Technical Analysis For Dummies book cover

Technical Analysis For Dummies

By: Barbara Rockefeller Published: 10-01-2019

Grasp and apply the basic principles of technical analysis

Savvy traders know that the best way to maximize return is to interpret real-world market information for themselves rather than relying solely on the predictions of professional analysts. This straightforward guide shows you how to put this into profitable action—from basic principles and useful formulas to current theories on market trends and behavioral economics—to make the most lucrative decisions for your portfolio.

The latest edition of Technical Analysis for Dummies includes a brand-new chapter on making the right decisions in a bull or bear market, an updated look at unique formulas and key indicators, as well as refreshed and practical examples that reflect today today's financial atmosphere.

  • Become an expert in spotting market trends and key indicators
  • Get the skinny on the latest research on behavioral economics
  • Take a deep dive into how to read market sentiment and make it work for you
  • Get a look at the first innovation in charting for decades—straight from Japan

With comprehensive coverage from charting basics to the cutting edge, Technical Analysis for Dummies includes everything you need to the make informed independent market decisions that will maximize your profits. Happy trading!

Articles From Technical Analysis For Dummies

10 results
10 results
How to Identify the End of a Trading Chart Trend

Article / Updated 10-28-2021

When looking at a price chart, you can call the end of a trend by using the moving average level rule: an uptrend when the moving average today is less than the moving average yesterday, and a downtrend when the moving average today is higher than yesterday. A moving average always lags the price action. In this figure, look at the prices and moving average in the left-hand ellipse. From the peak close, it takes the price six days to cross below the moving average — and ten days for the value of the moving average to be lower than the day before. By the time the moving average puts in a lower value than the day before, it’s Day 10 and the price has fallen from $82.49 to $75.38, or by 8.6 percent. But despite giving up 8.6 percent from the highest close while you wait for the moving average to catch up with prices, to trade this stock by using this indicator during this period would have been profitable. The black arrows on the chart in the preceding figure mark the buy/sell entry and exit points, using the moving average level rule. You buy and sell at the open the day after the moving average meets the rule. This table shows the profit you make by applying the rule. Your gain is $43.07 on an initial capital stake of $71.05, or 61 percent, compared to 14 percent if you buy on the first date and account for the gain on the last date (called mark-to-market). This is a classic example of the technical trader mindset; you have an indicator-based trading rule, in this case the price crossing the moving average. You make buy/sell decisions on that rule without regard for the fundamentals of the security. You keep track of the gains and losses associated with the trading rule (and some day may want to alter the indicator parameters). That’s technical analysis in a nutshell — indicators built on bars, trading rules based on indicators, following the trading rules strictly, and keeping track of the results. Hypothetical Profit from the Moving Average Level Rule No. of Days Action Price Level Rule Profit Buy-and-Hold 22 days Buy $71.05 $71.05 Sell $78.24 $7.19 42 days Sell $78.24 Buy $61.54 $16.70 29 days Buy $61.54 Mark-to-market $80.72 $19.18 $80.72 Total $43.07 (61%) $9.67 (14%) Mark-to-market gains are named unrealized, and it’s a good phrase, meaning that the gain is only an accounting convention — and not real, although in futures trading, you may use unrealized gains to add to positions. Needless to say, a mark-to-market valuation is valid only until the next market price becomes available. Be on the lookout for trading system vendor performance track records that rely on mark-to-market gains for wonderful end-of-period gains. Mark-to-market gains are only paper gains and can vanish in a puff of smoke. To evaluate a technique, look at its performance on closed trades.

View Article
Technical Analysis For Dummies Cheat Sheet

Cheat Sheet / Updated 07-06-2021

Need help making trading decisions in securities markets? Technical analysis is a collection of techniques that can help you do that. Discover 16 trading secrets that can help you beat the market, figure out how to read stock charts like a standard bar chart and how to interpret a candlestick chart. Also, learn how to identify the end of a trading chart trend by using the moving average level rule.

