We have previous covered some philosophical issues, that there are 3 directions the price can take, and then we very briefly touched on the risks and rewards of different types of positions that can be entered to take advantage of these 3 directions. We then briefly looked at Fundamental analysis and compared it to some results of using Technical Analysis.
So just what is Technical Analysis? This is the study of charts, where the history of the stock and different patterns are examined. A chart is nothing more than a graphic representation of price and time for a stock or index. I am going to refer you to the “Charting Basics” section of the Time Frame Investor web site to cover some of the basics.
A few things I have learned is that you can very easily put too many indicators on a chart and wind up with “analysis paralysis”. You can clutter the screen with moving averages, different types of channels & bands, macd’s, stochastics, RSI, CCI, Money Flow, trend lines, support and resistance lines, Fibonacci levels, and even Elliot Wave counts.
For traditional charts, what I found works best is to find just a few indicators that work in most situations, and stick with them. And to occasionally augment these “core” indicators with some of the other indicators. There will be times that support or resistance lines will be handy, and after a long trend, a set of Fibonacci retracement lines would show levels that the price could move back to as it takes back a measured amount of the gains from the trend.
What is important is that you experiment with the different indicators and settings until you find the ones that YOU are most comfortable with.
The chart shown here is part of the Time Frame Analysis charts that I use. I am using some complex algorithms to interpret the strength or weakness of a time frame, and to display it in a very simple format.
The one thing that leads most people into trouble is that they only evaluate the daily chart. This is like driving your car while wearing a set of blinders on your face so you can only see what is right in front of you. This leads us to one of the most important aspects of Technical Analysis, TIME FRAMES!
A time frame is based on the interval of the chart. An intraday chart, say where each candle represents 15 minutes of trading does not tell you what to expect for a long term trade. That 15 minute chart can not be used to tell you what the price is likely to be doing a week from now. And likewise, a weekly chart, where each candle represents a week does not help you determine when it would be a good time to place a day trade.
This does not mean that these different time frames can not be used together. The best trades will be found when you have different time frames pointing to the same expectations. The price does not always go straight up, there are ebbs and flows to each and every time frame. You can have a longer term weekly chart moving up, but have a daily chart pullback to create a dip to set up for a continuation of the weekly chart move.
A good way to use the different time frames would be to determine on the longer term charts what the most likely move would be, and for this discussion lets just say that on the longer term charts we are seeing indications that the price is likely to move up. We then look at the shorter term charts, and they are also showing potential to move up. If we were looking to place a day trade, this information would tell us that the strongest moves are most likely going to be upwards moves, and that pullbacks are going to be opportunities to get positioned for an upwards move. If you are looking to enter a longer term position, this same set up would be applicable. You would want to have the upwards expectations on the longer term charts to show that the trade can last for more than a few minutes or a few days. And then you can use the short term charts to refine your entry point, to wait for some intraday weakness to let up and then enter for the expected longer term move.
And the different time frames can be used to help determine if a move has reached become over extended and is getting ready to reverse. This can be used to know it is time to take or lock in profits, depending on the type of trade that you have.
The purpose of using Technical Analysis is to develop expectations for what the price is likely to do. You will want to use these expectations to develop a trading plan, one that will give you a plan of action, and also identify what to look for to know that you were “wrong”. And there will be times when you ARE “wrong”. The trading plan along with money management is the cornerstone to a successful trader. Whether it is a short term directionally biased trader, or a longer term “non-direction” trader. If you do not have a plan, and if you are not using money management practices, you are not going to be around very long.
The answers to the following questions will give you a trading plan that you can confidently use.
Short or long term? This will help you determine the time frames on the chart to pay the closest attention to, and it will help you to determine the best type of position to enter. Such as a butterfly would not make for a trade you would want to enter with expectations of exiting it within a few days.
What are the expectations of the stock or index? This goes along with the time frame, for the duration of your trade, is the stock or index showing potential to move up, down or sideways? This will help to determine what type of position to enter. An example of this would be if the stock has formed a top and is starting to move down, or is in a strong downtrend, you might not want to sell puts because of the risk of the price falling below the strike sold.
Buy premium or sell it? This will depend on the expectations of the stock and the duration of the trade for an options position.
Simple or complex position, and is there potential to change the position as it develops? An example of this would be a calendar spread. This type of position is where you buy an option that has many months of time, and each month during the duration of this trade you want to sell a near month option, so this position does require a change each month. Or if you enter a spread or multiple spreads, would there be potential to roll part or all of the position to another strike or another month? You need to examine this issue before entering the trade so you will not try to “fly by the seat of your pants”.
What are your expectations for the trade? This is where you start to look at profit objectives, and an exit strategy. Is there a defined time or profit level that will signal an exit for the trade, or will you use a “trailing stop” type of philosophy to try to stay in the trade as long as possible?
Probably the most important question, what will tell you that you are “wrong”? You need to know what your stop will be. This will either be the price of the stock or index moving beyond a certain level, it could be if an indicator gives a specific signal, or it could be when a certain amount of money is lost in the position. You do need to know how much money would be lost should the stop be hit.
And finally, the position size. How big or small of a position will you get? I feel that you must know how much you can afford to lose, and based on your stop, size the position accordingly to control your risk.
In the next article we will start to look at some common types of simple positions in greater detail to learn what the characteristics are of the different types of positions that can be used. After that we will start to examine some charts to show how expectations can be developed, and how to tie these expectations into a trade selection.