Knowing what direction your research is

Securities are affected by matters specific to each type and by huge global macroeconomic factors that affect every security in different ways. Some traders prefer to think of the big picture first, whereas others start small. And some use a combination of the two approaches. Neither is better; each is simply a different perspective on what’s happening in the markets.

Examining fundamental research

Day traders do very little fundamental research. Sure, they know that demand for ethanol affects corn prices, but they really want to know what the price will do right now relative to where the price was a few minutes ago. How a proposed farm bill might affect ethanol prices in six years doesn’t figure into day trading.

Knowing a little bit about the fundamentals — those basic facts that affect the supply and demand for a security in all markets — can help the day trader respond better to news events. It can also give you a better feel for when swing trading (holding a position for several days) will generate a better profit than closing out every night. But knowing a lot can drag a day trader down.

Fundamental analysis can actually hurt you in day trading, because you may start making decisions for the wrong reasons. If you know too much about the fundamentals, you may start considering long-term outlooks instead of short-term activity. For example, many people buy Standard & Poor’s (S&P) 500 Index mutual funds for their retirement accounts because they believe that in the long run, the market will go up. That does not mean that people should trade E-mini S&P futures or an S&P exchange-traded fund today, because a lot of zigzagging can happen between now and the arrival of the long-run price appreciation.

Fundamental research falls into two main categories: top-down and bottom-up. As I mention earlier, top-down starts with broad economic considerations and then looks at how those will affect a specific security. Bottom-up looks at specific securities and then determines whether those are good buys or sells right now.

If you love the very idea of fundamental research, then day trading is probably not for you. Day trading requires quick responses to price changes, not a careful understanding of accounting methods and business trends. A little fundamental analysis can be helpful in day trading, but a lot can slow you down.

Looking closer at technical analysis

Information about the price, time, and volume of a security’s trading can be plotted on a chart. The plots form patterns that can be analyzed to show what happened. How did the supply and demand for a security change, and why? And what does that mean for future supply and demand? Technical analysis is based on the premise that securities prices move in trends and that those trends repeat themselves over time. Therefore, a trader who can recognize a trend on the charts can determine where prices are most likely to go until some unforeseen event comes along that creates a new trend.

Technical analysis shows the strength of supply and demand in the market. It offers clues about behavior and psychology, which is valuable information for a day trader. In markets with highly uncertain fundamental values, like cryptocurrency, the charts will give you the best sense of where an asset’s price is moving.

Most traders rely on software to spot patterns because it makes them easier to find and to act upon. Remember that the vast volume of short-term trading takes place by computer algorithm. You can’t beat them, so join them.

The basic element of technical analysis is a bar, which shows you the high, low, open, and closing price of a security for a given day. It looks like the one shown in Figure 8-1.

In most markets, every day generates a new bar (many traders talk about bars instead of days, and they aren’t talking about where they go after work). A collection of bars, with all their different high, low, open, and close points, is put together into a larger chart. Often, a plot of the volume for each bar runs underneath, with the result looking like Figure 8-2.

Many patterns formed in the charts are associated with future price moves. Technical analysts thus spend a lot of time looking at the charts to see whether they can predict what’s going to happen. Many software packages (some of which are discussed in Chapter 12) send traders signals when certain technical patterns occur so that the traders can place orders accordingly.

Technical analysis is a way to measure the supply and demand in the market. It’s a tool for analyzing the markets, not predicting them. If deciphering the meaning of the data were that easy, everyone would be able to make money in the markets.

First things first: Should you follow a trend or deviate from it?

The next sections go into all sorts of detail about how to spot a trend, but the key thing to understand as a day trader is whether you should follow a trend or not. Sometimes a trend is good to follow, but sometimes deviating from it is better.

Remember when you were a kid wanting to do something that all your friends were doing and your mother would invariably say, “If all your friends jumped off of a bridge, would you have to jump off, too?”

