Trading or Investing: Technical Analysis

Technical analysis is the study of how securities prices behave and how to exploit that information to make money while avoiding losses. The technical style of trading is opportunistic. Your immediate goal is to forecast the price of the security over some future time horizon in order to buy and sell the security to make a cash profit. The future time frame is unknown at the beginning of a trade, but it's not "forever" — as it may be with buy-and-hold investing. The emphasis in technical analysis is to make profits from trading, not to consider owning a security as some kind of savings vehicle. Therefore, technical analysis dictates a more active trading style than you may be used to.

Trading or investing: The many faces of technical analysis

Both traders and investors use technical analysis. What's the difference between a traderand an investor?

  • A trader holds securities for a short period of time.
  • An investor holds securities for a long time.

Okay, what's the difference between these holding periods?

  • A short holding period is anywhere from one minute to one year.
  • A long holding period is anywhere from six months to forever, depending on who you ask.

Notice that the holding period of the trader and the investor overlap. Actually, the dividing line between trader and investor isn't fixed (except for purposes of taxation).

You can use technical methods over any investment horizon, including the long-term. If you're an expert in Blue Widget stock, for example, you can add to your holdings when the price is relatively low, take some partial profit when the price is relatively high, and dump it all if the stock crashes. Technical analysis has a tool for identifying each of these situations. You can also use technical tools to rotate your capital among a number of securities depending on which ones are delivering the highest gains these days. At the other end of the investment horizon spectrum, you can use technical analysis to spot a high-probability trade, and execute the purchase and sale in the space of an hour.

Setting new rules

You may have the idea that because technical analysis entails an active trading style, you're about to embark on a wild and risk-laden adventure. Nothing could be further from the truth. Executing the one-hour trade has less inherent risk of loss than buying and holding a security indefinitely, without an exit plan, based on some expert's judgment of its value.

Preventing and controlling losses is more important to practically every technical trader you meet than outright profit-seeking. The technical analysis approach is demonstrably more risk-averse than the value-investing approach.

That's because to embrace technical analysis is to embrace a way of thinking that's always sensitive to risk. Technical trading means to trade with a plan that identifies the potential gain and the potential loss of every trade ahead of time. The technical trader devises rules for dealing with price developments as they occur in order to realize the plan. In fact, you select your technical tools (from the many available) specifically to match your trading style with your sensitivity to risk.

Using rules, especially rules to control losses, is the key feature of long-term success in trading. Anybody can get lucky — once. To make profits consistently requires you not only to identify the trading opportunity, but also to manage the risk of the trade. Most of the "trading rules" that you hear about, such as "Cut your losses and let your winners run," arise from the experience of technical traders.

Making the case for managing the trade

To buy and hold securities for a very long period of time is a well-documented path to accumulating capital, but only if your timing is good — you're lucky enough to buy the security when its price is rising. If your timing isn't so hot or you're unlucky, it's a different story all together. Consider the following:

  • If you had bought U.S. stocks at the price peak just ahead of the 1929 Crash, it would've taken you 22 years to get back your initial capital.
  • Since the end of World War II, the Dow Jones Industrial Average has fallen by more than 20 percent on 11 occasions.

More recently, from January 2000 to October 2002, the S&P 500 fell by 50 percent. If you owned all the stocks in the S&P 500 and held them throughout the entire period, you lost 50 percent of your stake, which means you now need to make a gain equivalent to 100 percent of your starting capital to get your money back, as Table 1 shows. Ask yourself how often anyone makes a 100 percent return on investment.

Table 1: Recovering a Loss

Loss

Gain Needed to Recover Loss

10%

11.1%

20%

25.0%

30%

42.9%

40%

66.7%

50%

100.0%

60%

150.0%

75%

300.0%

Timing your entry and exit from the market is critical to making money and controlling losses.

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