Should I buy today? What will prices be tomorrow, next week, or next year? Wouldn’t investing be easy if we knew the answers to these seemingly simple questions? Alas, if you are reading this trading article in the hope that technical analysis has the answers to these questions, I’m afraid, it doesn’t. However, if you are reading this article with the hope that technical analysis will improve your investing and trading skills, I have good news, it will!
The term “technical analysis” is a complicated sounding name for a very basic approach to investing. Simply put, technical analysis is the study of prices, with charts being the primary tool.
The roots of modern-day technical analysis stem from the Dow Theory, developed around 1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these roots include such principles as the trending nature of prices, prices discounting all known information, confirmation and divergence, volume mirroring changes in price, and support/resistance. And of course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow Theory.
The future can be found in the past
Technical analysis is the process of analyzing a security’s historical prices in an effort to determine probable future prices. This is done by comparing current price action (i.e., current expectations) with comparable historical price action to predict a reasonable outcome. The devout technician might define this process as the fact that history repeats itself while others would suffice to say that we should learn from the past.
Contrary to popular belief, you do not need to know what a security’s price will be in the future to make money. Your goal should simply be to improve the odds of making profitable trades. Even if your analysis is as simple as determining the long-, intermediate-, and short-term trends of the security, you will have gained an edge that you would not have without technical analysis.
Consider the chart of Merck in Figure 1 where the trend is obviously down and there is no sign of a reversal. While the company may have great earnings prospects and fundamentals, it just doesn’t make sense to buy the security until there is some technical evidence in the price that this trend is changing.
Mechanical trading systems can help us remove our emotions from our decisions…That is not to say that computers aren’t wonderful technical analysis tools–they are indispensable. In my totally biased opinion, technical analysis software has done more to level the playing field for the average investor than any other non-regulatory event. I caution you not to let the software lull you into believing markets are as logical and as predictable as the computer you use to analyze them.
15 Ways To Trade Moving Averages
Reading a chart without moving averages is like baking a cake without butter or eggs.
Those simple lines above or below current price tell many tales, and their uses in market interpretation are unparalleled. Simply stated, they’re the most valuable indicators in technical analysis.
You can trade without moving averages, but you do so at your own risk. After all, these lines represent median levels where your competition will make important buying or selling decisions. So it makes sense to predict what they’re going to do before the fact, rather than afterward.
15 Ways To Manage Opportunity Through Moving Averages
1. The 20-day moving average commonly marks the short-term trend, the 50-day moving average the intermediate trend, and the 200-day moving average the long-term trend of the market.
2. These three settings represent natural boundaries for price pullbacks. Two forces empower those averages: First, they define levels where profit- and loss-taking should ebb following strong price movement. Second, their common recognition draws a crowd that perpetrates a self-fulfilling event whenever price approaches.
3. Moving averages generate false signals during range-bound markets because they’re trend-following indicators that measure upward or downward momentum. They lose their power in any environment that shows a slow rate of price change.
4. The characteristic of moving averages changes as they flatten and roll over. The turn of an average toward horizontal signifies a loss of momentum for that time frame. This increases the odds that price will cross the average with relative ease. When a set of averages flatline and draw close to one another, price often swivels back and forth across the axis in a noisy pattern.
5. Moving averages emit continuous signals because they’re plotted right on top of price. Their relative correlation with price development changes with each bar. They also exhibit active convergence-divergence relationships with all other forms of support and resistance.
6. Use exponential moving averages, or EMAs, for longer time frames but shift down to simple moving averages, or SMAs, for shorter ones. EMAs apply more weight to recent price change, while SMAs view each data point equally.
7. Short-term SMAs let traders spy on other market participants. The public uses simple moving average settings because they don’t understand EMAs. Good intraday signals rely more on how the competition thinks than the technicals of the moment.
8. Place five-, eight- and 13-bar SMAs on intraday charts to measure short-term trend strength. In strong moves, the averages will line up and point in the same direction. But they flip over one at a time at highs and lows, until price finally surges through in the other direction.
9. Price location in relation to the 200-day moving average determines long-term investor psychology. Bulls live above the 200-day moving average, while bears live below it. Sellers eat up rallies below this line in the sand, while buyers come to the rescue above it.
10. When the 50-day moving average pierces the 200-day moving average in either direction, it predicts a substantial shift in buying and selling behavior. The 50-day moving average rising above the 200-day moving average is called a Golden Cross, while the bearish piercing is called a Death Cross.
11. It’s harder for price to break above a declining moving average than a rising moving average. Conversely, it’s harder for price to drop through a rising moving average than a declining moving average.
12. Moving averages set to different time frames reveal trend velocity through their relationships with each other. Measure this with a classic Moving Average-Convergence-Divergence (MACD) indicator, or apply multiple averages to your charts and watch how they spread or contract over different time.
13. Place a 60-day volume moving average across green and red volume histograms in the lower chart pane to identify when specific sessions draw unexpected interest. The slope of the average also identifies hidden buying and selling pressure.
14. Don’t use long-term moving averages to make short-term predictions because they force important data to lag current events. A trend may already be mature and nearing its end by the time a specific moving average issues a buy or sell signal.
15. Support and resistance mechanics develop between moving averages as they flip and roll. Look for one average to bounce on the other average, rather than break through it immediately. After a crossover finally takes place, that level becomes support or resistance for future price movement.
by Alan Farley
1. Successful traders stay neutral:
Staying neutral means to be emotionally detached from your trading decisions. I’ve met many day traders that were emotionally suffering for the rest of the day after losing $100 or even less and when they made $1000 they would be “on top of the world”. They are definitely not trading neutral.
