Technical analysis was introduced by Charles Dow in the late 1800s and is a methodology for determining the future direction of a stock’s price by studying past market data. It uses patterns in market data to identify trends and make predictions. Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
The theory of technical analysis is based on three premises. The first is that market action discounts everything. This means that sales, earnings potential, market share, and other economic factors, including market psychology, have already been priced into the security. Therefore, technical analysis purists do not consider the value of a security when predicting future price movements. Instead, technicians study price action.
This first premise describes a technicians mindset more so than practical market operation. If known information were immediately priced into the market – the efficient market hypothesis would be true, and there wouldn’t be phases of semi-predictable price movement that could be systematically exploited. Keep this in mind.
The second premise of technical analysis is that prices move in trends. Even random price movements appear to move in recognizable patterns that consistently repeat over time. Technical analysis intends to identify and follow existing trends, to determine when a trend is in place, when it isn’t, early stages of development, and when a trend is reversing.
The third premise is that history tends to repeat itself. Price movement is repetitive, and this repetitive nature is attributed to market psychology. The idea is that market participants tend to provide a consistent reaction to similar market stimuli over time. Analyzing the past is conducive to understanding the future.
Technical indicators are pattern-based signals that are produced primarily by the price and volume of a security. As noted, by analyzing historical data, technical analysis uses these indicators to exploit future price movements and confirm previous price movements. .
As soon as the market opens, the price the market is first traded at is the opening price. The NYSE opens at 9:30 AM EST. Let’s say we are analyzing stock XYZ at 9:29 AM EST. Prices will likely fluctuate before the opening bell. However, the price at which XYZ first trades when 9:30 AM rolls around is the opening price of XYZ.
The high of the day is the highest price XYZ market traded for the session. For example, let’s say stock XYZ opens at $100 at 9:30 AM, trades to $105 later in the session, and then ends the day at a lower price than $105. If this were to occur, the high of the day is $105.
The low of the day is the lowest price a market traded for the session. Let’s say stock XYZ opens at $100, increases to $105, decreases to $98, and closes higher than $98 at the end of the trading day. In this example, the low of the day is $98.
The closing price is the price a market ended the session at, the last transaction before the market closes for the day. Let’s say stock XYZ opens at $100, increases to $105, decreases to $98, and closes at $103. If so, the closing price of the session is $103. The closing price is the most important price of any session. Think of it this way, if stock XYZ opens at $100, and then trades up to $115, we would interpret the substantial increase in price as bullish, right? Well, what if XYZ ends the session with a close of $98? There was strong buying pressure intrasession, however, selling pressure proved stronger by the end of the session. Generally, if prices close lower than the previous session, selling pressure overpowered buying pressure. If prices close higher than the previous session, buying pressure overpowered selling pressure.
A bullish trader/investor holds the opinion that a particular market or asset will rise in price. Some traders use “bullish” and “uptrend” interchangeably. For example, you may hear someone say, “bullish trend.” This means that prices are uptrending.
A bearish trader/investor holds the opinion that a particular market or asset will decrease in price. Some traders use “bearish” and “downtrend” interchangeably. For example, you may hear someone say, “bearish trend.” This means prices are downtrending.
A chart is a graphical representation of a market’s historical price action. There are numerous ways in which a market’s historical price action can be presented. Bar charts, line charts, point & figure charts, Kagi charts, Heikin-Ashi charts, and candlestick charts are all methods in which historical price action can be portrayed. Each chart type has unique characteristics. For example, a line chart only displays closing prices. Point & figure charts do not plot the volume traded for the session. Kagi charts do not plot a time axis. I mentioned our analysis will be performed on candlestick charts.
Examples of chart time frames include 1-minute, 5-minute, 30-minute, 1-hour, 4-hour, Daily, Weekly, Monthly, etc. When selecting the 1-minute chart, candlesticks will materialize that reflect the price action during the current minute. A 1-minute candlestick chart will illustrate the open, high, low, and closing prices for each minute. A 1-hour candlestick chart will illustrate the open, high, low, and closing prices for each hour. A daily candlestick chart will illustrate the open, high, low, and closing prices for each day. A weekly candlestick chart will illustrate the open, high, low, and closing prices for each week. A monthly candlestick chart will illustrate the open, high, low, and closing prices for each month.