View Cheat Sheet
The Role of Volatility in Technical Analysis

Article / Updated 12-03-2019

Volatility is a measure of price variation, either the total movement between low and high over some fixed period of time or a variation away from a central measure, like an average. Both concepts of volatility are valid and useful. The higher the volatility, the higher the risk—and the opportunity. A change in volatility implies a change in the expected price range yet to come. A volatile security offers a wide range of possible outcomes. A nonvolatile security delivers a narrower and thus more predictable range of outcomes. The main reason to keep an eye on volatility is to adjust your profit targets and your stop-loss to reflect the changing probability of gain or loss. Volatility is a concept that can easily slip through your fingers if you aren’t careful. Just about everybody uses the word volatility incorrectly from a statistician’s viewpoint — and even statisticians squabble over definitions. To the mathematically inclined trader, volatility usually refers to the standard deviation of price changes. Standard deviation isn’t the only measure of volatility, but it suffices for most technical analysis purposes. In general usage, volatility means variance. Variance is a statistical concept that measures the distance of each bar between the high and low from the mean (such as a moving average). You calculate variance by taking the difference between the high or low from the average, squaring each result (eliminating the minus signs), adding them up, and dividing by the number of data points. Squaring magnifies wildly aberrant prices, so the bigger the variation from the average and the more instances of such big variations in any one series, the higher the volatility. Traders don’t use variance as a stand-alone measure or indicator, and it’s not offered in most charting packages. Why? Because variance isn’t directly useful as a separate measure from the standard deviation, which is essentially the square root of variance. Don’t panic at the thought of square root or any other statistical measure in technical analysis. Your software will supply the indicators that incorporate variance, and you don’t have to know how to calculate the indicators in order to use them effectively. Time frame is everything. How you perceive volatility depends entirely on the time frame you’re looking at. Failure to specify a specific time frame is why you see so many conflicting generalizations about volatility. The period over which you measure volatility has a direct effect on how you think about volatility and, therefore, what kind of a trader you are. Your trading style isn’t only a function of what indicators you like, but also of how you perceive risk. Two traders can use the same indicators but get different results because they manage the trade differently by looking at volatility differently (scaling in and out, choosing a stop-loss level, and so on). In the following figure, your eye tells you that the low-variance prices on the left side of the chart are less volatile and therefore less risky to trade than the high-variance prices on the right side of the chart, even when the high-variance prices are in a trending mode. And that’s the point about volatility — it describes the level of risk. High variance means high risk. How volatility arises Think of volatility in terms of crowd sentiment. Volatility rises when traders get excited about a new move. They anticipate taking the price to new highs or lows, which arouses greed in bulls putting on new positions and fear in bears, who scramble to get out of the way in a cascade of stop losses. The start of a new move is when you get higher highs (or lower lows). Volatility tends to be abnormally low just before a turning point and abnormally high just as the price is taking off in the first big thrust of a new trend. It’s also, however, a sad fact of trading life that sometimes volatility is high or low for no price-related reason you can find. High volatility means trading is riskier but has more profit potential, while low volatility means less immediate risk. Volatility isn’t inherently good or bad. Stability of volatility over time is a good thing because it allows you to estimate maximum potential gains and losses with greater accuracy. Every security has its own volatility norm that changes over time as the fundamentals and trader population changes. Sometimes you can impute a “personality” to a security that is really a reflection of the collective risk appetite of its traders. Low volatility with trending Refer to the preceding figure. As the price series begins, you instantly see an upward trend. Your ability to see the trend is due in part to the orderliness of the move. You see the trend, not variations away from it. A trending security with low volatility offers the best trade because it has a high probability of giving you a profit and low probability of delivering a loss. It’s also easier on the nerves. Here’s why low volatility means the best trade: You can project the price range of a low-volatility trending security into the future with more confidence than a high-volatility security. You generally hold a low-volatility trending security for a longer period of time, reducing trading costs such as brokerage commissions. Low volatility without trending A security that’s range-trading sideways with little variation from one day to the next is simply untradeable in that time frame. You have no basis on which to form an expectation of a gain, and without an expectation of gain, you shouldn’t trade it. You can reduce the time frame (from one day to one hour, for example) to make visible and tradeable the minor peaks and troughs. If a price is trading sideways without directional bias but the high-low range of the bars contracts or widens, now you’re cooking with gas. Range contraction and expansion are powerful forecasting tools of an upcoming breakout. You can start planning the trade. In the figure, every bar is the same height except the ones in the circle, which are narrowing. The drop in high-low range and therefore in volatility often precedes a breakout, although you don’t know in advance in which direction unless you also have a reliable pattern, including candlesticks. High volatility with trending You may think that the degree of volatility doesn’t matter when your security is trending, but an increase in volatility automatically increases the risk of loss. You may start fiddling with your indicators to adapt them to current conditions. Tinkering with the parameters of indicators when you have a live trade in progress is always a mistake. A better response to rising volatility is to recalculate potential gain against potential loss. High volatility without trending When a security is range-trading, it’s called a trader’s nightmare. When it’s range-trading with high volatility, it’s a horrible nightmare. The right section of the price series in the figure shows this. In this situation, the range is so wide you can’t identify a breakout; you see spiky one- and two-day reversals as bulls and bears slug it out, making it hard to find entries or to set systematic stops. The solution to high volatility in a nontrending case is to stop trading the security or to narrow the time frame down to an intraday time frame. Often you can find tradeable swings within 15-minute or 60-minute bars that don’t exist on the daily chart.

