Getting Started in Technical Analysis

1. Technical Analysis: A Practical Approach

Trading success cannot be capsulized in a simple indicator, formula, or system-the pronouncements of countless books, advertisements, and brochures notwithstanding.

Beyond Simple Formulas. Technical analysis is more than just applying indicators or systems; it's a trader's perspective, focusing on real-world application and understanding what works and doesn't. It's about designing and testing systems to maximize future performance, not just past results. This book supplies the tools, but the architectural design is up to the individual reader.

Fundamental vs. Technical. The debate between fundamental and technical analysis is ongoing, with successful traders on both sides. Some use fundamentals to determine market direction and technicals to time entries and exits. Ultimately, the best approach fits the individual's personality.

Combining Approaches. While traditionally treated as opposites, technical and fundamental analysis are related. Technicians believe price data incorporates fundamental factors, and analyzing price is the best way to understand their impact. Fundamental analysis focuses on the "why" of market behavior, while technical analysis focuses on the "when."

2. Charts: A Trader's Compass, Not a Crystal Ball

Chart analysis provides a means of acquiring common sense in trading-a goal far more elusive than it sounds.

Charts as a Tool. Charts are not foolproof predictors but valuable tools for traders. They provide a concise price history, a sense of market volatility, and can be used for timing trades and managing money. Even skeptics can benefit from charts by using them to define stop points.

Types of Charts. Bar charts are the most common, showing the daily high, low, and closing prices. Close-only charts focus solely on closing values, while point-and-figure charts ignore time and focus on price movements. Candlestick charts add color and dimension to bar charts, highlighting reversal and continuation patterns.

Data Considerations. Stock traders should be aware of how stock splits affect price data, while futures traders need to understand linked contract series and the distortions that can arise from using nearest futures charts. Continuous futures charts offer an alternative that eliminates price gaps.

3. Trends: Identifying and Riding the Market's Waves

The trend is your friend except at the end when it bends.

Defining Trends. An uptrend is a succession of higher highs and higher lows, while a downtrend is a succession of lower lows and lower highs. Trends can also be defined using trend lines, which connect a series of higher lows in an uptrend or lower highs in a downtrend. Trend channels are parallel lines that enclose a trend.

Trend Line Rules. Declines approaching an uptrend line and rallies approaching a downtrend line are often good opportunities to initiate positions in the direction of the major trend. The penetration of a trend line can be a buy or sell signal, but trend lines often need to be redrawn as a bull or bear market extends.

Moving Averages. Moving averages smooth a price series and make trends more discernible. A simple moving average is the average close of the past N days. In trending markets, moving averages can effectively identify trends, but they can generate false signals in choppy, sideways markets.

4. Trading Ranges and Support/Resistance: Finding Order in Chaos

In a narrow market, when prices are not getting anywhere to speak of but move in a narrow range, there is no sense in trying to anticipate what the next big movement is going to be-up or down.

Trading Ranges. Trading ranges are horizontal corridors that contain price fluctuations for an extended period. They are difficult to trade profitably, and most chart patterns are relatively meaningless within a trading range. Breakouts from trading ranges can provide important trading signals.

Support and Resistance. Once a trading range is established, the upper and lower boundaries tend to define resistance and support areas. After prices break out from a trading range, the upper boundary becomes a zone of price support, and the lower boundary becomes a zone of price resistance.

Prior Highs and Lows. Resistance will often be encountered near previous major highs, and support will often be found near major lows. The penetration of a previous high can be viewed as a buy signal, and the penetration of a prior low can be viewed as a sell signal.

5. Chart Patterns: Recognizing Recurring Market Behavior

Never confuse brilliance with a bull market.

One-Day Patterns. Gaps, spikes, reversal days, thrust days, and wide-ranging days can provide clues about market behavior. Breakaway, runaway, and exhaustion gaps signal different phases of a trend. Spike highs and lows can indicate temporary climaxes in buying or selling pressure.

Continuation Patterns. Triangles, flags, and pennants are congestion phases within trends that suggest an impending price move in the same direction that preceded their formation. Breakouts from these patterns can be viewed as confirmation that the trend is continuing.

Top and Bottom Formations. V tops and bottoms, double tops and bottoms, head and shoulders, rounded tops and bottoms, triangles, wedges, and island reversals are patterns that can signal major trend transitions. Recognizing these patterns can help traders anticipate and profit from trend reversals.

6. Oscillators: Gauging Momentum and Identifying Extremes

I know millions of things that won't work. I've certainly learned a lot.

Momentum Indicators. Oscillators, such as the Relative Strength Index (RSI) and stochastics, are mathematical formulas based on momentum, the rate at which prices change. They help identify overbought and oversold levels, signaling potential price reversals.