Here is the textbook definition of “sentiment”: An attitude, thought, or judgment prompted by feeling. Now, we can apply this to the markets. Market sentiment = the predominant attitude of investors/traders toward an individual asset or market. We will discuss market sentiment extensively in. For now, I want to mention that there is no better way to evaluate market sentiment than through analyzing price and volume. Your spouse, parents, friends, and neighbors could be bearish as a grizzly, but, if a particular market continues increasing in price on high volume, their sentiment does not align with the opposite sentiment, which is of greater magnitude at the time.
For those actively trading during the COVID-19 crash, we all know how the majority of retail traders/investors were bearish as a grizzly throughout the first couple of months of the bullish reversal. When you overhear random people at the grocery store, the gym, out on the town, etc. talking about the market; you know something chaotic is transpiring. During the bullish reversal following the COVID-19 crash, virtually everywhere I went I overheard others saying, “A second leg down is coming,” or, “This is just a dead cat bounce,” and, “The Fed is injecting billions of dollars into the market. Businesses are closing, people are out of work, the GDP is down, the market is going to crash even harder.” In real-time while everyone was panicking these opinions were justifiable. However, the market just kept increasing. If prices increase: demand > supply. If prices decrease: supply > demand. An expert could draft up a one-thousand slide presentation on why the market should continue decreasing and present it to the masses. Each point of the presentation could be rationally vindicated. However, if the market keeps increasing, who was wrong? The market? Or the presenter? Well, the presenter was. Increasing prices = bullish sentiment. Decreasing prices = bearish sentiment.
A trend is the primary direction in which a market’s prices are moving. We can sort trends into three time-frames: short-term (near-term), intermediate-term (intermediate), and long-term (major).
Short-term trends are generally characterized as any trend shorter than three weeks. The exact timeframe in which a short-term trend can be observed is subject to multiple interpretations. Some traders may define a short-term trend as a sequence of price movements less than two weeks, or even less than one month. I consider a month or less as a short-term trend.
Intermediate-term trends are generally characterized as any trend in effect for three weeks to one year. Again, the timeframe in which an intermediate-term trend operates is ambiguous. Some traders define an intermediate-term trend as a sequence of price movements from one to six months, some define an intermediate-term trend as no less than one month and no more than nine months.
Long-term trends are generally characterized as any trend in effect for greater than one year.
Distinguishing between a short-term, intermediate-term, and long-term trend is critical to performing technical analysis.
Now, let’s discuss how trends can be classified through disparity in price movement.
An uptrend consists of increasing prices with observably higher price peaks and troughs. For prices to consistently uptrend, bullish sentiment must overpower bearish sentiment. Therefore, demand is greater than supply. An uptrend can be short-term, intermediate-term, or long-term. Think of it this way, short-term trends materialize within intermediate-term and long-term trends. Intermediate-term trends materialize within long-term trends. There is a myriad of short-term trends within intermediate-term trends within long-term trends.
A downtrend consists of decreasing prices with observable lower price peaks and troughs. For prices to downtrend, bearish sentiment must overpower bullish sentiment. Therefore, supply is greater than demand.
The term “sideways trend,” and “trendless,” are often used interchangeably. If someone refers to a particular market as “trendless,” they are saying the market is trading sideways. A sideways trend consists of horizontal price movement in which the power of supply and demand are virtually identical. When an uptrend or downtrend is in motion, and prices suddenly trend sideways for a transient period, it is known as “consolidation.” Consolidation often precedes the continuation of an uptrend or downtrend. If prices are trending sideways, neither demand nor supply is dominant enough to institute an uptrend or downtrend. Many traders also refer to sideways price movement as a “phase of congestion.” Periods of consolidation/congestion often result in prices fluctuating between major support and resistance levels. For this phase to terminate, demand must overpower supply, thereby instituting an uptrend, or, supply must overpower demand, thereby instituting a downtrend.
Price peaks form during short, intermediate, and long-term trends. A price peak is a level prices increase to before failing to increase further. Price peaks do not signal the end of a trend. Price peaks are areas of resistance where the trend stalls. A price peak will always precede a bearish reversal or change to a sideways trend. However, not every price peak will precede these trend changes. An uptrend consists of progressively higher price peaks and troughs. A downtrend consists of progressively lower price peaks and troughs.
