Technical Analysis For Dummies
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Indicators measure stock market sentiment — bullish, bearish, and blah. Indicators are only patterns on a chart or arithmetic calculations whose value depends entirely on how you use them. You use indicators when doing technical analysis for many trading-related decisions, including identifying a trend, knowing when to stay out of a security that isn’t trending, and knowing where to place a stop loss, to name just a few. This list offers a few tips and tools you need to maximize your use of technical analysis indicators.

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Don’t jump the gun

Figuring out technical analysis starts with bars, both standard bars and candlesticks. To use fancy indicators before you understand bars is to rush the learning process. Think of the bar as a miniature indicator. Besides, indicators are constructed by manipulating bar components arithmetically, and indicators will be easier to understand after you have mastered the bar and its components. And you can trade on bars alone without ever needing to dive into the intricacies of indicators. One example is trading on candlesticks alone. Many setup traders never look at indicators; they just look at bars.

Every bar tells a story about crowd behavior. Exceptional bars tell you more than ordinary bars, but try to listen to all bars. Floor traders complain that electronic trading lacks something valuable that being on the exchange floor offers — the noise of the crowd. As an individual trader, you can’t hear the crowd, either, but as you look at bars, imagine the noise each bar must be sending out — shouts, hisses, groans.

Defeat your math gremlins

You don’t need to be good at math to use math-generated indicators. You may not understand how your microwave works, but you can still use it to re-heat the soup. Don’t give up too fast. If an indicator isn’t immediately obvious, just observe it for a while.

If you put in the effort and still don’t get it, don’t worry — move on. The world is full of great indicators. You just need to find the ones that make sense to you. For example, I never did get the hang of average directional movement (ADM) indicators. Don’t use an indicator because some self-styled expert says that it has a great track record. If you don’t understand it, it won’t work for you. Keep in mind that everything works. You just need to find what works for you.

Embrace patterns

Patterns are indicators, too. Prices never move in a straight line, at least not for long, and patterns can help you identify the next price move. When you see a double bottom, you can feel confident that the right trade is to buy — and this principle is true well over half the time and normally returns a gain of 40 percent. Some patterns are easy to identify and exploit, whereas others may elude you. As always, if you can’t see it, don’t trade it.

Pattern identification may be subjective, but it’s a handy adjunct to math-based indicators, especially the candlestick patterns. They can save your bacon while your indicators are in the process of leading you astray.

Finally, you don’t have to believe in elaborate theories about cycles or Fibonacci numbers to use a Fibonacci retracement pattern. Many experienced traders eschew math-based indicators and use only patterns, and for this reason alone, it pays to find out how to see patterns.

Use support and resistance

Support and resistance are central concepts in all technical trading regimes. You can pinpoint support and resistance by using any number of techniques, including hand-drawn straight lines or bands and channels created out of statistical measures. Momentum and relative strength indicators can help estimate support and resistance, too. To preserve capital, always know the support level of your security and get out of Dodge when it’s broken.

Follow the breakout principle

The breakout concept is universally recognized and respected. A breakout tells you that the crowd is feeling a burst of energy. Whether you’re entering a new trade or exiting an existing one, trading in the direction of the breakout usually pays. You’ll still get zapped by failed breakouts — everyone does. The reason to study successful versus failed breakouts is to minimize those whipsaw losses. One of the key reasons to include ichimoku in your strategy is that it has a built-in whipsaw detector.

Watch for convergence and divergence

When your indicator diverges from the price, look out. Something’s happening. You may or may not be able to find out why, but divergence often spells trouble. Convergence is usually, but not always, comforting. (This rule refers to convergence and divergence of indicators versus price, not the internal dynamics of indicators like the moving average convergence/divergence, or MACD.)

If your security is trending upward and the momentum indicator is pointing downward, you have a divergence. The uptrend is at risk of pausing, retracing, or even reversing. If you’re averse to risks, exit. I know a trader who makes the buy/sell decision exclusively on convergence/divergence.

Look for divergence between price and volume, too. Logically, a rising price needs rising volume to be sustained. The most useful divergence is a paradoxical one, where the price is falling but by less than abnormally high volume would suggest. This divergence may mark the end of a major downtrend and is more reliable than the percentage retracement or round numbers touted by so-called market experts.

