Sneaking a Peek at Technical Traders’ Secrets
Technical traders come in all stripes (and some are plaid). Go to any technical analysis conference, and you’ll meet people ranging from the geeky math whiz to the goal-oriented fund manager to the retired schoolteacher. You can’t tell from looking at them what technical style they use, either. Some are quick-trade artists who make rapid-fire trades lasting no more than an hour every day. Other technical traders immerse themselves in chart after chart for hours every day but hardly ever make a trade. Another kind of technical trader is always in the market, either long or short, and willing to take big losses for the chance to make spectacular gains.
Whatever their style, successful technical traders all have one thing in common — they’ve each built a trading plan that uses the technical tools that suit their personality and appetite for risk, and they follow it.
Trust the chart
The essence of technical analysis is to analyze the price action on a chart to arrive at buy/sell decisions. You determine whether the security offers a positive expectancy of making a profit by looking at indicators on the chart, not on the fundamental characteristics of the security itself. This doesn’t mean selecting securities without judgment. The world has tens of thousands of securities to choose from. You’re welcome to choose your own universe of what you consider to be fundamentally sound securities from which to select high-probability trades.
The trend is your friend
Many advisors, analysts, brokers, economists, fund managers, and journalists are smart, sensible, and honorable. They’d never intentionally mislead you about the prospects of Company X or the supply and demand for Commodity Y. But a zillion factors can influence the price of a security. Any number of bizarre and even unprecedented contingencies can combine to move a security’s price straight into a brick wall — or onto a rocket ship to the moon.
The single best way to know what’s happening and what’s likely to happen to the price of your security is to follow its trends. If you buy when a new uptrend is just starting and sell when the uptrend peaks, you’ll make money over the long run. If you’re a short-seller or a two-way trader, you’ll make money when you sell short at a peak and cover (buy back) at a bottom.
You make money only when you sell
A policy of “buy and hold” is the optimum long-term strategy only if you meet all of the following criteria:
- You start with a winning period rather than a loss that has to be recovered.
- You pick securities that survive.
- Your concept of success is the average return on some benchmark like a stock index.
- You start early and live a long time.
Many people rode the bull market in the 1990s to great fortunes — on paper. Then, when the crash came, they saw their net worth go down the drain. They were afraid to sell because they were holding onto the idea that to buy and hold is the best rule, always and under every circumstance.
No single rule is right in every circumstance. Securities rise and fall according to market sentiment. Common sense suggests selling securities when they fall to lock in a profit or to stop a loss, even if you intend to buy the very same securities again when they start moving up.
Avoid euphoria and despair
Human nature directs you to bet a larger sum of money when you’ve just had a win, perhaps on less evidence than you normally require to “take” a trade. Likewise, traders often become timid after taking a loss and pass on trades that by any technical standard offer a fabulous profit opportunity.
This is why technical traders use indicators and try to use them as systematically as possible, even the ones who modestly shy away from claiming to have a “trading system.” A good trading regime employs trading rules that impart discipline to every trading decision in a conscious effort to overcome the emotions that accompany trading.
To damp down emotion is a clear objective in all technical trading. Better to get mad at the indicator that lets you down than to kick the cat. Trading is a business, and business should be conducted in a non-emotional manner.
Making money is better than being right
When you ask brokers and advisors for the single biggest character flaw of their customers, they all say the same thing, “The customer would rather be right than make money.” This fault can rear its ugly head in any number of circumstances, although one stands out: refusing to take a loss and get on with the next trade. Either the trader didn’t have a stop-loss rule in the first place, or he refused to obey it. To take a loss says to him that he’s wrong about the direction of the security, and he takes it as a personal affront.
Some people have an unusually hard time facing losses, and because they can’t take a small loss, they end up taking big ones, which only reinforces the fear and loathing of losses. Soon you’re not trading systematically, but on emotion, and worse, the single emotion of fearing losses.
Diversification reduces risk. The proof of the concept in finance won its proponents the Nobel prize, but the old adage has been around for centuries: “Don’t put all your eggs in one basket.” In technical trading, the idea is relevant in two places:
- Your choice of indicators: You improve the probability of a buy/sell signal being correct when you use a second and non-correlated indicator to confirm it. You don’t get confirmation of a buy/sell signal when you consult a second indicator that works on the same principle as the first indicator. Momentum doesn’t confirm relative strength because it adds no new information. They both use the same arithmetic construction, so they give you the same information. Widen your horizon beyond a few indicators, and seek different-concept indicators instead of torturing old indicators to come up with better parameters.
- Your choice of securities: You reduce risk when you trade two securities whose prices move independently from one another. If you trade a technology stock, you achieve no diversification at all by adding another technology stock. Instead, you may get a better balance of risk by adding a consumer products company or a utility. If you trade the euro, you get no risk reduction by adding the Swiss franc. The two currencies move in lockstep — they’re highly correlated to one another.