Well, Mom, guess what? If the bridge were on fire, the escape routes blocked by angry mobs, and the water just a few feet down, then yes, I just might jump off the bridge like everyone else. Likewise, if someone were paying us good money to jump and I knew I wasn’t likely to get hurt on the way down, I’d be over the railing in a flash. Sometimes being a follower is good. But if my friends were idiots, there were no fire and no angry mob, and I couldn’t swim, I might not be so hasty to leap.

Trend following is like those mythical childhood friends on that mythical hometown bridge. Sometimes, you should join the crowd. Other times, deviating is best. When should you follow and when should you deviate? Well, that depends. You need to know what you’re trading and what the other people trading that asset are considering when they place their orders. That’s why a good understanding of what trends are and how they work can help you.

Finding trends

A technical analyst usually starts off by looking at a chart and drawing lines that show the overall direction of the price bars for the period in question. Rather than plot the graph on paper or print out the screen, she probably uses software to draw the lines. Figure 8-3 shows what this basic analysis looks like.

With the basic trendlines in place, the trader can start thinking about how the trends have played out so far and what may happen next.

Drawing trendlines

As shown in the preceding section, the most basic trendline is a line that shows the general direction of the trend. And that’s a good start, but it doesn’t tell you all you need to know. The next step is to take out your ruler, or set your software, to find the trendlines that connect the highs and the lows. Doing so creates a channel that tells you the support level (the trendline for the lows) and the resistance level (the trendline for the highs), as Figure 8-4 shows. Unless something happens to change the trend, securities tend to move within the channel, so extending the line into the future can give you a sense of where the security is likely to trade.

When a security hits its support level, it is usually seen as relatively cheap, so that’s a good time to buy. When a security hits its resistance level, it is usually seen as relatively expensive, so that’s a good time to sell. Some day traders find that simply moving between buying at the support and selling at the resistance can be a profitable strategy, at least until something happens that changes those two levels.

Calculating indicators

In addition to drawing lines, technical analysts use their calculators — or have their software make calculations — to come up with different indicators, numbers used to gauge performance. The following sections cover some common indicators, with definitions.

PIVOT POINTS

A pivot point is the average of the high, low, and close price for the day. If the next day’s price closes above the pivot point, that sets a new support level, and if the next day’s price is below the pivot point, that sets a new resistance level. Hence, calculating pivot points and how they change may indicate new upper and lower stops for your trading. (Refer to Chapter 2 for more about using stops.)

For markets that are open more or less continuously, such as foreign exchange, the close price is set arbitrarily. The usual custom in the United States is to use the price at 4 p.m. Eastern time, which is the closing time for the New York Stock Exchange.

MOVING AVERAGES

Looking at all those little high-low-open-close lines on a chart will give your bifocals a workout. To make the trend easier to spot, traders calculate a moving average by averaging the closing prices for a given time period. Some traders prefer to look at the last 5 days; some at the last 60 days. Every day, the latest price is added, and the oldest price is dropped to make that day’s calculation. Given the wonders of modern computing technology, pulling up moving averages for almost any time period you want is easy. The average for each day is then plotted against the price chart to show how the trend is changing over time. Figure 8-5 shows an example of a 10-day moving average chart.

Traders use the moving average line to look for crossovers, convergences, and divergences. A crossover occurs whenever the price crosses the moving average line. Usually, buying is a good idea when the price crosses above the moving average line, and selling is a good idea when the price crosses below it.

To use convergence and divergence in analysis, the trader looks at moving averages from different time periods, such as 5 days, 10 days, and 20 days. Figure 8-6 shows what convergence and divergence look like.

When two or three of the moving average lines converge (come together), that means that the trend may be ending. That often makes it a good time to buy if the trend has been down and a good time to sell if the trend has been up. If two or three of the moving average lines split up and diverge, the trend is likely to continue. That means it’s probably a good time to buy if the trend is up and sell if the trend is down.

