Technical views provide a “hypothesis” of what is going on in the market. They are like notes taken by scientists studying some phenomena. Each one makes a set of assumptions based on what has been observed, and involves a prediction. If the phenomenon behaves as predicted, then the hypothesis would be correct, but if not, then the hypothesis must be discarded immediately and a new one needs to be created. This framework creates an environment in which traders behave scientifically and rationally, following rules and not emotion. The thing with technical analysis is that there is no right or wrong way to analyse an event. This is not surprising because different scientists observing a new phenomenon would develop different hypothesis as no one knows what the truth is. But what it does do, is to provide a system of rules behind each trade to make decisions more objective. Technical analysis, if used properly is a form of scientific method.

Let’s take an example to see what we mean.

In our technical view, the hypothesis is that we have reached a top on the KLSE, and certain events must occur over the next few days if this is to hold. If not, then the view should be discarded.

On the weeklies, you can see that we have had a strong rebound from August, caused in my view by money rotating into blue chips, which is a defensive play - since we have not seen any particular growth in volume. The sellers are therefore not out yet. But if you use the RSI indication (which can be considered the “lungs” of the KLSE) you will see that it has been falling. This means that as the KLSE climbs the mountain, it is running out of air. Although there are buyers out there, the number of them is decreasing. This drop in the RSI compared to the rise in the KLSE is called a negative divergence and should be taken as a bearish sign.

On the dailies, you also see resistance at 1390-1400. The greater the number of times this has acted before as a resistance level in the past, the stronger it will act as a resistance level in the future (by the opposite token, if this is broken it should be viewed as a bullish sign).

So what next? Here is a description of all the possible events and how they should be interpreted in the context of the view and a statement of what technical traders should do.

If in the next few days, the KLCI turns down, the technical view has been supported. Technical traders should think about selling or rotating into more defensive counters (if their existing counters are showing the same signs). If it does not, and keeps on going up, the view needs to be discarded and new one needs to be set up. Traders should examine the nature of the move up in terms of how strong it is and whether it is supported by volume to be able to develop a fresh hypothesis that the KLCI will continue to trend up - this will be for another lesson. If the KLCE stays where it is without moving, the hypothesis has not been proven right or wrong. Traders should wait.