View Article
Cycles and Waves in Technical Analysis

Article / Updated 12-03-2019

Stock and commodity market prices often move in a regular and repetitive manner that looks like a series of ocean waves on the chart. Each wave in a series of waves has a specific height and length, and when those are the same or nearly the same from wave to wave — or waves are consistently proportional to one another — the pattern is called a cycle. Some market price cycles follow economic developments, and some patterns that look like cycles follow some other organizational principle, like the lunar cycle. In some cases, analysts can find a strong correlation with numbers series or a connection to some other cause that is unseen and unproved. In economics and finance, cycles all look alike and start with a continuous line that begins at a low, forms a semispherical bump, and returns symmetrically to the same or near the same low, over and over again, over time. A cycle is made up of waves, and the wave is modeled on the sine wave as the following figure shows. You see this pattern all the time in music and electrical energy, not to mention the ocean tides. As applied to financial markets, the core concept is that human behavior forms and repeats in specific recurrent patterns. Whether the impulse for financial market prices to form cycles is inherent in the universe or arises from some unexplained aspect of crowd behavior, nobody knows. Think of the following to differentiate between cycles and waves: Cycles have a repetitive character. Not only will prices surge and retreat, but they’ll also surge and retreat in a more or less orderly manner so that you can count the periods between them and use that count to project the next surge and retreat. Waves, on the other hand, can be big or small, short-term or long-lasting, choppy or orderly. You don’t know when a wave begins how far it will go. Market waves aren’t like the ocean tides. Cycle theorists (and physicists) speak of their cycle components as waves. You can have waves without a cycle, but you can’t have a cycle without waves. Just as you try to attribute supply and demand dynamics to the shape of indicators, you can consider a bigger form of crowd behavior when looking at cycles and waves. Refer to Chapter 3 to read about George Soros’ reflexivity feedback loop. This idea postulates that expectation of a market price move causes crowd behavior that validates the very price behavior that was expected. If and when the crowd is disappointed because an intervening event has now changed conditions, a new expectation gets a grip and the crowd causes that expectation to come true, too. This causes an up-and-down pattern that can have the appearance of regularity — otherwise known as cyclicality. Starting with economics The economic cycle is the process by which an economy (and the businesses in it) expand, reach a peak, and then contract and go into recession. They do all this in a wave-like pattern around a growth trend. Economists have been trying to pin down the economic cycle for more than two centuries. So far there have been the following: A super-long cycle, the Kondratiev wave of 45 to 60 years The infrastructure cycle of 15 to 25 years The business cycle of 5 to 7 or 7 to 10.5 years The inventory cycle (another business cycle) of about 40 months devised by Joseph Kitchin in 1927 All are still in use today. Some traders who write newsletters and blogs feature these economic cycle theories as the basis of their trading decisions. Economic cycle theories can be based on data like the number of ships leaving a harbor each week, the unemployment rate, the rising and falling cost of commodities like cocoa, salt, and coffee, or a thousand other data points. One of the off-putting aspects of cycles is that there are so many of them. They overlap, they offset, they last too long for practical application. But hang on. Consider that in the 19th century, the Rothschilds had minions to plot many cycles from data series going back hundreds of years. They were seeking the confluence points where a preponderance of overlapping cycles hit a top or a bottom at the same time. The confluence points comprised a buy/sell indicator for the securities the Rothschilds were trading. The Rothschilds’ secret cycle technique, which clearly was working for them, sparked a small industry of cycle-seekers starting around 1912. It has never stopped. It’s interesting that at least one of the Rothschild companies still uses cycles and has still kept their exact nature a secret. Move on to magic numbers Looming over the cycle question is the issue of whether some giant mystical order in the universe dictates financial price movements. One of the best explanations of specific numbers that reveal the mystical order of the universe is in Tony Plummer’s The Law of Vibration: The Revelation of William D. Gann (Harriman House). This book attributes regular rhythms and recurring patterns to a “sacred geometry” that reveals the “deep structure” of the universe. Maybe there are gravitational waves from outer space affecting trading crowd behavior. Einstein predicted these cosmic ripples almost a hundred years ago and their existence was proven only in the last decade. Other number-based cycle theories include Elliott Wave, which I describe in the last section of this chapter, and a lesser known theory based on the number embedded in pi, which I don’t cover. I call these specific number “magic numbers” because the theorists who propose them consider the numbers to have magical properties that somehow determine future prices in securities markets. Using cycles Market cycle analysis is far more complicated — and contentious — than applying indicators. Just about every technical analyst will use an indicator for the same purpose, but put a group of cycle theorists in a room and you will get a fist-fight. Every cycle theorist can show you charts of his cycle-based predictions overlaid on actual prices to demonstrate his theory works — but with a lot of adjustments and exceptions, and each theory involves different numbers — 4 days (no, 5), or 20 days (no, 22). If the experts can’t come up with something reliable on cycles, why bother? The answer is easy: Indicators fail sometimes, so any extra help you can get from elsewhere can add to your trading edge, whether volume, market sentiment, fundamentals, seasonality, or cycles. Opinion is divided about whether cycles are an integral part of technical analysis. Cycles fit into the technical universe because they’re couched in price terms alone without reference to fundamentals. Some technical analysts embrace a cycle theory alone, some modify a cycle theory with other indicators, and some dismiss all cycle ideas out of hand as crackpot, requiring too much effort or not useful. You don’t need to embrace a cycle theory to become a skilled technical analyst. You can safely ignore cycle theories altogether. But you should know about the existence of cyclical theories to be able to evaluate assertions and promotions. Besides, cycle theories are fun. Cycle material is far more complex than standard indicators. You’ll have to accept (or overlook) some wild-eyed, mystical, and possibly fruitcake ideas. But don’t dismiss cycles out of hand. Several big-name traders embrace some aspects of cycle theory. You don’t have to believe in some hidden order in the universe if you are lucky enough to get a feel for cycles.