A moving average is a lagging indicator. It sums up trading activity in the last 5, 10, 30, or 60 days, which means that the line smooths out changes in the trend that may affect future prices, giving you a more accurate picture of the overall trend over the time period.

Those ever-changing trends

Although technical traders look to follow trends, they also look for situations where the trend changes so that they can find new profit opportunities. In general, day traders are going to follow trends, and swing traders — those who hold securities for a few days or even weeks — are going to be more interested in identifying changes that may play out over time.

Finding breakouts

A breakout occurs when a security price passes through and stays above — or below — the resistance or support line, which creates a new trend with new support and resistance levels. A one-time breakout may just be an anomaly (what technicians sometimes call a false breakout), but pay attention to two or more breakouts. Figure 8-7 shows what breakouts look like.

When a true breakout occurs, a new trend starts. That means an upward breakout is accompanied by rising prices, and a downward breakout is accompanied by falling prices.

False breakouts can wreak havoc for a day to two of trading. With a false breakout, some traders buy or sell, thinking that the trend will continue. When they see that it doesn’t, they then turn around and reverse their positions at a loss. During these times, the ability to size up the intelligence of the other traders in the market can come in handy.

Good technical analysts look at several different indicators to determine whether a change in trend is real or just one of those things that goes away quickly as the old trend resumes. For example, they may look at short interest or overall market volatility. You can learn more about these indicators in Chapter 8.

Wave your pennants and flags

Pennants and flags are chart patterns that show retracements, short-term deviations from the main trend. With a retracement, no breakout occurs from the support or resistance level, but the security isn’t following the trend, either. Because there is no breakout, the trend is more short-term.

Figure 8-8 shows a pennant. Notice how the support and resistance lines of the pennant (which occur within the support and resistance lines of a much larger trend) converge almost to a point.

Figure 8-9, by contrast, is a flag. The main difference between a flag and a pennant is that the flag’s support and resistance lines are parallel.

Pennants and flags are usually found in the middle of the main phase of a trend, and they seem to last for two weeks before going back to the trendline. They are almost always accompanied by falling volume. In fact, if the trading volume isn’t falling, you are probably looking at a reversal — a change in trend — rather than a retracement.

Not just for the shower: Head and shoulders

The head and shoulders formation is a series of three peaks within a price chart. The peaks on the left and right (the shoulders) should be relatively smaller than the peak in the center (the head). The shoulders connect at a price known as the neckline, and when the right shoulder formation is reached, the price plunges down.

The head and shoulders is one of the most bearish technical patterns, and Figure 8-10 shows an example.

The head and shoulders formation seems to result from traders holding out for a last high after a security has had a long price run. At some point, though, the trend changes, because nothing grows forever. And when the trend changes, the prices fall.

An upside-down head and shoulders sometimes appears at the end of a downtrend, and it signals that the security is about to increase in price.

Drink from a cup and handle

When a security hits a peak in price and falls, sometimes because of bad news, it can stay low for a while. But eventually, the bad news works itself out, the underlying fundamentals improve, and the time comes to buy again. The technical analyst sees this scenario play out in a cup and handle formation, and Figure 8-11 shows you what one looks like.

The handle forms as those who bought at the old high and who felt burned by the decline take their money and get out. But other traders, those who haven’t the same history with the security, recognize that the price will probably resume going up now that those old sellers are out of the market.

A cup and handle formation generally shows up over a long period of trading — sometimes as long as a year — and many subtrends occur during that time. As a day trader, you’ll probably care more about those day-to-day changes than the underlying trend taking place. Still, if you see that cup formation and the hint of a handle, you can interpret that as a sign that the security will probably start to rise in price.

Mind the gap

Gaps are breaks in prices that show up all the time, usually when some news event takes place between trading sessions that causes an adjustment in prices and volume. Whether the news is about an acquisition, a product line disappointment, or a war that broke out overnight, it’s significant enough to change the trend, and that’s why traders pay attention when they see gaps.

A gap is a break between two bars, as shown in Figure 8-12.

