T/A + cautionary advice by Equity Analytics, Ltd.
Edited for emphasis:
Main link:
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" Invest Your Time Before You Invest Your Money
Test Your Strategy Before You Risk Your Money"
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>>> Tutorials On Technical Indicators:
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Directory Of Financial Glossaries:
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Bibliography: Stocks, Options, Futures, Commodities, Bonds
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Ten Points For Beginning Technical Traders :
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This is part of a larger Technical Analysis site provided by Equity Analytics, Ltd.
---Technical indicators can be quite confusing to the trader who is not used to using them. The first thing I always recommend to anyone is to read as much as you can. Below are some books that I recommend to people.
---Second, you have to be comfortable with the indicators you choose to use. Start out with the basic indicators like moving averages, RSI, and stochastics. When you get comfortable with those, move on and try to learn how some other indicators work.
By the way, I find that the basic indicators which have been around for years seem to work the best. These are moving averages and RSI. There are literally hundreds of indicators around. Most of them aren't worth 2 cents. Technicians spend hours writing new formulas for indicators which may or may not give good results. We are always looking for an indicator which will provide us with better predictive results. And there are quite a few people out there making a lot of money selling these indicators and systems.
---Third, paper trade with the indicators you're using first with daily data. Make sure that you try to simulate real trading as closely as possible. To do this, evaluate your selections in the evening using end of day data. Pick the securities you want to trade and pick the prices you want to either go long or short. Pick the exact prices at which you will enter the trade. Set stop loss levels at that time and stick with them. If the trade moves in your direction and becomes profitable, move your stops up (trailing stops) and stick with them. Hold the stocks until you do get stopped out. Keep accurate records. Records are crucial. This process may take a couple of months. But it will be well worth the effort. Done right, you will get a good feel for the indicators and systems you're using; and you will see how well your indicators and systems are working.
---Fourth, don't even think about day trading until you can trade end of day profitably. Day trading is the hardest type of trading there is. It's incredibly difficult and nerve racking. And if you're making money trading end of day, why bother day trading. Profitable traders are far outnumbered by losing traders.
---Fifth, experiment with different indicators and their inputs. You may come up with something that works for you. And that's the key to any indicator. The indicator can be the best in the world, but if it doesn't work for you, it's no good. Find one or two that work for you and stick with them.
---Sixth, if you're working with systems, don't over-optimize the system. No system is going to work 100% of the time. If you can get a system to work in real time somewhere between 60% to 70% of the time, and you cut your losses early, you will make money. I have a friend who has a system which produces winners just 40% of the time. Out of ten trades, he has six losers. But he is able to cut his losses early. At the end of each year he's turned a nice little profit. I can turn any system into what looks like a winner by backtesting it and fitting it to the markets it's analyzing. However, it will never work in real time. After you optimize a system, test it on paper first and see if it is working in real time. Then trade it.
---Seventh, if you don't feel like trading, don't trade. The worst thing a trader can do is trade when he doesn't feel like it. The next worst thing a trader can do is make a trade which he isn't sure is going to be a winner. A trader has to be confident that every trade he makes is going to be a winner. They're not all going to be winners. But you have to have confidence in your judgment.
---Eighth, read all you can. There is an extensive bibliography in this web site. Take advantage of it. Start with some of the easier books and then move on to the journals which deal with some advanced theory on investing. Reading is one of the more important things a trader can do. The more you read and absorb, the better able you are to evaluate different strategies and tactics. Further, the more you read, the better able you will be to evaluate the more basic strategies. Keep pressing to learn more and more. The more you learn the more you will realize there is to learn. There's much more to trading than picking a couple of indicators and trading.
---Ninth, you should have a working knowledge of fundamental analysis. Despite the fact that you might be a technician by choice, a trader should have a good feel for the financial dynamics of an organization and be able to read balance sheets, income statements, statements of changes in financial position, and so forth. And he should be able to understand the formulas which indicate the financial shape of a corporation (i.e. quick ratio, accounts receivable turnover, price/earnings, etc.).
---Tenth, beginning traders have a tendency to listen to an analyst on television with charts and graphs, and fancy indicators on them, give his opinion on a security or an index, and then trade based on their analysis. I never trade based on someone else's analysis. They may be of a different opinion than you. Who's right. Only time will tell. However, if your analysis of the same security or index is sound, your opinion is just as valid as their opinion.
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About Technical Analysis:
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The stock market or any market never reflects what its true value is. It reflects investors perception of the value or what people think it is worth.
Technical analysis is part of what we provide our customers. A technical analyst doesn't look at income statements, balance sheets, company policies, or anything fundamental about the company. The technician looks at the actual history of trading and price in a security or index. This is usually done in the form of a chart. The security can be a stock, future, index, or a sector. It is flexible enough to work on anything that is traded in the financial markets.
The technical analyst believes that the market price reflects all known information about the individual security. It includes all public and insider information. The market price reflects all the different investor opinions regarding that security.