View Article
What is the Ichimoku Cloud Trading Strategy?

Article / Updated 12-03-2019

Ichimoku embodies just about every technical analysis concept—trending, support and resistance, pivots, trend reversal, momentum, stops. This seems like a lot of performance for a few lines on a chart, but it’s all there if you take the time to study it. Ichimoku takes more time than conventional technical analysis, in part because the mindset is less focused on raw supply/demand and fear/greed, and tries to detect value in a more organic way. This entails some tricky arithmetic. Ichimoku’s design is intended to deliver an instant visual snapshot of a price’s trendedness — up or down, strong or weak, nearing or at a turning point, and other aspects of the price move. Ichimoku means “at a glance” in Japanese, and that seems like an impossibly tall order. But with a little practice, you can find ichimoku does work to deliver the goods. When you first see an ichimoku chart, you’ll be tempted to say “at a glance” must be ironic and you’re being the butt of a joke. As Nicole Elliott says in her YouTube video, at first ichimoku seems like spaghetti. But stick with it. With a little practice, the “glance” aspect will turn out to be true, and very useful. That’s because the raw price lines will fall above or below the clouds, and the clouds form a range of prices that are an estimate of the equilibrium price. In a nutshell, ichimoku places a series of specific fixed-number moving averages on the chart, and the crossover delivers the buy/sell signal, as in conventional technical analysis. Ichimoku also projects an arithmetic manipulation of the moving averages into the future to create an area of support/resistance (named a cloud) that is self-adjusting because it’s based on the moving averages. Ichimoku’s differences with conventional technical analysis Ichimoku doesn’t offer anything conceptually different from conventional technical analysis, and all the techniques will be familiar to you. Ichimoku, for example, uses the midpoint of the high-low range in its moving averages. See the following table for some of these differences. Comparing Ichimoku and Conventional Technical Analysis Ichimoku Conventional technical analysis Uses only candlestick notation. Uses several varieties of bar notation. Always uses standard time on x-axis. Has the option of looking at price action regardless of time (point-and-figure, other methods). Uses midpoint of high-low range. Uses high and low separately in indicators. Uses moving average of the midpoints with one using the close. Uses the moving average of the close. Delivers self-adjusting areas of support and resistance. User needs to add support and resistance. Midpoint methodology entails display of self-adjusting 50 percent retracement. Fifty percent retracement can be added; not self-adjusting. Moving averages have stair-step appearance. Moving average are smooth. Momentum is implicit. Momentum can be explicit. Projects moving averages forward and backward in time. Doesn’t project moving averages. Self-contained and self-sufficient. Can be added to endlessly. The new core concepts of ichimoku To start grasping ichimoku, you have to abandon a few of the core concepts you probably have accepted and buy into some new ones. For example, in conventional analysis, analysts consider the relationship of the close to the high. If the close is at the high, the market is wildly bullish. If the close is at the low, sentiment is seriously bearish, and both of those judgments inform your decision on your next trade. But the ichimoku mindset considers the high and low as extremes when what you’re seeking is the best expression of sentiment — the average. In addition, conventional technical analysis uses the close to calculate moving averages (as well as other indicators). Not so in ichimoku, which uses a slew of moving averages calculated on the average of the high and low over the period, not the close alone. This makes a great deal of sense if you consider that what you’re aiming for in a moving average is the essence of the price change. So, a conventional moving average built on the close will incorporate some of those wildly bullish or bearish price extremes, while the ichimoku technique waters them down by using the midpoint. Think of ichimoku as using moving midpoints rather than moving averages based on the close. A third difference is that ichimoku calculates averages based on past data but then projects some of those lines out into the future. This is such a problem for software designers that it took several years for them to catch up. You may have to buy an add-on to your software program, although many have it built-in