Price troughs form during short, intermediate, and long-term trends. A price trough is a level prices decrease to before failing to decrease further. Price troughs do not signal the end of a trend. Price troughs are areas of support where the trend stalls. A price trough will always precede a bullish reversal or change to a sideways trend. However, not every price trough will precede these trend changes. A downtrend consists of progressively lower price peaks and troughs.
Now, let’s look at some examples of trends, price peaks, troughs, etc.
Figure I.1 shows a short-term uptrend on a candlestick chart. We can observe progressively higher troughs and progressively higher peaks through a sequence of 20 sessions spanning a little less than a month.
Figure I.2 shows the short-term uptrend we analyzed in Figure I.1 incorporated within an intermediate-term uptrend. We can also identify a short-term sideways trend within the intermediate-term uptrend. The intermediate-term uptrend consists of approximately 100 sessions (100 trading days) spanning over approximately 4-5 months. Therefore, we can consider an intermediate-term uptrend in operation. The short-term sideways trend within the intermediate-term uptrend consists of approximately 20 sessions. Therefore, we can characterize the sideways price movement as a short-term sideways trend.
Now, let’s see how the intermediate-term uptrend and short-term sideways fit within the long-term trend.
Figure I.3 Long-Term Uptrend, Intermediate-Term Sideways Trend, and Short-term Uptrend – Technical Analysis
Figure I.3 shows a long-term uptrend, a marked intermediate-term sideways trend, and a marked short-term sideways trend. Do not let the title of Figure I.3 confuse you; there are several short-term trends and a few intermediate-term trends present within the long-term trend. Be sure to identify them. Not all short-term and intermediate-term trends are marked to reduce clutter.
Through observation of the previous examples, we can conclude that short-term trends are a constituent of intermediate-term and long-term trends. Intermediate-term trends are a constituent of long-term trends.
Do you think a day trader, swing trader, and long-term trader interpret short-term, intermediate-term, and long-term trends similarly? Certainly not! A day trader may designate a few days of price movement up, down, or sideways to comprise a long-term (major trend). A swing trader may consider the same price sequence as a short-term trend. A long-term trader may consider the same price sequence as entirely inconsequential.
Now, let’s look at an example of downtrends.
Figure I.4 shows a short-term downtrend identifiable when analyzing decreasing peaks and troughs.
Let’s expand the number of observable sessions to see how the short-term downtrend is a constituent of an intermediate-term trend.
Figure I.5 shows an intermediate-term downtrend which can be discerned by examining progressively lower peaks and troughs. The short-term downtrend we analyzed in figure I.4 exists within the intermediate-term downtrend; there are several short-term downtrends present within the intermediate-term downtrend. The intermediate-term downtrend stalled in June, and a short-term sideways trend was instituted.
Let’s see how the short-term trends and intermediate-term trend in the figure compose the long-term trend.
Figure I.6 shows a long-term downtrend with progressively lower peaks and troughs over approximately one year. Notice the marked short-term uptrend. This short-term uptrend is considered a retracement of the long-term downtrend. We will cover retracements shortly. For now, be sure to analyze the short-term trends incorporated within the long-term trend.
Figure I.7 shows a long-term uptrend in operation for approximately five years. Incorporated within the long-term uptrend are short-term and intermediate-term trends. A long-term uptrend consists of intermediate-term trends with larger price increases and smaller bearish retracements. A long-term downtrend consists of intermediate-term trends with larger price decreases and smaller bullish retracements.
Through analyzing Figure I.7, we can conclude that intermediate-term trends often serve as retracements of a long-term trend.
Now, let’s discuss retracements.
Not to be confused with “reversals.” Retracements are temporary changes in the trajectory of an overarching trend. A retracement occurs against the predominant trend; however, the trend will be reinstituted thereafter. A long-term uptrend will see numerous bearish retracements throughout its continuance. Conversely, a long-term downtrend will see numerous bullish retracements throughout its continuance. Many traders use the terms “pullback” and “retracement” interchangeably. However, you should consider a “pullback,” as short-lived price movement against the predominant trend that does not meet the percentage price move requirement to be considered a retracement.
