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Cheat Sheet

Technical Analysis For Dummies

Need help making trading decisions in securities markets? Technical analysis is a collection of techniques that can help you do that. Discover 15 trading secrets that can help you beat the market, figure out how to read a standard bar chart, and know how to interpret a candlestick chart.

15 Technical Analysis Secrets for Boosting Your Trading Skills

Technical analysis can give you an edge in beating the stock market. How, exactly, do you do that? Here are 15 technical analysis secrets to becoming a skilled technical analysis trader:

  • Use at least two indicators. One technical indicator is better than none; just using the 200-day moving average on the Dow or S&P 500 would have saved your bacon in all the recent bear market downturns. Then apply a second indicator to get the confirmation effect that improves your odds of being right.

    You'll never be 100 percent right 100 percent of the time, so confirmation is a must. But don't demand so much confirmation from so many indicators that you hardly ever get a signal — analysis paralysis. Use indicators that work well together without duplicating the ruling concept.

  • Figure out what the indicator is saying about crowd sentiment. Indicators measure trendedness, the strength of a trend, when a trend is running out of steam, and other aspects of the price move. No indicator measures everything, so understand which aspect of crowd sentiment your technical indicators is focused on.

    Take an empirical approach. See what you're looking at on the chart. Don't let wishful thinking skew your vision. Accept the evidence of your eyes. When you misinterpret a chart, go back and find what you missed.

  • Use multiple time frames for confirmation. When you have the same buy/sell signal in the six-hour, daily and one-week timeframe, you have confidence that the indicator is telling you the truth. You won't get multiple timeframe confirmation all the time but look for it anyway. When in doubt, expand your timeframe to the weekly chart from the daily chart—seeing the big picture may help.

  • Trade with the trend. If the security is trending upward, buy it. When it stops trending upward, sell it. If you don't know what's going on, don't trade. Don't fall into the "value trap" — that a high-quality security will come back after a fall. It may, but you may have to live a long time to see it happen. While you're waiting, you're missing opportunities to build capital.

  • Dismiss people who say "market timing doesn't work." They are people who couldn't get it to work for themselves. Millions of people use technical analysis in one form or another today. Every U.S. broker offers technical charting capability. They wouldn't do that if traders didn't demand it.

  • Don't bring a knife to a gunfight. It takes real skill and superior analytical capabilities to excel at trading, as in any other endeavor. You can beat the index averages. And you can make extraordinary profits in securities markets. But you have to strive for excellence in your analysis and in managing the trade. You're up against serious professionals who want to take your money. You need to be just as smart as they are, if not smarter.

  • Don't trade for amusement or to make a point. The purpose of trading is to make money—period. If you're trading for entertainment or to prove some philosophical or political point, you'll almost certainly lose your shirt. For amusement, go to the movies. To make a political point, write a letter to the editor.

  • Use fundamentals to select securities, not to trade them. Nobody says you have to trade junky securities. High-class "value" securities can be just as trended as junk. You're free to trade only the securities you like on a fundamental basis, but you use fundamentals to select securities, not to set a trading regime.

  • Manage your trades with military discipline. Indicators are sometimes wrong and you'll take losses. Compensate for the shortcomings of indicators by imposing strict risk-management controls. Don't lie to yourself about your track record. Examining losses may uncover a surprisingly simple way to avoid losses in the future. Examining gains may disclose some personal talent on which you can build.

  • Never override your trading plan. The trading plan has two components — the signals generated by your indicators and your stop-loss and take-profit rules. You can't control the indicators or the market while a trade is in progress but you need to control yourself. Establish your trading rules when you're unemotional for times when you're emotional to overcome bad decision making.

    Reduce trading after a big loss and a big gain alike. Pace your trading to the amount of money you have. Don't overtrade.