by now. Finally, non-Japanese ichimoku users didn’t rename the components but kept their Japanese names, including some that aren’t normal usage in English. This is a form of respect for the techniques. Take a deep breath and just master the names. There are only seven. The ichimoku open-close averaging arithmetic makes for smoother, less choppy moving averages than averages constructed using just the close. This process delays the crossover signal. This is only one of the reasons ichimoku is an excellent way to avoid whipsaws, something all trend-following suffer from. Building a cloud: Starting with the five moving averages The ichimoku chart consists of a series of moving averages and their attendant crossovers, just as in conventional technical analysis, but by also shifting some of the moving averages forward, the ichimoku chart offers a new feature, an area of support and resistance named a cloud. Moving averages are the workhouse of technical analysis, but in ichimoku, they have a twist. Not only does the ichimoku calculation methodology apply plain-vanilla moving averages, it also projects two of them into the future to form a cloud and one of them backward in time to nail down perspective, as the following list shows: Tankan-sen: This is the highest high plus the lowest low over the past 9 periods divided by 2. Sen means line in this context. Kijun-sen: This is the highest high plus the lowest low over the past 26 periods divided by 2. The following figure shows the tankan and kijun in the regular manner. The crossover of these two lines is a buy or sell signal as in any other moving crossover rule, but with some refinements I describe in this list. Senkou span: To most English speakers, the word “span” means the amount of space something covers, like a bridge span or an arch span. A span is the distance of something from end to end not interrupted by anything else. It’s an uncommon usage to apply the word span to a chart line, but you can get used to it. The senkou-span has two parts: Part A: The tankan + kijun divided by two projected out 26 days. So, Part A is an average of shorter-term plus longer-term prices projected into the future. Part B: The highest + lowest price over the past 52 periods divided by 2 and also projected out 26 periods. So, Part B is the average of a full year of the high and low and thus ultra-long-term. Parts A and B together form the cloud or kumo, as the following figure shows. Chikou span: Today’s close projected 26 periods back in time. This is the only calculation in ichimoku that doesn’t use the midpoint but rather the close directly. The following figure is the most like the ichimoku charts you’ll see and use, although it looks a lot better in glorious living color. Each software program will color each line and the two clouds differently. On this chart, the lighter gray cloud marks that the cloud is support, and note that the price doesn’t break the bottom of the cloud. The cloud then reverses and crosses over to the downside and changes color to darker gray. The cloud is now resistance, and prices are far below the cloud for a longish time. This means your short trade is safe, or if you can only buy, it’s not time yet. You wait to buy until the price crosses to above the cloud. At that point the cloud is thin and you can’t have a lot of confidence support will hold. Ichimoku’s embedded momentum Ichimoku uses moving averages, but the end result is different from a conventional moving average crossover system in the following ways: Ichimoku uses three numbers in its moving averages — 9 periods, 26 periods, and 52 periods. The ichimoku moving average uses 26 days because in Japan at the time the technique was invented, trading took place on Saturdays, making 26 days an accurate count for a month. Weirdly, nobody adjusts the ichimoku moving average to match the Western week, presumably because it works well the way it is. And oddly — very oddly — when Gerald Appel devised the MACD in the late 1970s, he also used 26 days as one of the parameters, long before ichimoku became known in the West. He selected 26 days because it was the optimum number over a gazillion trials. Elliott notes that when Hosoda wrote down the ichimoku methodology in 1969, computers weren’t available to all, and he used dozens of students to do the backtesting work — and validated the 26-day parameter. The MACD isn’t only a directional indicator, but also a momentum indicator. To the degree ichimoku contains momentum, it’s more a suggestion and inference than a direct calculation. Another difference between Appel’s MACD and ichimoku — Appel uses a 12-day as the second moving average whereas ichimoku uses nine days.