Gaps are usually great signals. A security that gaps up at the open usually means a strong uptrend is beginning, so it’s time to buy. Likewise, if the security gaps down, that’s often the start of a downtrend, so it’s better to sell.

Day traders can get sucked into a gap, a situation known as a gap and crap (or gap and trap, if you prefer more genteel language). Many traders view the security going up in price as a great time to sell, so the day trader who buys on the gap up immediately gets slammed by all the selling pressure. For that reason, some day traders prefer to wait at least 30 minutes before trading on an opening gap, while others rely on their knowledge of the buyers and sellers in a given market to decide what to do.

Grab your pitchforks!

A pitchfork is sometimes called an Andrews pitchfork after Alan Andrews, the technical analyst who popularized it. This pattern identifies long-run support and resistance levels for subtrends by creating a channel around the main trendline. Figure 8-13 shows what a pitchfork looks like.

The upper line shows the resistance level for upward subtrends, and the lower line shows the support level for lower subtrends. The middle line forms a support and a resistance line, depending on which side of it trading takes place. If the price crosses above the midline, it can be expected to go no higher than the highest line. Likewise, if the price crosses below the midline, it can be expected to go no lower than the lowest line.

Dow Theory

Charles Dow, the founder of The Wall Street Journal, developed the Dow Theory. The theory and the market indexes that are part of it helped sell newspapers; they also helped people make money in the markets. The Dow Theory is the basis for the traditional technical analysis described in this chapter.

Dow believed that securities move in trends, that the trends form patterns that traders can identify, and that those trends remain in place until some major event takes place that changes them. Further, trends in the Dow Jones Industrial Average and the Dow Jones Transportation Average can predict overall market performance.

Not all technicians believe that the Dow Jones Industrial Average and Dow Jones Transportation Average are primary indicators in the modern economy, but they rely on the Dow Theory for their analysis, and they still read the Journal.

Fibonacci numbers and the Elliott Wave

Remember back when you had to take standardized tests, you’d often have to figure the next number in a series? Well, here’s such a test. What’s the next number in this series? (Hint: This is not a phone number in Chad.)

0, 1, 1, 2, 3, 5, 8, 13, 21

If you answered 34, you’re right! The series is known as the Fibonacci numbers, sometimes called the Fibonacci series or just the Fibs. You find this number by adding together the preceding two numbers in the series, starting with the first two digits on the number line. 0 + 1 = 1; 1 + 1 = 2; 1 + 2 = 3; and so on into infinity. Furthermore, when the series gets well into the double digits, the ratio of one number to the one next to it settles at 0.618, a number known as the golden ratio, which means that the ratio of the smaller and the larger of two numbers is the same as the ratio of the larger number to the sum of the two numbers. In nature, this is the proportion of a perfect spiral, like that found on a pinecone and a pineapple.

Ralph Elliott was a trader who believed that over the long run the market moved in waves described by the Fibonacci series. For example, Elliott believed that three down waves and five up waves would characterize a bull market. He also believed that support and resistance levels would be found 61.8 percent above lows and below highs. Under the Elliott Wave system, if a security falls 61.8 percent from a high, it’s a good time to buy.

Elliott believed that these waves ranged from centuries to minutes, so both traders and investors use the system to identify the market trends that suit their timeframes. Others — including me — think it’s highly unlikely that the human activity in the stock market would follow the same natural order as the ratio of the spiral on a mollusk shell.

Japanese candlestick charting

Traders in the Japanese rick futures market developed candlestick charts in the 18th century, and the charts have carried through into the present. The basic charts are similar to the high-low-close-open bars that I talk about earlier in this chapter, but they are shaped a little differently to carry more information. Figure 8-14 shows an example of a candlestick.

The length of the rectangle (the so-called candle, also known as the body) between the open and the close prices gives a sense of how much volatility the security has, especially relative to the high and low prices above and below the rectangle (the so-called wick, also known as the shadow). The shapes and colors create different patterns that traders can use to discern the direction of future prices. (Most technical-analysis packages color the candlesticks green on up days and red on down days, to make finding trends even easier.)