We know how to distinguish a long-term uptrend now. We analyze progressively higher peaks and progressively higher troughs. In the previous examples, I am certain you noticed how price movement would trade against the predominant trend for transient periods. These price moves are considered retracements. There is a myriad of catalysts that may initiate a retracement. More often than not, retracements are the result of natural supply/demand dynamics. For now, let’s think of bearish retracements during an uptrend as a transient period in which selling pressure overpowered buying pressure. Bullish retracements during a downtrend reflect a transient period in which buying pressure overpowered selling pressure.
Remember, retracements always precede the continuation of the predominant trend. For example, let’s say an uptrend is in operation. Prices reach a peak and subsequently move against the predominant uptrend. A trough forms and buyers regain control of the market. The uptrend continues thereafter. This is a retracement. Now, let’s say prices continue uptrending and form another peak. Buying pressure exhausts and sellers take control of the market, similar to how a bearish retracement initiates. Prices decrease, but the buyers never regain control. Eventually, the uptrend is considered inoperative. This is not a retracement, but a reversal. We will cover reversals shortly. For now, let’s take another look at figure I.7 and distinguish the bearish retracements that transpire.
Figure I.8 shows marked bearish retracement during a long-term uptrend spanning several years. Notice how the retracements are conspicuous. Each marked retracement precedes the continuation of the predominant uptrend. Let’s look at the chart once more and identify pullbacks, not retracements.
Figure I.9 shows marked pullbacks during a long-term uptrend. Remember, many traders and analysts use the terms “pullback” and “ retracement” interchangeably. I prefer to keep the two distinct. Pullbacks incorporate a small percentage price movement against the predominant trend. Retracements incorporate a larger percentage price movement against the predominant trend. If we were to analyze an intermediate-term trend, even smaller price movements against the intermediate-term trends would constitute a pullback. Let’s take a look at retracements and pullbacks during an intermediate-term trend.
Figure I.10 shows the disparity between pullbacks and retracements during an intermediate-term downtrend. Notice how retracements are more conspicuous.
All trend reversals begin as a potential trend retracement. Remember, a trend retracement always precedes the continuation of the predominant trend. However, a trend reversal never precedes the continuation of trend. If a trend reverses, a new trend is instituted. An uptrend reversal consists of a subsequent downtrend. A downtrend reversal consists of a subsequent uptrend. An uptrend or downtrend converting to a sideways trend is not considered a reversal. Uptrend or downtrend converting to a sideways trend is considered a period of consolidation. When the phase of consolidation ends, the predominant trend should continue. If a phase of consolidation persists for a prolonged period, it is no longer considered consolidation. Instead, it is simply considered a sideways market. Many traders consider a “sideways market” and “consolidation” synonymous. It is important to keep the two distinct.
The word “consolidation” implies that an occurring action or process makes something stronger. A secondary definition of the word consolidation implies that an action or process combines several things into a unified more effective whole. Therefore, consolidation should precede the continuation of the predominant trend. If a phase of consolidation precedes a trend reversal or prolonged sideways market, then we cannot logically consider the sequence of price movement to be consolidation. During a trend, if prices trade sideways for a transient period before continuing the trend, we should consider the sideways price movement as a phase of consolidation. During a trend, if prices stall and trade sideways for a prolonged period, we should not consider the price sequence as consolidation. Instead, we should interpret the price sequence as an extended period of indecision and equal force between bulls and bears. During a trend, if prices stall and subsequently reverse, we should not consider the sideways price sequence as consolidation. Instead, we should attribute the sideways price sequence as a reflection of trend exhaustion and weakness. As a result, the opposing force (bulls during a downtrend, bears during an uptrend) reclaimed control of the particular market.
Let’s look at an example of a bearish reversal and bullish reversal.
Figure I.11 shows an uptrend converting to a downtrend; a bearish reversal. In real-time, the initially marked trough may be perceived as a bearish retracement. However, buyers did not regain control of the market intermediate to long-term. The particular market continued to decrease in price. We can identify the downtrend by analyzing descending peaks and troughs.
Figure I.12 shows the variance between a bearish retracement and a bearish reversal.
Figure I.13 shows the variance between a bearish retracement and a bullish reversal. Notice how each bullish retracement precedes the continuation of the predominant downtrend. However, the bullish reversal constitutes a change in the predominant trend; bearish to bullish.