So what's the big deal? Just as fundamental analysis looks at the past, technical analysis also incorporates the past into its analysis. True. However, the technical analyst believes that securities move in trends. And these trends continue until something happens to change the trend. With trends, patterns and levels are detectable. Sometimes the analysis is wrong. However, in the overwhelming majority of instances, it's extremely accurate. Many times I've successfully traded securities with only the knowledge of its chart behind me. I didn't know what the company did. But the underlying technicals indicated a direction to me. The technicals were right.
The tools of the technical analyst are indicators and systems which are used on price charts. Moving averages, support and resistance lines, envelopes, Bollinger bands, momentum... are all examples of indicators. These indicators all tell a story.
Many people believe that buy and hold is the right strategy for owning securities. I don't agree with that. ABC might be a company you want to own for the long term. That's great. However, there's nothing wrong with buying at 50; selling at 67; and buying it back at 55. There's also nothing wrong with buying at 50; selling at 67; shorting the stock at about 67; then closing your short at 55 and buying back the security. In the latter, you've made your money work a little more efficiently. In the case of the former, you've made money when the stock was going up, coming down, and then going back up again. Either way, your money has worked harder for you. Technical analysis can aid in predicting turning points and direction in securities prices.
Sentiment Indicators
Sentiment indicators measure the expectations of participants in the market. These participants can be broken down to include odd lotters, corporate insiders, NYSE members, advisory services, mutual funds, institutional traders, and floor traders.
These sentiment indicators are actually measuring the emotions of these investors. As is the case with most things in life, emotions change. They swing back and forth. And these sentiment indicators swing back and forth between extremely bearish to extremely bullish.
Some sentiment indicators are contrary indicators and some are correspond with their indication. The majority is usually most optimistic at a market top and the most pessimistic at a market bottom. The more optimistic or pessimistic the majority is, generally, the more significant the top or bottom is.
Market participants who are better informed (the minority of investors) seem to buy and sell in a contrary manner to the majority. When the minority seems to think things are the worst they've ever been and will probably get worse, a small minority is buying. Conversely, when things are great and will only get better is when this small minority is selling. At significant turning points, insiders are usually following a different course than the general investing public.
One very important thing to keep in mind with sentiment indicators is their results have been distorted over the past several years. This is due to the widespread use of options and futures on both individual securities and indexes. For example, short interest is not a reliable indicator anymore. In fact, it's probably irrelevant now. Stocks are shorted in conjunction with other strategies. Therefore, it is not a reliable signal.
Flow Of Funds Indicators
Flow of Funds indicators attempt to measure the ability or the financial position of different investor groups. It tries to measure their capacity to buy or sell stocks. It also attempts to measure where the money is going. If the money is going out of mutual funds, where is it going.
The flow of funds analysis looks for trends in bank trust accounts, customer's accounts, foreign investors, initial public offerings and secondary offerings, insurance companies, margin debt, mutual funds, and pension funds.
Flow of funds analysis has a couple of drawbacks. First, the data is lagged. It does not arrive at the technical analysts desk in a timely fashion. Second, the data is not always sufficiently detailed to be of much use in technical analysis. Third, it doesn't give the user a good idea as to where the money is going. It is much better at describing where the money is leaving. Some technicians believe that looking at liquidity in the banking system is a superior approach. As this measures pressure on the banking system and the entire economy.
Market Indicators
Technical analysis is mainly concerned with market indicators. These technical indicators look at the trend of price indexes and individual securities. They evaluate the position of the security or index.
In technical analysis we look for divergence between indicators and continuity between indicators, all in an effort to determine the validity of a trend. It is important to understand that technical analysis measure the mass of investors or mass psychology. These indicators do not measure what a select few are doing.
The theory underlying these indicators is that once a trend is in motion it will continue in that direction. Technical analysis attempts to determine the strength of the trend and the direction of the trend. The technical analyst will attempt to identify the trend or the change in trend early. The technical analyst will also use his analysis to stay away from a market or a security unless there is a good amount of protection in place.
On a regular basis I'm asked to give an opinion on a particular security and my answer is, "I have no idea what it's going to do." On the other hand, a very dear friend of mine called me up one day and told me that his firm had just taken a position in one particular stock. He asked me what I thought. I told him that I would have waited until it bottomed at 51. He had bought it at an average price of 57-3/8. This was definitely not what another pro wanted to hear. About three weeks later it bottomed at 49-1/2 and traded between 49-1/2 and about 52 for another couple of weeks before it headed back up to where my friend bought it. He's dealing in tens of thousands of shares at a time. The difference between where he bought it at and where I would have recommended buying it is a significant amount of money.
Without sounding trite, he could have been right and I could have been wrong. In which case he may not have gotten into the trade. I obviously saw something his analysts didn't see or they may have seen it and discounted its importance. Nevertheless, this example underscores the importance of looking at technical indicators from many different perspectives.
When I read in a book or a magazine article or someone tells me that the preferred time period to look at a certain indicator is X, I become very skeptical. If they look at it in period X, I'm sure that I can find many more technical analysts who look at it in time period Y, or Z, or A, etc. The good technical analyst will look at different indicators in different time periods. However, we all become comfortable with certain time periods for certain indicators or securities. We've already experimented with other time periods and found the time period we feel the most comfortable with. What that particular analyst is really saying is that he feels the most comfortable with time period X. You may not.