View Article
10 Secrets of the Top Technical Traders

Article / Updated 11-23-2019

Technical trading can take any number of equally valid forms. The trader who waits for multiple time frame confirmations on three indicators can claim just as much technical validity as the guy with the itchy trigger finger who has to trade every hour. The technical trader is the retired rocket scientist the self-taught housewife, the cubicle programmer, and the college student. You can’t tell from looking at them who is the best technical trader. The technical trader may be sane and reasonable or an outright crackpot, but both types are technical traders. You’ll also run into poseurs who claim technical expertise but really only know one or two things, and although those one or two things may work for them, the danger is real they won’t work for you. As for the academics with systems perpetually in test mode, they may be technical analysts, but they aren’t traders. Until you put cold, hard cash down on your technical trading ideas, you aren’t a trader. You may be the smartest guy in three counties, but if you can’t make money trading, you’re just a smart guy, not a trader. In fact, the ability to focus is far more important than brainpower in technical trading. Whatever their styles, successful technical traders all have one thing in common — they’ve built a trading plan that uses the technical tools that suit their appetite for risk, and they follow it. A plan contains not only high-probability indicators, but also money management rules. This list discusses ten secrets that successful technical traders utilize. Remember them as you start trading. Appreciate probability Technical analysis works because stock market players repeat the same behaviors, but history never repeats exactly. The probability of any particular pattern or indicator repeating itself — getting the same outcomes — is never 100 percent. If you want to be a technical trader, you have to gather the data from your trades carefully and apply expectancy rules in order to have any hope of long-run success. You must keep track of your win-loss ratio and the other metrics of the expectancy formula. To trade without having a positive expectancy of a gain is gambling. It’s not trading. You may have a slight edge from using a few indicators, but you don’t really have control of your trading. Position sizing and other aspects of money management are useful, too, but if you don’t have positive expectancy on every trade, in the long run you will lose. Backtesting matters You need to examine the trades your indicators would have generated over some period of time — a minimum of six months, and a year is better — to get a fair estimate of the expected gain/loss. You have to write it down and do the arithmetic. Technical analysis entails a scientific mindset and that means keeping records. I keep an Excel spreadsheet on every trade and update it every day. It takes less than ten minutes per day, and it’s a small price to pay to know exactly what indicators were working that day and what indicators didn’t work. Betting your hard-earned cash on an unproven set of indicators is wishful thinking, not informed trading. Indicators give you an edge, but not a winning lottery ticket. The trend is your friend The single best way to trade is to follow price trends. If you buy when an uptrend is forming and sell when the uptrend peaks, you’ll make money over the long run. If you can’t see a trend, sit back and wait for the trend to appear. Nobody is holding a gun to your head forcing you to trade. To stay out of the stock market when the security isn’t trending is okay — as is getting out of the trade temporarily when a pullback occurs. A security purchase isn’t a life-long commitment. You’re not being disloyal or unfaithful to your security if you sell it during a pullback. It doesn’t matter if your security — Apple, Amazon, or whatever —is the best security of all time. 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 trading opportunity by looking at indicators on the chart, not on the fundamental characteristics of the security itself. You’re welcome to trade only high-quality names, but in practice, you can make just as much gain from a real dog of a stock as from the market’s darlings. Entries count as much as exits The buy-and-hold strategy has been discredited many, many times. Buy-and-hold is never the optimum methodology. Look back at the two big stock market crashes in recent history — the tech wreck that started in March 2000 and the financial crisis collapse that started in October 2007. It took 13 years for the S&P to recover and hold a level above the high of March 2000; in other words, if you owned the entire 500 stocks in the S&P, you would have made no net gain for 13 years. Debunking buy-and-hold is why you often see “it’s when you sell that counts.” But, obviously, when you buy counts, too. You can have a so-so trend identification system, but if you get in at a relative low, you will thrive, whatever your holding period. Stops aren’t optional Stops are different from the embedded buy/sell signals in indicators. A moving average crossover doesn’t know how much cash loss you’ll be taking as it lollygags its way to the sell signal. You have to decide ahead of time how much loss you can tolerate, either in cash