At this very moment, we must dispel the belief that we can consistently time trend reversals. Yes, we can implement techniques and methods to forecast a potential reversal, and we can use indicators that signal a potential reversal. However, these techniques, methods, and indicator signals will often precede a retracement of the predominant trend, not a complete reversal. In theory, we can time every trend reversal when they institute. However, we will be incorrect in our forecast more often than not. So, what can we do? We can consistently confirm a trend reversal in motion. Trying to time every market reversal is a foolish pursuit. More often than not your forecast of a trend reversal will result in a trend retracement. Let me ask you this. What is the better approach? Riding a trend until we can confirm it has ended? Or, failing to enter a strong trend while it persists, trying to time a reversal of the trend, and attempting to enter a position against the trend? Well, the former is much more conducive to profitability.
Let’s dial in on this. If a strong trend is in motion, we should use techniques, methods, and indicators to evaluate the momentum of the trend, confirm it, and distinguish potential entry points that align with the trend. Why would we sit on the sidelines while a strong trend is in motion and try to pinpoint the precise moment it will reverse? All the time we spend trying to pinpoint the reversal results in missed profit. An optimal approach involves identifying an entry point, entering a position aligned with the trend, and holding the position until our exit-criteria are satisfied.
We can define momentum as the speed at which a market’s price is changing. Strong bullish momentum results in prices increasing. Strong bearish momentum results in prices decreasing. For an uptrend to persist, bullish momentum must remain strong. For a downtrend to persist, bearish momentum must remain strong. We can evaluate the momentum propelling a trend through technical analysis and indicators. We won’t discuss how to do so in this article. For now, just know that we can perform technical analysis to adequately evaluate momentum and reach definitive trading decisions.
If a market is uptrending, demand > supply. If demand > supply, then bullish momentum is present.
If a market is downtrending, supply > demand. If supply > demand, then bearish momentum is present.
Volume – Technical Analysis
An entire book could be written on volume, particularly volume analysis. For now, let’s focus on the basics. Volume defines the number of transactions a market has experienced over an established period. The daily chart depicts price action throughout a single trading day. Have you noticed the green and red bars which materialize below individual candlesticks? These bars reflect volume. The volume below a candlestick of any timeframe is a graphical representation of the number of shares a market traded between its open and close, relative to the timeframe.
For example, a one-minute candlestick chart will display the number of shares transacted each minute. A four-hour candlestick chart will display the number of shares transacted every four hours. A daily candlestick chart will display the number of shares transacted each day. A weekly candlestick chart will display the number of shares transacted each week.
We want the volume to confirm a market’s price trends. If an uptrend is in operation, the volume should be greater on up days than on down days. Such an occurrence reflects strong buying pressure that confirms uptrending prices. If a downtrend is in operation, the volume should be greater on down days than on up days. Such an occurrence reflects strong selling pressure that confirms downtrending prices. If the volume does not confirm a trend, we have an anomaly. We won’t discuss volume-to-price anomalies quite yet. Just know that: volume should confirm a trend.
Think of it this way. If an uptrend is in motion, but volume is greater on down days than on up days, we should think, “this uptrend may stall soon.” If an uptrend is strong, buying pressure must overwhelm selling pressure. If on down days, selling pressure overwhelms buying pressure during an uptrend, sellers must be comfortable enough to open a position at the current price level with the expectation of a future profit. In addition, traders holding shares of the underlying stock are taking-profit. If a downtrend is in motion, but volume is greater on up days than on down days, we should think, “this downtrend may stall soon.” If a downtrend is strong, selling pressure must overwhelm buying pressure. If on up days buying pressure overwhelms selling pressure during a downtrend, buyers must be comfortable enough to open a position at the current price level with the expectation of a future profit. In addition, traders short on the underlying stock are likely taking-profit.
For an uptrend to persist, demand > supply. For demand to be greater than supply, buyers must overpower sellers. For a downtrend to persist, supply > demand. For supply to be greater than demand, sellers must overpower buyers.
Volume can sometimes be deceitful. Still, we must be cognizant of the importance of volume and how it can be assessed to improve our analytical abilities. Volume analysis allows us to evaluate price areas where demand or supply overpower one another. In addition, we can analyze volume to confirm trends, identify trend exhaustion, and even confirm price reversals.