Backtest or practice-trade honestly

Backtesting serves two purposes:
  • To get a better parameter for an indicator than the default setting that came packaged in your software or online service
  • To count your hypothetical trades with their gains and losses that arise from an indicator or set of indicators you chose to use in your trading
Experience shows that the standard technical analysis parameters are useful over large amounts of data and large numbers of securities — that’s why their inventors chose them. For this reason, some traders never feel the need to perform their own backtests. They accept the standard parameters and put their effort into something else, like bar or pattern reading that is subjective and the very devil to track accurately and evaluate for effectiveness.

But if you are going to backtest indicators to refine parameters, do it right. Use a large amount of price history when testing an indicator — and don’t make the indicator fit history so perfectly that the minute you add fresh data, the indicator becomes worthless (curve-fitting). Observing price behavior and estimating the range of sensible and reasonable parameters is better than finding the perfect number. The perfect number for the future doesn’t exist.

While fiddling with indicator parameters is optional, backtesting to get gain/loss data and other information is not. You simply have to do it or else you’ll be flying blind. You should never plunk down your money on a trade if you don’t have an estimate ahead of time of how much you’re likely to make and how much you’re likely to lose and the percentage of times you can expect either outcome. In other words, you need positive expectancy to trade properly using technical analysis and the only way to get it is by some tiresome bookkeeping.

Conditions are changing all the time in the technical analysis industry, but you won’t find free online services that allow full backtesting where you supply your trading rules and indicators in deep detail. To do proper backtesting, you need your own software or one of the advanced brokerage platforms. Even then, it’s a slog to master backtesting.

Accept that your indicators will fail

Indicators are only an approximation of market sentiment. Sentiment can turn on a dime, or the approximation can be just plain wrong. In fact, indicators are often wrong. Support lines break for only a day or two instead of signaling a new trend as a breakout is supposed to. Textbook-perfect confirmed double bottoms fail the very next day instead of delivering that delicious 40 percent profit. And moving averages generate whipsaw losses even after you’ve added every clever and refined filter known to man.

It’s a fact of life — your indicator will fail, and you will take losses in technical trading. Don’t take it personally. Indicators are only arithmetic, not magic. Console yourself with knowing that indicators reduce losses, and reducing losses helps you meet a primary goal — to preserve capital.

Get over the idea of secret indicators

Technical traders have devised thousands of patterns and math-based indicators. They can be combined in an infinite variety of ways over an infinite number of time frames with an infinite number of qualifying conditions. So the idea that somebody has discovered a superior combination of indicators is possible. But none of the indicators are secrets, and no indicator combo is going to be right all the time.

The secret of successful trading doesn’t lie in indicators. Shut your ears to the guy trying to sell you an indicator that “never fails!” Of course it fails. If it never fails, why would he sell it to you? And why should you have to pay for an indicator in the first place? You don’t. Every indicator ever invented is easily available in books, magazines, and on the Internet.

The secret of trading success lies not in indicators, but rather in managing the trade. You can have a mediocre set of indicators but make very nice gains if your trade management is topnotch, which can include scaling in and out, allocation among securities, diversification, and the Big Kahuna — intelligent stops.

Open your mind

Indicators are addictive. You read about a new indicator that seems so logical and appropriate that it becomes your new darling. Suddenly you can apply it everywhere. It’s good to be adaptive and flexible, but remember that the purpose of using indicators is to make money trading, not to get a new vision of how the world works. Always check that your new indicator plays well with your old indicators. You picked your favorite indicators for a good reason — they help you make profitable trading decisions. Keep discovering new indicators, but don’t fall in love unless the new indicator meshes well with the old ones. A top reason to stay up-to-date on indicators is that their popularity waxes and wanes. Always take a new indicator out for a spin, if only to get a feel for what other traders are looking at. Remember, traders form a crowd and crowds move in conjoined ways.

Technical analysis never throws anything out. Ideas that were devised and written hundred years ago are still valid and have been refined and improved over the years — and added to charting software on online charting. Don’t close your mind to a concept because some old fuddy-duddy invented it in 1930. Equally, don’t close your mind to something new. New things come along all the time, too. New things take two forms: modifications to core concepts and ideas from left field like ichimoku. The best way to see modifications is in the pages of Technical Analysis of Stocks and Commodities magazine.

About This Article

This article is from the book:

About the book author:

Barbara Rockefeller is an international economist and forecaster who specializes in foreign exchange. A pioneer in technical analysis, she also led the way in combining technical and fundamental analysis. Barbara publishes daily reports using both techniques for central banks, professional fund managers, corporate hedgers, and individual traders.

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