or percentage terms, and just accept it when stops get hit (without remorse or anger). A good stop is not so tight that you forego any real chance of achieving the expected gain, nor so loose that you give back a big chunk of previously earned gain. You need to acquire skill at crafting stops that combine your security’s behavior patterns with your risk appetite — a double set of conditions. Don’t trade without stops. There are no acceptable excuses for failing to use stops. Treat trading as a business You should make the trading decision on the empirical evidence on the chart and not on emotional impulse. It’s human nature to bet a larger sum of money when you’ve just had a win. Likewise, you may become timid after a loss. A good technical trader follows his trading plan and disregards the emotions created by the last trade or by the emotions that swell up from being in trader mode. Trader mode can inspire competitive aggression, analysis paralysis, confirmation bias, and any number of other interferences with the rational application of your trading regime. You may not have a full-bore trading system, but you should trade what you do have systematically. A good trading regime uses rules that impart discipline in a conscious effort to overcome the emotions that accompany trading. Trading is a business, and business should be conducted in a non-emotional manner. Eat your spinach It’s not a personal insult when you take a loss. Ask brokers or 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.” You can’t control the stock market. The only thing you can hope to control is yourself. If you become unhinged by your losses, you haven’t built the right trading plan. You need to start over with different securities, different indicators, and/or a different win/loss ratio in your expectancy calculation. 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 (which only indicate) and trading and money-management rules (which manage the risk). Technical stuff never goes out of date Nothing is ever discarded in technical analysis. Books written 70 years ago are still useful today. Technical thinking never goes out of date; the technical analysis crowd just keep adding to it. Thumb through the index of Technical Analysis of Stocks and Commodities magazine. You can find multiple reviews, updated nuances, and suggested uses for old-timey indicators and new candidates alike. You’ve made a good decision to start your journey of technical discovery with this book. Start at point-and-figure or momentum and work back to moving averages. Start at candlesticks and move back to standard bars. Get a certain bare minimum of information under your belt before you start placing trades; the universe of technical analysis is flexible, and you can bend it in many different equally valid directions. Although technical ideas never go out of date, they do go in and out of style. During the 1980s and enduring to today, Elliott Wave has been in style. In the 1990s, MACD was the fad of the moment. It’s still a splendid indicator, but not front-page news. Today ichimoku is all the rage. You should care about fads in indicators because to some extent, the number of technical traders using the star indicator of the day are making its outcomes a self-fulfilling prophecy. 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 market indicators: You improve the probability of a buy/sell signal being correct when you use a second, noncorrelated 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. 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. You’ll get a better balance of risk by adding a stock from a different sector. Swallow hard accept some math Appreciating the limitations imposed on trading by probabilities is one thing. Each indicator and each combination of indicators has a range of probable outcomes. Say you’ve designed a good set of market indicators that will likely generate a high return. But tweaks to your money management rules can double or triple that. Money management can be tricky and difficult, and it needs to be in a feedback loop with your indicator system. For example, should you increase your position in a winning trade? This is the position-sizing problem, and analysts are passionate about whether to do it or not. Money management takes you into the realm of betting. In a nutshell, you have to know when to hold ‘em and when to fold ‘em. These decisions can be informed by your indicator probabilities, but the final decision is risk management in the face of other (non-indicator) factors that are unknown, known as the realm of game theory. Don’t be surprised to discover that the first originator of the theory of games modelled it on . . . poker. Refer to the Appendix for additional reading on the subject. Money management is the central reason why it’s usually a mistake to buy someone else’s trading system, which was customized for the risk preferences of the designer — not you. To find your own risk preferences, you need to experiment with different money management rules. You can have a so-so system but magnify it into a splendid system with clever money management alone.

View Article
10 Rules for Working with Market Indicators

Article / Updated 11-23-2019

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. 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.