We know that bearish retracements manifest during an uptrend. However, bearish retracements during a strong uptrend should occur on below-average volume. If the volume is high during bearish retracements of an uptrend, we know that sellers are entering the market aggressively and bullish traders are taiking-profit. We know that bullish retracements manifest during a downtrend. Bullish retracements during a strong downtrend should occur on below-average volume. If the volume is high during bullish retracements of a downtrend, we know buyers are entering the market aggressively, and short-sellers are taking-profit.
For us to establish an average volume metric, we can implement a moving average of volume over an established amount of sessions.
Buying pressure may sound synonymous with buying volume. However, I will primarily refer to buying pressure as an increase in price. Remember, if prices are increasing, demand > supply. During an uptrend, even if the volume is low on up days, prices still closed above where they opened. For this to occur, demand must be greater than supply. Buyers must overwhelm sellers for the session.
Selling pressure may sound synonymous with selling volume. However, I will primarily refer to selling pressure as a decrease in price. Remember, if prices are decreasing, supply > demand. During a downtrend, even if the volume is low on down days, prices still close below where they opened. For this to occur, supply must be greater than demand. Sellers must overwhelm buyers for the session.
A price gap occurs when a market’s price opens higher or lower than the closing price of the previous session. When the NYSE closes, the final price traded is the closing price. If prices trade at a higher or lower price as the market opens, a price gap transpires. Most price gaps are common and do not precede a substantial price move. There are instances in which a large price gap will occur. These price gaps reflect strong sentiment in the direction of the gap and often precede prices further trending in favor of the gap. Some traders look to trade in favor of a considerable price gap.
The Best Method to Beat the Market?
There seems to be perpetual disagreement on the best way to beat the market; you are likely to get several different answers. Ultimately, the best way to beat the market is to be in the market.
What does this mean?
Having a diverse portfolio of investments is advantageous. The S&P 500 has increased exceptionally over the previous few years. Matching the percentage gain of the S&P on an annual basis still allows for strong portfolio gains. There is no guarantee this will continue indefinitely; however, the S&P 500 is up approximately 4600% since 1970.
If we match the market, how exactly are we going to beat it?
We should invest in the market and trade it. We commit to a diversified portfolio of growth stocks and reinvest a portion of our trading profits to accumulate more shares. We can also reinvest the profits into securities we don’t own shares of yet. For example, a portion of our swing-trading profits can be realized and reinvested into blue-chip positions, or a security of similar stability.
Subjective Trading Vs. Objective Trading – Technical Analysis
It is generally advised that beginners implement an objective approach to trading. In addition, the beginner trader should look to objectify their technical analysis. Your technical trading methods should be precisely defined and unambiguous.
There is one overarching issue with on-the-fly subjective trading: we don’t know if our strategy has a negative or positive expected outcome. If our untested strategy has a negative expected outcome, the more we implement the strategy, the greater chance we lose money in the long-run. If we performance test a trading strategy, with a sufficient sample size, and the results reflect impressive historical performance: we might consider the strategy to have a positive expected outcome. As a result, the more we use the strategy the more likely we are to make money in the long-run.
Money management is the most important constituent of your trading plan. Distinguishing high-quality setups is meaningless without prudent money management. Let’s discuss a few aspects of money management.
Let’s say you close 75% of your positions for a profit, but your winning positions achieve a $1000 net gain while your losing positions result in a $3000 net loss. If this occurs, you won’t be a profitable trader. Let’s say you close 75% of your positions at a profit, and your winning trades result in a $1000 net gain while your losing trades result in a $500. If this occurs, your reward/risk ratio will be 2:1 while 75% of your trades are profitable: you will be a profitable trader.
A reward/risk ratio of 2:1 is advised for novice traders. When implementing a 2:1 ratio, two losing-trades will be negated by one winning trade. Conversely, one winning trade will be negated by two-losing trades. In theory, you can lose 50% of your trades and still be a profitable trader. It isn’t necessary to adhere to this ratio and your personal reward/risk ratio should appease your preferences. However, we must consider trading as a numbers game. If you profit from 50% of your trades, and your reward/risk ratio is 1:1, your losing trades are equal to your winning trades, you will not be a profitable trader.
Many traders consider a 1:1 reward/risk ratio to be suboptimal, but we must account for win-rate. If 70% of your trades are winners with a 1:1 reward/risk ratio: you will be a profitable trader. Let’s say you construct two trading strategies, the first strategy has a 70% win-rate when using a 1:1 reward/risk ratio, and the second strategy has a 40% win-rate when applying a 2:1 reward/risk ratio. Both strategies are theoretically profitable, however the 1:1 strategy has a better edge.
