Trading For Dummies
Book image
Explore Book Buy On Amazon

You can trade technically in any number of equally valid ways. In fact, technical traders come in all stripes (and some are plaid). Whatever their styles, 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 trading 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.

Befriend the trend

The single-best way to know what’s happening and likely to happen to your security’s price is to follow its trends. If you buy when an uptrend is forming and sell when the uptrend peaks, you make money over the long run. Remember, your job is to define trend for yourself. A trend can be as small as six bars on a ten-minute chart or hundreds of bars on a weekly chart.

Understand that you make real cash money only when you sell

On many occasions, securities rise and fall according to overall market sentiment and through no credit or fault of their own. Selling a falling security to lock in a profit or to stop a loss is common sense, even if you intend to buy the very same security again when it starts moving up.

Take responsibility

You should have a reason for making every trade — the expectation of a positive gain at a level of risk you can live with. If your broker, trust fund manager, or Uncle Fred proposes that you sink some money into a security but the chart shows that the price is on a downward trajectory, just say no.

If you do succumb to the broker or Uncle Fred, acknowledge that taking the trade is gambling and doesn’t belong in the same mental box as trades made under your carefully thought-out risk-reward trading plan.

Avoid euphoria and despair

Make the trading decision on the empirical evidence on the chart, not on some emotional impulse. It’s human nature 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 in the first place. Likewise, you may become timid after taking a loss and pass on trades that offer a fabulous profit opportunity by your own technical standards.

Focus on making money, not 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.” 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 loss. If you start falling into this morass, stop trading. Develop a different trading plan that’s designed to takes fewer losses.

Don’t let a winning trade turn into a losing trade

You can have a fine trading system with excellent indicators properly backtested for the securities you’re trading but still be a lousy trader if you don’t have sensible trading rules. A good trader differentiates between indicators, and trading and money-management rules.

How can a winning trade turn into a losing trade? Many ways, including

  • Failure to use a stop-loss

  • Adjusting perception of risk while the trade is in progress by looking at a new indicator that’s not backtested and not part of the trading plan

  • Tricking yourself into thinking that the market “owes” you the highest price it already attained

Sidestep the temptation to curve fit

Just because an indicator “fits” your chart of historical data doesn’t make it a workable indicator for the future. Curve-fitting refers to backtesting your indicators on historical data to see which parameters would have worked the best. A good technical trader doesn’t curve fit, but rather backtests indicators by using realistic assumptions. If you overanalyze indicators so that they’re a perfect fit for the past, they almost certainly fail to work in the future.

Know when to hold ‘em and when to fold ‘em

You need to rely on your indicators to tell you whether you have a good hand and can scale up the amount at risk, or have a dud and may need to tighten stops or even fold. The more confirmation of a buy/sell signal you can get, the safer it is to place the trade. For example, if you have only one indication that the trend is turning your way, you can bet small, and add to the trade as confirmation comes in from other indicators. Or you can just wait for all the confirmations. Either method is “right,” but only one method is right for you and your risk appetite.

Diversify

Diversification reduces risk. The proof of the concept in financial math 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, diversification applies in two places:

  • Your choice of indicators: You improve the probability of a buy/sell signal being correct when you use a second, noncorrelated indicator to confirm it. 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. You can estimate degree of correlation scientifically with a spreadsheet or informally by eye (charting both securities in the same space).

About This Article

This article can be found in the category: