The Need for Statistical Techniques

<!– /* Font Definitions */ @font-face {font-family:Calibri; panose-1:2 15 5 2 2 2 4 3 2 4; mso-font-charset:0; mso-generic-font-family:swiss; mso-font-pitch:variable; mso-font-signature:-1610611985 1073750139 0 0 159 0;} /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin-top:0cm; margin-right:0cm; margin-bottom:10.0pt; margin-left:0cm; line-height:115%; mso-pagination:widow-orphan; font-size:11.0pt; font-family:Calibri; mso-fareast-font-family:”Times New Roman”; mso-bidi-font-family:”Times New Roman”; mso-ansi-language:EN-GB;} @page Section1 {size:612.0pt 792.0pt; margin:72.0pt 90.0pt 72.0pt 90.0pt; mso-header-margin:36.0pt; mso-footer-margin:36.0pt; mso-paper-source:0;} div.Section1 {page:Section1;} –> Statistical methods were developed in order to make sense of large amounts of data, to boil that data down into a few meaningful conclusions. Never is this more necessary than in the world of Technical Analysis – the analysis of current share prices and the prediction of future ones. There are a vast number of publicly traded shares and each share price changes frequently, often several times a day. This produces a large amount of data, which is usually plotted as a series of graphs. To the untrained eye, these graphs look pretty meaningless, but by applying statistical methods, the information that they contain can be extracted.

Many traders find candlestick charts easy to read and to interpret. They know, for instance, that a Marubozu indicates that either buyers controlled the market in a particular share or sellers did, and that an upper wick considerably longer than a lower one shows that buyers dominated, driving the prices higher. It takes a while to learn to read a candlestick chart at a glance, but, when mastered, they make a useful tool in the Technical Analysts armoury.

Occasionally you will see a candle that does not have a wick, either above or below the body of the candle. This is called a Marubozu and it indicates that the price of the stock never went outside the range set by the opening and closing prices. Either the peak price was the opening price and the low price was the closing price (in the case of a black candle) or vice-versa (for a white candle).

Reading a Candlestick Chart at a glance

Several white candles in a row indicate stock prices that ended each day consistently higher than their opening values – a rising trend. Bull markets are characterised by white candles. Similarly, a series of black candles represents a generally falling (bearish) market. The lengths of the wicks gives an indication of the volatility of the share price. If the wicks are comparatively long, then the price fluctuated wildly. You can also glean information from the general shape of the candle itself. For instance, if the body of the candle is quite short, but it has a long lower wick, then during the day, the price of the stock fell rapidly before rallying to close near its opening value.

Each day on a candlestick chart is represented by a symbol resembling a small candle (hence the name): a vertical rectangle that can be black or white with a small vertical line sticking out of the top, the “shadow” (or “wick” to persist with the candlestick metaphor). Unlike real candles, there is another vertical line or wick sticking out of the base as well! The vertical axis on a candlestick chart represents share price, so the tops and bottoms of the rectangle and wicks represent price values.

The four elements represented on a Candlestick Chart

The stock starts each day at a particular price, called the opening value, and ends each day at a (possibly) different value, the closing value. During the day it may reach a peak price above the opening value or drop to a minimum price below the closing value, the high and low values respectively. These are the four elements represented by each candlestick on a candlestick chart.

What are Candlestick Charts?

Candlestick charts are a graphical way of expressing the movement of share prices from day to day. Each entry in the chart represents a single day but encodes information about the behaviour of the price on that day. They are sometimes known as Japanese Candlestick Charts because they are supposed to have been developed in Japan during the nineteenth century as a way of tracking rice prices.

Technical Analysis does have its critics – those economists who say it is nothing more than a pseudoscience, one that has no basis in fact. Investors such as Warren Buffett and Peter Lynch say that there is precious little evidence that Technical Analysis works. However, various academic studies have shown that technical analysis, particularly when carried out by neural networks, can produce statistically significant returns, and many investors have made fortunes through the application of its principles. It is therefore unfair to dismiss it as mere nonsense, and one ignores it at one’s peril!

Computer software lends itself readily to the processing of massive amounts of data, and they are ideal tools to use in Technical Analysis. There are two broad approaches to the automatic prediction of shares: those that use rule-based prediction (where the computer program is fed certain predetermined rules about how shares generally behave and when to buy or sell) and those that use neural networks (software based on networks of brain cells). Neural networks are trained by example on sets of data and which hone their prediction abilities as they accumulate experience.

One of the tenets of Technical Analysis is that prices follow trends, either upwards, downwards or sideways (when the price is generally holding steady – a “flat” price). If investors spot an upward trend in a share, they may well try to jump on the band-wagon and buy that share, hoping to benefit from its rise, and thereby driving its price up further. Similarly, a downward trend may cause investors to dump shares on the market, causing a further fall in the price. This can cause the price to “zig-zag” – rise and fall several times in line with investor confidence.