High win-rate strategies, even one where losing trades are bigger than winning trades, complement a conservative options strategy
Maximum Intrasession Loss
Most trades are executed near the closing of a session, or at the opening bell. Generally, novice traders should open/close their orders within the closing hour of a session. Intrasession price fluctuations can be deceptive. Let’s say you are long on stock XYZ. As the session opens, XYZ’s price plummets 3% and you sell for a loss. As the session progresses, selling exhausts while demand increases and prices close back at the opening price; a hammer forms. The formation implies strong demand at lower price areas, which is good if we are long on the underlying security; however, we closed our position during the intrasession dip.
Let’s say we are waiting for an RSI move above 55 to enter a position. The underlying security experiences strong demand intrasession, and RSI moves above 55 during the period. We enter a position to capitalize on the move; however, demand exhausts, prices close lower, and RSI closes under 55; our entry-point criteria were not fulfilled.
The closing price is typically the most important price of the session. Despite this, we should implement maximum intrasession loss criteria. Our criteria may incorporate a percentage loss or a fixed dollar amount loss. For example, if our position loses 5% of its value intrasession, we might look to close our position.
A market order is an order to buy or sell a stock at the best available market price. Assuming the market is liquid, a market order virtually guarantees execution. If you want your hands on a stock, or off it, immediately and near the current price, market orders are a good option.
Profit-Taking with Limit Orders
Letting our winning positions run is important, but holding a winning position as profits quickly diminish is generally ill-advised.
A commonly employed practice is to set limit-orders at a predetermined percentage profit. Let’s say you open a position with a profit target of 5%. You can set a limit order to close the position when earning 5% of your initial investment. Limit orders can also be placed at a dollar amount away from the current price. I could set a limit order $5 above my entry-price. Assuming the market is liquid, if prices increase $5 my position will automatically close for a profit. Prices might continue increasing/decreasing after your limit-order executes, resulting in missed profit, and this can be frustrating. However, we must remember that trading is a numbers game and our ultimate objective is consistent profitability. In addition, we must take what the market gives us. If we are consistently seeing 5% returns on our profitable trades, and only losing 2% on our losing trades, we are going to make money, even if we are losing 50% of our trades.
Trailing-stop orders are critical for new traders to implement. A trailing-stop orders functions just as it sounds. If prices move a precisely defined percentage amount, or dollar, against your position: a market order to close the position will execute. Trailing-stops are great for securing profits and ensuring you don’t sit on a losing position breaching your risk tolerance.
Assume I buy 100 shares of XYZ at $100 per share, and set a trailing-stop order for a 3% move against the position. When prices move 3% below the highest price reached my position will automatically close. If prices reach a high of $110 and decrease 3% from that amount, my trailing-stop order will activate and my position will close. The same concept applies to a short position. If prices move a defined percentage amount from the lowest low, your trailing-stop will activate and the position will be closed. This order only executes during market hours; your position will not close during a substantial pre-market price move.
Stop-loss orders are similar to trailing-stop orders, except they do not trail price movement. Assume I buy 100 shares of XYZ at $100 per share. If I set a stop-loss order at 3% below my entry price, and prices decrease 3%, my position will close. If prices increase to $110, my stop-loss order remains stagnant; my position won’t automatically close unless prices decrease 3% from where I set the stop-loss. Stop-loss orders can trigger at a predetermined dollar amount as well. I could set my hypothetical stop-loss order to $97 instead of 3% below my entry price.
There are quite a few applicable order types. You do not have to inundate yourself quite yet. However, you should familiarize yourself with the available order types and learn to capitalize on them. Learning the various order types allows for versatile trading and strategy refinement.
Backtesting – Technical Analysis
Backtesting a trading strategy involves coding the strategy into a programming language and evaluating how the strategy would have performed on historical data.
Backtesting a trading strategy allows us to ascertain its historical efficacy across numerous markets. This is good if we want to trade other securities or markets. We can backtest the strategy for the particular security or market and decide if we have a good edge using the strategy in that market. New trading strategies and ideas that come to mind can be coded and backtested. This allows us to see if the strategy is worth pursuing, when it works and when it doesn’t, and if the strategy would have been profitable over any number of years.