Basic Oscillators. Momentum is calculated as the difference between today's price and the price N days ago, while rate of change (ROC) is today's price divided by the price N days ago. Moving averages can also be used to construct momentum oscillators.

Overbought and Oversold. Extreme oscillator readings above a certain level represent overbought conditions, while extreme readings below a certain level represent oversold conditions. Divergence, where momentum moves in the opposite direction of price, can also signal potential trend reversals.

7. The Most Important Rule: Capitalizing on Failed Signals

The market is like a flu virus-as soon as you think you have it pegged, it mutates into something else.

Failed Signals. A failed signal is one of the most reliable chart signals. When a market fails to follow through in the direction of a chart signal, it strongly suggests a significant move in the opposite direction. Recognizing and acting on these situations can greatly enhance the effectiveness of chart analysis.

Bull and Bear Traps. Bull and bear traps are major breakouts that are soon followed by abrupt, sharp price reversals. False trend line breakouts, filled gaps, return to spike extremes, return to wide-ranging day extremes, and counter-to-anticipated breakouts of flags or pennants are all examples of failed signals.

Capitalizing on Failure. The novice trader ignores failed signals, while the skilled trader reverses their position, capitalizing on the market's unexpected behavior. This flexibility is essential for effective chart analysis and trading.

8. Midtrend Entry and Pyramiding: Adding to Winning Positions

Nobody can catch all the fluctuations.

Entering Midtrend. Traders may find themselves considering whether to enter a new position after the market has already witnessed a substantial price move. Pauses or corrections in a trend offer opportunities to enter a market in preparation for a possible resumption of the trend.

Entry Strategies. Strategies for midtrend entry include percent retracement, reversal of minor reaction, continuation pattern and trading range breakouts, and reaction to long-term moving average. The goals are favorable timing of entry and risk control.

Pyramiding. Pyramiding, the process of adding new positions to an existing open trade, is identical to the problem of midtrend entry. Guidelines for pyramiding include adding to positions only if the last unit shows a profit, not adding if the stop point implies a net loss, and keeping pyramid units no greater than the base position size.

9. Choosing Stop-Loss Points: Protecting Your Capital

It was the same with all. They would not take a small loss at first but had held on, in the hope of a recovery that would "let them out even."

Importance of Stops. The success of chart-oriented trading depends on effective loss control. A precise stop-loss liquidation point should be determined before initiating a trade. The position should be liquidated at or before the point at which price movement causes a transition in the technical picture.

Technical Reference Points. Technical reference points for placing stops include trend lines, trading ranges, flags and pennants, wide-ranging days, and relative highs and lows. If the implied risk is too great, a money stop, determined by the desired dollar risk level, can be used.

Trailing Stops. Stops should be used to protect profits as well as limit losses. Trailing stops are raised in long positions as the market rises and lowered in short positions as the market declines. Stops should only be changed to reduce risk.

10. Setting Objectives and Other Position Exit Criteria: When to Take Profits

It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

Chart-Based Objectives. Many chart patterns provide clues regarding the magnitude of the potential price move. Double tops and bottoms, head and shoulders, and triangles can all be used to project price objectives.

Measured Move. The measured move concept suggests that markets will move in approximately equal-size price swings. Prior price swings can be used to project potential price objectives.

Support and Resistance. Prices near support levels provide a reasonable choice for setting initial objectives on short positions, while prices near resistance levels can be used for setting initial objectives on long positions.

Overbought/Oversold Indicators. Overbought/oversold indicators can be used to signal when prices have risen or fallen too sharply and are vulnerable to a reaction. Trailing stops and changes in market opinion can also be used to determine trade exit points.

11. The Planned Trading Approach: A Roadmap to Success

If making money is a slow process, losing it is quickly done.

Define a Trading Philosophy. Base trading decisions on fundamental analysis, chart analysis, technical trading systems, or a combination of these approaches. The more specific the trading strategy, the better.

Choose Markets to Be Traded. Select markets based on suitability to trading approach, diversification, and volatility. Diversification reduces risk, while volatility should be considered in relation to available funds.

Specify Risk Control Plan. A risk control plan should include maximum risk per trade, a stop-loss strategy, diversification, reduced leverage for correlated markets, market volatility adjustments, adjusting leverage to equity changes, and losing period adjustments.

Establish a Planning Time Routine. Set aside time each evening to review markets, update trading strategies, plan new trades, and update exit points for existing positions.

Maintain a Trader's Notebook. Keep a record of each trade, including entry and exit points, risk, objectives, and comments.

Maintain a Trader's Diary. Record the reasons for each trade, how the trade turned out, and lessons learned.

Analyze Personal Trading. Analyze segmented trades and equity charts to identify strengths and weaknesses and improve trading performance.

Last updated: February 21, 2025