Chapter 8
IN THIS CHAPTER
Researching markets and trades
Using technical analysis to forecast prices
Gleaning information from the charts
Reviewing schools of thought in technical analysis
Avoiding the traps that technical analysts can fall into
In some ways, day trading is easy. Open up an account with a brokerage firm and off you go, buying and selling securities! But how are you going to know when to buy and when to sell? That’s not a simple matter. Most day traders fail because it’s easy to place the order but hard to know whether the order is the right one.
Traders use different research systems to evaluate the market and have access to tools that can help them figure out when a security is likely to go up in price and when it is likely to go down. Two primary types of investment research systems exist: technical analysis and fundamental analysis. Technical analysis, which is widely used by day traders, looks at the supply and demand for a security and how it shows up in price data. Fundamental analysis, which is less commonly used by day traders, looks at the financial and operational factors that affect a security’s value. This chapter tells you what you need to know about each.
Day traders need to make decisions fast, and they need to have a framework for doing so. That’s why they rely on research. But what kind? Most day traders rely heavily on technical research, which is an analysis of charts formed by price patterns to measure the relative supply and demand for the security. But some people use fundamental analysis to help inform their decisions, too. Even though you’ll mostly use technical analysis in day trading, taking the time to find out a bit about fundamental analysis can help you understand what longer-term traders and investors are doing in the market.
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.
With a top-down approach, the trader looks at the big economic factors: interest rates, exchange rates, government policies, and the like. How will these things affect a particular sector or security? Is this a good time to buy stocks or short interest-rate futures? The top-down approach can help evaluate the prices in big market sectors, and it can also help determine what factors are affecting trading in a subsector. You don’t have to trade stock market index futures to know that the outlook for the overall stock market will have an effect on the trading of any specific company’s stock.
Bottom-up analysis looks at the specific performance of the asset. It looks at the company’s prospects and then works backward to figure out how it will get there. What has to happen for a company’s stock price to go up 20 percent? What earnings does it have to report, what types of buyers have to materialize, and what else has to happen in the economy?
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 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.
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.
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.
Market observers debate market efficiency all the time. In an efficient market, all information about a security is already included in the security’s price, so there’s no point to doing any research at all. Few market participants are willing to go that far, but they concede the point that the price is the single most important summary of information about a company. That means that technical analysis, looking at how the price changes over time, is a way of learning about whether a security’s prospects are improving or getting worse.
The basic bar shows how price changed during the day, but adding volume information tells the other part of the story: how much of a security was demanded at that price. If demand is going up, then more people want the security, so they are willing to pay more for it. The price tells traders what the market knows; the volume tells them how many people in the market know it.
Technical analysis helps day traders identify changes in the supply and demand for a security that may lead to profitable price changes ahead. It gives traders a way to talk about and think about the market so that they can be more effective.
Most brokerage firm quote systems generate charts, sometimes with the help of additional software that automatically marks the chart with trendlines. Technical traders look for those trendlines. Before placing an order to buy or sell, a trader needs to know whether the security’s price is going up and whether that trend is going to continue.
One interesting aspect of technical analysis is that the basics hold no matter what market you’re looking at. Technical analysis can help you monitor trends in the stock market, the bond market, the commodity market, and the currency market. Anywhere people try to match their supply and their demand to make a market, technical analysis can be used to show how well they’re doing 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.
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.
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.
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.
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.)
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.
Price trends tend to move in cycles that can be seen on the charts or observed in market behavior. Knowing the phases of a trend can help you better evaluate what’s happening. Here is a summary of some phases of a trend:
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.
Following the trend is great, but if the trend is moving quickly, you want to know so that you can get ahead of it. If the rate of change on the trend is going up, then rising prices are likely to occur.
To calculate momentum, take today’s closing price for a security, divide that by the closing price ten days ago, and then multiply the result by 100. This gives you a momentum indicator. If the price didn’t go anywhere, the momentum indicator is 100. If the price went up, the indicator is greater than 100. And if the price went down, the indicator is less than 100.
In technical analysis, trends are usually expected to continue, so a security with a momentum indicator above 100 is expected to keep going up, all else being equal. But that “all else being equal” is the sticky part. Technical analysts usually track momentum indicators over time to see whether the positive momentum is, itself, a trend. In fact, momentum indicators are a good confirmation of the underlying trend.
Momentum trading is usually done with some attention to the fundamentals. When key business fundamentals, such as sales or profits, are accelerating at the same time that the security is going up in price, the momentum is likely to continue for some time. You can find out more about momentum trading and investing in Chapter 11.
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.
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.
How long does it take to find the trend? How long does it take for the trend to play out? When do you act on it? Do you have minutes, hours, or days to act?
Because markets tend to move in cycles, technical analysts look for patterns in the price charts that give them an indication of how long any particular trend may last. In this section, I show you some of the common patterns that day traders look for when they do technical analysis. Alas, some patterns are obvious only in hindsight, but knowing what the patterns mean can help you make better forecasts of where a security price should go.
This section provides just an introduction to some of the better-known (and cleverly named) patterns. Technical analysts look for many others, and you really need a book on the subject to understand them all. Check out the appendix for books that provide more information on technical analysis so that you can get a feel for how you can apply it to your trading style.
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.
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.
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.
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.
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.
Technical analysts tend to group themselves under different schools of thought. Each approaches the charts differently and uses them to glean different information about how securities prices are likely to perform. In this section, I offer an introduction to a few of these approaches. If one strikes your fancy, you can look in the appendix for resources to help you learn more.
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.
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.
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.)
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.
A lot of people make a lot of money selling services to day traders. They produce videos, organize seminars, and (ahem) write books to tell you how to be a success. But in the financial world, success is a combination of luck, skill, and smarts.
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.
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.
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.