You can be a profitable trader even if you don’t know how to backtest. You should narrow your analysis to a handful of securities and manually backtest your trading strategy. This involves hypothetically applying your trading strategy on historical data and recording the results. You should record the results, i.e., percentage profit, percentage loss, number of winning and losing trades, etc. in Excel or a journal. Another great alternative is to use the “bar replay” feature on TradingView. You can select a specific date and TradingView will omit all the price data after that date. Select “play” and TradingView will reveal the hidden price data candlestick by candlestick. This is a good way to test your strategy if you are unable to code it.
The market is dynamic, many trading strategies become obsolete, and some trading strategies only work for particular securities or markets. Of course, some strategies have remained consistently profitable and work across numerous markets, however, we can’t know for certain without backtesting the strategy. If you are unable to backtest, you should develop a trading strategy for a handful of securities and look to capitalize on what is currently working. For example, you won’t know if your strategy worked 5 years ago for 400 different stocks. In the absence of this capability, you must dial-in on a small basket of stocks and familiarize yourself with the price movement of each stock.
If you ever want to backtest your trading strategy, some trading platforms and brokers have developed proprietary languages which aren’t too difficult to learn.
The Scope of Technical Analysis. Does it Work?
Does technical analysis work? Yes, as a constituent of a comprehensive trading strategy. Prudent money management combined with diligence, realistic expectations and technical analysis can work quite will for the average retail trader. Can we predict market moves with technical analysis? Probably not. Can we call the huge bearish reversal? Probably not. So, what can we do? We can identify an edge and exploit it. We implement an effective money management strategy, require precisely defined conditions to be satisfied, wait for a definitive trading signal, and let the market take care of the rest. Ideally, you want your trading to boil down to one of three scenarios. You have an entry signal, you have an exit signal, or nothing. No deliberation while staring at the 5 minute chart trying to decipher what’s happening.
Why does technical analysis fail some retail traders? Trying to prophesize a countertrend market move is usually the culprit. Analyzing an excessive amount of indicators can also be detrimental. Worst of all, sorting through indicators to find signals that align with one’s predisposition.
Most commonly used indicators were contrived more than 30 years ago, if not longer. It’s safe to assume the inventors designed the indicator for a market that was vastly different than today’s. This isn’t to say traditional interpretation doesn’t work in some markets; it can. However, trading a market as if one definitive signal is universally applicable isn’t likely to work.
To be fair, it doesn’t really matter what precise measurement or indicator sequence constitutes a “real” trading signal. By “real” trading signal I mean how websites and most Youtube videos teach use of the indicator. For example, RSI measuring above 70 might be disastrous for one security, but that same measurement could be exceptionally bullish in another market. Prices trading two standard deviations above a moving average might spell imminent reversion in one market, but might be an upside breakout in another market. Ultimately, our objective is to construct a trading strategy that works for us, and this sometimes means having a few different strategies for different markets. There might be markets we simply can’t identify an edge for.
We only trade when our edge is present; precisely defined criteria must be satisfied. If our trading strategy gives us an edge, it doesn’t make much sense to trade in the absence of that edge.
Try to objectify your trading!
Join our Discord server! We will help you build a mechanical trading system and backtest it! We will send you the code; you can backtest the system on ANY stock at ANY time!
The servers getting a bit large.
Make sure to join before we are forced to close off access for a bit!
Check out our Youtube Channel for trading systems with code access! (You can backtest the systems at any time AND set alerts)
Follow our twitter!
Legal Disclaimer: The information contained in the article is not intended as, and shall not be understood or construed as, financial advice. The author is not an attorney, accountant, or financial advisor, nor are they holding themselves out to be, and the information contained in this article is not a substitute for a professional who is aware of the circumstances and facts of your personal financial situation.
The author does not have a position for the discussed securities and does not plan to open a position for the discussed securities.
Losses can exceed investment. Any stock mentioned throughout the article does not constitute advice or a recommendation. Any losses incurred that are due to error, accident, malfunction, or any loss due to any reason is not the legal responsibility or fault of the author.
The article reflects an expressed opinion from the author.
© Kioseff Trading. All rights reserved. No portion of this article, or any content on the website, may be redistributed or passed as one’s own without express permission from the author.