If you are like that, then your trading will definitely be driven by fear and greed; if you are down $100 you probably don’t want to take a loss, just because you know that you will be emotionally suffering. If you are up $1000 you might want more, even though you should take profits. Or you might end up taking profits way too early because you are afraid that the position might turn against you. The professionals don’t let the day-today oscillations in their account faze them. The results of one week don’t matter much, not even the monthly results. It’s just a small blip of time in their career, so the day-to-day oscillations don’t really matter. Emotional ups and downs are pretty normal for beginners. If they influence your trading decisions too much, then I would strongly advise you to go back to paper trading in order to gain the confidence you need to not let those oscillations affect you too much.
Staying neutral also means to see the price movements like they really are, not how you want them to be. You might all know the situation where a trade is going against you, and you start looking for other reasons why it is still a good trade and you should hold it. This is very dangerous since it leads people to breaking their stops and to lose big. Your entry and exit criteria has to be absolutely clear before you make a trade. Switching strategies while you are in a trade is one of the worst things you can do. You can always find a reason for your position to go up or down, but you don’t see the actual price movement anymore. You are shifting from reaction to prediction! A day trader should under no circumstance try to predict future price movements. As traders we have to play the actual price movement, not what we think the movement should be! Please leave prediction to investors. A lot of times I see traders taking positions in stocks they know very well fundamentally. They mix trading with investing. This is very dangerous too. While there might be reasons to enter a position for a short-term trade they often end up holding it as an investment if it goes against them. Just think about Enron.
Yes, there were points during the Enron sell off where a trade would have been justified. Even I held Enron for a short recovery from about $8.5 to $10. The problem is, that if you base your entry on the belief that the company is cheap and it has to recover, you will be more and more inclined to hold your position or even add to it once it goes lower. The stronger your opinion on a stock, the harder it is to make decisions based on the actual price movement. I would strongly advise you to have a separate account for fundamentally based trades. A day trading account gives you too much leverage, making it very tempting to take risks that are way too high!! I am not saying that it is not good to have expectations; everyone should know what his potential trades are most likely going to do. Should those expectations be wrong though, then we have to accept that and react according to what is really happening.
2. They are not afraid to place a trade:
Fear or a lack of confidence in your trading decisions makes it hard to enter trades in the first place. You will often find yourself letting good opportunities pass by, or you are waiting for additional confirmation that the stock is going your way, which makes you enter trades too late and you end up chasing the stocks; often getting in at the end of the movement. Fear of losing money makes it harder to take losses. To much fear will either make you not take losses at all and cause significant draw downs, or it will make you take losses to soon, before the actual stop price was hit. Confidence in your ability to make good trading decisions will help you to be patient since you know that eventually there will be good opportunities. Traders with a lack of confidence tend to look for different trading strategies every time something goes wrong for them. They are therefore never able to focus on one strategy and master it. Even if you are a experienced trader you might lose some confidence once in a while. Go back to paper trading or to trading small shares in order to get yourself back on track.
3. Successful day trading – only use risk capital for trading:
If you are day trading with all the money you have without having another income you will be way too scared in order to make any neutral decisions. There is a saying that scared money never wins. I have yet to see a trader who was able to live off a 5K trading account without any additional income.
4. They focus on a few strategies that suit them well:
Many traders try to implement too many strategies at once. They think they have to make money every day. The most successful day traders I know only have a few strategies that they are highly successful with, sometimes only one. The goal is to find a strategy that YOU are comfortable with and to master it. This won’t come overnight. Of course you need to have a look (and try) different strategies until you find something that you are comfortable with. Keep in mind that no strategy works in every market. Therefore it is normal to sit on the sidelines every once in a while. You don’t have to make money every day. The key is to only trade when the odds are in your favor and to stay in the game. Once you have established a “bottom line” strategy you should slowly move on and implement other strategies.
5. They are patient:
This starts with patience in your learning process. Take time to trade on paper for a while. You will make mistakes and it will take time to get comfortable with your trading decisions. Please make your mistakes on paper; this will keep you in the game. If you absolutely want to trade live right away please do so with a very small amount of shares. You can make a lot of mistakes if you are trading a small amount of shares. If you use your full buying power though one blown stop can wipe you out. I have yet to see a trader (including myself) who didn’t blow a stop at least once!!
Patience to wait for trading opportunities is very important too. As stated above, not every strategy works every day. You might have to wait a while to find a good trade. It can also happen that you have a losing streak. A good trader will not worry too much about that and will do something else. Sitting in front of your computer trying to make back losses is the worst thing you can do. I would strongly advise you to set maximum losses per day, week and overall. Stop trading immediately if your maximum losses are hit. Remember, as long as you stay in the game there will always be another day with new opportunities.
6. They are great money managers:
A good day trader will never risk more than 2% of his trading capital on a single trade. This means that if he has to take a stop, the amount of money he is wiling to lose will be no more than 2% of his capital. 2% is the absolute maximum. You should attempt to risk less than that. The reason why this is so important is that even if you are right 99% of the time you can still lose 10 times in a row. Every once in a while this might happen to you. Only if you risk little money you will be able to survive such a draw down.
7. Successful traders – Trade with Confidence:
I believe that trading with confidence is by far the single most important secret to successful day trading. The most successful traders I know only use a few basic strategies based on simple technical analysis, candlestick charts and chart patterns.
What made them so successful was the confidence in their trading strategy, their ability to stay neutral and to execute their trades according to what they see.
Learn more about successful day trading in my free day trading ebook.
Disclaimer: Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risks. You must be aware of these risks and be willing to accept them in order to invest in these markets. Don’t trade with money you can’t afford to lose. This article is for educational purposes only.