The Gann system

William Gann supposedly made $50 million in the stock and commodities markets in the first half of the 20th century by using a system that he may or may not have taught to others before his death. A lot of mystery and mythology surrounds the Gann system; some traders rely on what they perceive to be his method, whereas others dismiss it, in part because Gann relied on astrology to build his forecasts.

The Gann system, as it is defined nowadays, looks at the relationship between price and time. If a security moves one point in one day, that’s a 1 × 1 Gann angle, and that’s normal trading. If a security moves two points in one day, it is said to create a 2 × 1 Gann angle, which is bullish. An angle of less than 1 × 1 is bearish.

Furthermore, Gann recognized that the market moves back and forth while in a general upward or downward cycle, but some of those fluctuations are more positive than others. Just as the system looks for price movements over time with even proportions (1 × 1, 2 × 1, and so on), it also looks for orderly retracements. When a security moves back 50 percent, say from a low of $20 to a high of $40 and then back to $30, it would be a good time to buy under the Gann system.

Many traders swear by the 50 percent retracement guide — even those who think that Gann is an otherwise crazy system. This may be the origin of one hoary trading chestnut: Buy whenever a price dips, because it’s likely to be heading on its way back up.

If it’s obvious, there’s no opportunity

Many day trading systems work much of the time. For example, a security gaps up, meaning that, due to positive news or high demand, the price jumps from one trade to the next (refer to Figure 8-12 for a gap formation). This is good, and the security is likely to keep going up. So you buy the security, you make money. Bingo! But here’s the thing: Everyone is looking at that gap, everyone is assuming that the stock will go up, so everyone buys, and that bids up the security. The profit opportunity is gone. So maybe you’re better off going short? Or avoiding the situation entirely? Who knows? And that’s the problem. Looking for obvious patterns like gaps tells you a lot about what is happening in the market, but only your own judgment and experience can tell you what the next move should be.

Overanalyzing the data

Technical analysis is a useful way to gauge market psychology. That’s what it was designed to do. However, when it was developed, most traders were human beings, with all their crazy human emotions. Nowadays, you aren’t trading against a person. In almost all cases, you will be trading against machines that do what they are programmed to do. They don’t suffer from doubt, fear, or greed — but you do. The market is an aggregation of everyone in it, but you don’t want to assign human emotions to nonhumans.

When trying to determine the mood of the market, you can easily start overanalyzing and working yourself into a knot. Should you follow the trend or trade against it? But if everyone trades against it, would you be better off following it?

Instead of puzzling over what’s really going on, develop a system that you trust. Do that through Backtesting, simulation, and performance analysis. Chapter 16 has plenty of advice on how to use these techniques. The more confident you feel in how you should react given a market situation, the better your trading will be.

Success may be the result of an upward bias

Under the efficient markets theory, all information is already included in a security’s price. Until new information comes into the market, the prices move in a random pattern, so any security is as likely to do as well as any other. In some markets, like the stock market, this random path has an upward bias, meaning that as long as the economy is growing, companies should perform well, too; therefore, the movement is more likely to be upward than downward, but the magnitude of the movement is random.

If price movements are random, some people are going to win and some are going to lose, no matter what systems they use to pick securities. If price movements are random with an upward bias, then more people are going to win than lose, no matter what systems they use to pick securities. Some of those who win are going to tout their systems, even though random chance was really what led to their success.

Technical analysis is a useful way to measure the relative supply and demand in the market, and that in turn is a way to gauge the psychology of those who are trading. But it’s not perfect. Before you plunk down a lot of money to learn a complex trading system or to subscribe to a newsletter offering a can’t-miss method of trading, ask yourself if the person selling it is smart or just lucky. A good system gives you discipline and a way to think about the market relative to your trading style. A bad system costs a lot of money and may have worked for a brief moment in the past, with no relevance to current conditions.