Technical Analysis For Dummies Cheat Sheet
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.
16 Technical Analysis Secrets for Boosting Your Trading Skills
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.
Technical Analysis: How to Read a Basic Price Bar
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.
Basics of Candlestick Charts in Technical Analysis
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.
How to Identify the End of a Trading Chart Trend
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|
|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.