  • Don't trade at all if you can't accept losses. Acknowledge that you'll take losses, and that you must control them ruthlessly to preserve capital. The biggest cause of losses isn't bad indicators; it's failure to admit your indicators are sometimes wrong. You can design a reasonable technical trading regime and still fail to make money if you don't control losses. Never trade without a stop-loss order.

  • Plan every trade and never trade without a profit target. Trading is not a savings plan; it's a pathway to building capital. Establish your best-case profit as well as your worst-case loss. Trading and investing aren't gambling — they're a business, with probable outcomes that you can estimate. Take money off the table once in a while and put it somewhere safe. Capital allocated to trading is not "savings." It is always at some risk when it is actively placed in a market.

  • Beware expert advisors. You can't evaluate an advisor unless you can judge both the indicator system and the trading rule regime, and you can do that only if you have first tried to do some designing yourself. Everyone trades the same indicator on the same security a different way, and no one way is the right way.

    If you take guidance from gurus, figure out their strengths and weaknesses, and verify their work with your own. Don't take tips from anyone you have not pre-qualified. Don't give tips, either, unless you're quitting your day job to set up an advisory business.

  • Diversify. Trade several securities and types of securities to reduce the risk of getting wiped out by a market catastrophe.

  • Seek the "Eureka!" moment. Technical analysis contains thousands of ideas, with new combinations of indicators, new types of securities, and new trading technologies being invented all the time. A lot of it is intimidating and frightening, but persevere—you never know when you might come across something that resonates with you and turns out to be the key concept in a new and improved, and successful, trading regime.

Technical Analysis: How to Read a Basic Price Bar

The price bar, the basic building block of technical analysis, describes and defines the trading action in a stock security for a given period. Trading action means all the real-money transactions conducted during the period.

Know how to read market sentiment in the components of the standard bar. If the bar is tall, it was a battle between buyers (bulls) and sellers (bears). If the bar is short, it was a pillow fight.

Here's a look at a standard price bar:

image0.jpg

Most market indicators are nothing more than an arithmetic manipulation of the four standard price bar components. The components are easy to learn and interpretation is fairly obvious once you review their meaning:

  • Open: The little horizontal line, or tick mark, on the left is the opening price.

  • High: The top of the vertical line defines the high of the day.

  • Low: The bottom of the vertical line defines the low of the day.

  • Close: The tick mark line on the right is the closing price.

Get ready to buy the security if it has a series of higher highs and higher closes. Higher highs and higher closes indicate demand for the security is outstripping current supply — buyers outnumber sellers. The opposite is true, too — lower lows and lower closes mean you should get ready to sell, because sellers are overwhelming buyers.

What if the price bars are not consistently offering higher or lower closes? This situation is called congestion, and you should hold off trading the security until you see a trend.

Basics of Candlestick Charts in Technical Analysis

Candlestick charting emphasizes the opening and closing prices of a stock security for a given day. Many candlesticks are simple to use and interpret, making it easier for a beginner to figure out bar analysis — and for experienced traders to achieve new insights.

image0.jpg

Become familiar with candlestick bar notation:

  • Open: The opening price.

  • High: The high of the day.

  • Low: The low of the day.

  • Close: The closing price.

  • Real body: The range between the open and close.

    The color of the real body shows how the struggle between buyers and sellers played out:

    • A white real body means the close is higher than the open. A white body is bullish (a buyer's market), and the longer the body, the more bullish it is. A long white candlestick indicates that the close was far above the open, implying aggressive buying.

    • A black real body means the close was lower than the open. A black body is bearish (a seller's market), and the longer the body, the more bearish it is. A tall black bar means the close was under the open and near the low, which may be hard to see on a regular bar but hard to miss in candlestick format; there was a preponderance of sellers throughout the session.

    What if the candlestick shows the open and close about the same? This configuration means you can't read supply and demand in the bar and should not trade the security on the basis of bar analysis.

  • Shadow: The thin vertical line at the top and bottom of the real body. Shows the high and low.

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