the channel.
    • Measure the width of the channel and project that distance from the breakout point to get the target price.
  9. Moving averages
    • 1-MA system: Go long/short when the price crosses above/below the MA line.
    • 2-MA system: Go long/short when the faster MA crosses above/below the slower MA.
    • 3-MA system: Go long when the fastest MA crosses the middle MA, and the middle MA crosses the slowest MA. Go short as soon as the fastest MA has declined below the middle MA.
  10. Relative strength
    • Stocks that performed well/poorly continued to perform well/poorly, so buy strength and sell weakness.
    • Relative strength can be calculated by dividing the daily/weekly close of a stock or group, by a market average or index.
    • Relative strength usually reverses ahead of the trend in the index.
  11. Volume
    • Volume leads price, and is a confirming indicator.
    • On-Balance Volume (OBV) is cumulative volume (if today closed higher/lower, you add/subtract today’s volume to OBV). If prices were going sideways and OBV is rising/falling, that meant smart money was accumulating/liquidating.
  12. Oscillators
    • Rate of Change (ROC) oscillators, and other momentum oscillators, will lead price action.
    • Look for confirmation once the oscillator diverges from price action (i.e. price makes a new high/low but oscillator does not make a new high/low).
  13. Relative Strength Index (RSI)
    • Fluctuates from 0 to 100. Overbought/oversold levels at 70/30.
    • Upward bias in bull market (i.e. levels should be 80/40), downward bias in bear market (i.e. levels should be 60/20).
  14. Stochastics
    • Determines where the current closing price resides, within the price range of the last x days. Overbought/oversold levels at 80/20.
    • Fast stochastic: %K is the stochastic indicator using actual price. %D is the smoothed average.
    • Slow stochastic: %K is the %D of the fast stochastic. %D is the MA applied again on the %K.
    • Either used like a normal momentum oscillator (i.e. trade based on the level) or like a MA (i.e. %K crosses above/below %D).
  15. Other indicators
    • Advance/Decline (A/D) line
      • Daily cumulative of (# of advancing issues – # of declining issues).
      • Similar to momentum indicators – move together with price trend is good, divergence is bad.
    • Last-hour indicator
      • Daily cumulative of (price change in last hour of trading) to know the “real” price action.
    • Arms Index (TRIN) – unclear explanations.
    • Sentiment
      • Investors Intelligence survey, Bullish Consensus survey, Barron’s surveys.
      • Look at the credit market report in WSJ to find the average maturity of securities held in portfolios of taxable money market funds, typically 29 – 65 days. When fund managers extend/shorten maturities, they expect short-term interest rates to decline/rise (shouldn’t it be the other way around???).
      • Put/call ratios. High at market bottoms, low at market tops.
    • Barron’s Confidence Index (BCI)
      • Calculated by dividing the average yield of high-grade corporate bonds by the average yield of intermediate-grade speculative bonds.
      • Investors will move to high-grade bonds if they anticipate recession, which lowers the yield, and decreases BCI.
      • BCI leads stock prices at turning points by 2 – 4 months.
  16. Guidelines for successful trading
    • Have patience and wait for the right opportunity and the right setup.
    • Look for confirmation of the pattern/signal.
    • Don’t trade without stops.
    • Money management is critical.
    • Always add to positions in the direction of the trend. If you are long, add to positions on strength. If you are short, add on weakness. Never add to your position if the market is going against you. Always let the market tell you that you are right.
    • Exiting a trade: Sell 1/3 of the position when the profit target is reached. If the market is still strong, hold the remaining 2/3 until a trend break or a reversal.

General comments: The explanations in the book are not clear and succinct, and the examples are often not obvious (i.e. the explanations below the charts say something, but you just don’t see it). There are also too many exceptions and too many patterns to make the material useful – it would have been better if a self-contained usable framework is presented rather than covering so much material without a proper structure. In general, the approach to viewing the many technical rules of the game, may be to know what others see, as opposed to following the rules blindly.



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