View Article
16 Technical Analysis Secrets for Boosting Your Trading Skills

Article / Updated 09-02-2019

Technical analysis can give you an edge in beating the stock market. How, exactly, do you do that? Here are 16 technical analysis secrets to becoming a skilled technical analysis trader: Don’t let the seeming complexity of technical analysis scare you off. The technical analysis workspace is a chart showing the price of a security over time. The tools you use in that workspace are indicators. You learned about charts in grade school and the arithmetic behind indicators is usually nothing more than the basic addition, subtraction, multiplication, and division from grade school. In a nutshell, technical analysis can be stunningly simple. You can go on to make it more complicated, but you don’t have to — you can keep it simple. The core concept of technical analysis is to trade with the trend. If your indicators tell you 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. Every indicator works. Indicators are effective in identifying both buying opportunities and warnings for when you should get out and sell. The technical analysis world has devised dozens of indicators, and you can’t hope to use them all. There is no single best indicator, but there are a few best indicators for you. The best indicators for you are the ones whose inner workings you understand and the ones you are comfortable trusting because they perform well consistently and reliably for you. Every indicator fails sometimes. Accept that all trading, including trading using technical analysis, sometimes results in losses. Losses can arise because the market goes haywire and behaves in a bizarre and abnormal way, while your indicators were chosen to work well under normal conditions. This is the luck factor and doesn’t mean your indicator skill is faulty. Similarly, every indicator has the potential to lead you into a trade that delivers gigantic gains. It’s still abnormal market behavior and doesn’t mean your indicators are magical and your indicator skills exceptional. 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 and you need to intervene to control losses. Technical analysis is about making money, not about proving your indicators are right. You can’t make money if you can’t control the occasional loss. The tool for managing losses is the stop-loss order. No trader is successful over the long run without using stop-loss orders. Interpret what the indicator is saying about crowd sentiment. Indicators measure whether a security is trending, the strength of the trend, and when the trend is running out of steam. 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 confirmation bias, more commonly known as wishful thinking, skew your vision. Accept the evidence of your eyes. When you misinterpret a chart, go back and find what you missed. 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 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 avoid analysis paralysis that comes from demanding so much confirmation from so many indicators that you hardly ever get a signal. Use indicators that work well together without duplicating the ruling concept. Use multiple time frames for confirmation. When you have the same buy/sell signal in the six-hour, daily and one-week time frame, you have confidence that the indicator is telling you the truth. You won’t get multiple time frame confirmation all the time but look for it anyway. When in doubt, expand your time frame to the weekly chart from the daily chart — seeing the big picture may help. Dismiss people who say “market timing doesn’t work.” They’re people who couldn’t get it to work for themselves. The crowd who say technical analysis doesn’t work includes some well-known and highly successful fund managers and pundits. But a higher number of well-known and successful fund managers do use technical analysis. Millions of people, from high-level experts to the ordinary Joe, 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 trade for amusement or excitement or to make a point. The purpose of trading is to make money — period. If you’re trading for entertainment or excitement or to prove some philosophical or political point, you’ll almost certainly lose your shirt. For amusement, go to the movies. For excitement, buy a motorcycle or ride a roller coaster. 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 are trending. Junky securities are trending. Both can offer the same opportunities and the same risk of loss. 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. Devise a trading plan and stick to it. Indicators are sometimes wrong and you’ll take losses. Compensate for the shortcomings of indicators by imposing strict risk-management controls. Examine your track record and 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. And 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. Plan every trade and never trade without a profit target and a stop loss. 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. Reduce trading after a big loss and a big gain alike. Pace your trading to the amount of money you have. Don’t overtrade, but don’t get paralyzed by uncertainty, either. Beware of self-appointed 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 in 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. 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.

View Article
Technical Analysis: How to Read a Basic Price Bar

Article / Updated 09-02-2019

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: 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 aren’t consistently offering higher or lower closes? This situation is called congestion, and you should hold off trading the security until you see a trend. A trend can be identified by connecting a series of price bars to form a support or resistance line and looking for a directional slope. You can also use a series of bars to create a moving average, simple or fancy, to do the same thing — discern a directional slope. On the whole, technical analysis seeks to identify trends to aid your trading decisions, and trends start with the bar.

View Article
Basics of Candlestick Charts in Technical Analysis

Article / Updated 09-02-2019

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. 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.

View Article