Price, time, volume, and breadth are inputs into these indicators. Price reflects the level of change in investors attitudes. Time measures the cycle or period of change. For example, the longer it takes to move the market from a bearish to a bullish position, the stronger this reverse in direction will be. Volume measures the intensity of the change in investors attitudes. A security which moves up on very low volume is not as stable as a security which moves up on high volume. And remember that volume is relative. Volume should always be measured against the volume that individual security or index typically demonstrates. Breadth measures how many different securities in the same market are moving in the same direction. The more significant a trend is, the greater the number of securities involved in the move will be. For example, a trend which is limited to blue chip stocks or tech stocks, is not as significant as if a wide array of sectors and stocks are involved.
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Trading Systems and Technical Analysis Indicators:
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Many new traders have a tendency to confuse trading systems and technical analysis indicators. From my observations, the majority of the confusion comes in the form of confusing the use of technical analysis indicators with systems. Nevertheless, I'll discuss both here.
Technical Analysis Indicators
An technical analysis indicator is used to determine the trend of a market, the strength of the market and the direction of the market. A technical analysis indicator may be specific or non-specific. Some technical analysis indicators can be quantified in the form of an equation or algorithm. Others show up as patterns (e.g. head and shoulders, trendlines, support and resistance).
At some point, the technical analyst will receive a signal. This signal is the result of one technical analysis indicator or more than one technical analysis indicators in combination. The signal indicates to the technical analyst a course of action (e.g. buy, sell, hold). The technical analyst will determine the method to use. However, it must be specific, objective, and reliable. The method is a subjective and not mechanical. This is a significant difference between a trading system and a technical analysis indicator.
Anyone with an imagination can create a technical analysis indicator. Everyday at least one new technical analysis indicator is created. Over the years thousands have come and gone. Most of them don't tell us anything about a market one of the times tested technical analysis indicators tell us. They're useless. Many others are of no use whatsoever.
Timing indicators tend to work in some types of markets (e.g. trending or sideways) and not others. They may also work with some securities and not others. Therefore, they tend to be unreliable. Timing indicators are also subjective and require interpretation. Based on my experience, most amateur traders tend to use timing indicators and base their decisions to buy, sell, or hold on them. Many traders, after using an indicator or indicators with success turn them into a trading system. This does not mean that the trader has found the holy grail of trading systems. Instead, what many traders find is that when the indicators are combined into a trading system, they lose their effectiveness.
Technical Analysis Trading Systems
A trading system is created by generating signals, setting up a decision making procedure, and incorporating risk management into the system. A trading system is supposed to be objective and mechanical. The analyst combines a set of objective trading rules (usually in a formula(s) or algorithm(s)).
As a general rule, good technical analysis indicators are the building blocks of good trading systems. However, as previously mentioned, even good technical analysis indicators can lose their validity when combined in a trading system. Therefore, it is important to not only back-test your system but to also forward-test your system in real time.
Pitfalls of Trading Systems and Technical Analysis Indicators
Trading systems are supposed to be objective and mechanical. They take the intuition out of trading. Buy when the system tells you to and sell when the system tells you to. The problem is that there are not a lot of good trading systems out there. At my company, Equity Analytics Ltd., we have created some very good systems. However, they are created for some institutions to take advantage of arbitrage opportunities, or tricky derivative strategies. They are not at all suitable for the average trader. We've tested many of the systems that are advertised in some of the trade publications. We haven't found one that works well. The result is that the trader follows a system and does what he is supposed to do. However, the system is poor to begin with.
Traders tend to lose objectivity when using technical analysis indicators. The trader is not able to remain objective and the subjectivity of using the indicator overwhelms him. I think it has to do with a compulsion many traders feel to have to trade. They then tend to subvert their indicators by trading when the signal is not entirely clear.
Traders have a tendency to test their trading systems and technical analysis indicators on an insufficient amount of data. Analysts need to test trading systems and technical analysis indicators on a wide array of data in different types of trading markets. Additionally, many traders and analysts don't forward test their trading systems and technical analysis indicators in real time. They is a rush to trade based on insufficient back-testing and forward-testing. Thus, it is really hope that they are trading on and not a sound, valid basis.
Many traders fail to incorporate sound risk management techniques in their trading systems. Additionally, many traders fail to incorporate stop loss orders with their initial orders when using technical analysis indicators only.
Traders also tend to over-optimize their trading systems. They start asking the what-if question and back-test the trading system with different parameters. Of course they are going to trade with the parameters which generate the highest amount of wins. However, in real time these over-optimized systems rarely perform well.
Another trap traders fall into is to use too many technical analysis indicators. Find the few that work consistently well for you and go with them. I find the time tested technical analysis indicators to be the best. However, there is no reason you won't find some new indicator that works consistently well for you. Just make sure that you forward-test it in real time.
Conclusions
I have always considered speculative trading more of an art than a science. The best traders I've ever seen use technical analysis indicators and intuition. However, despite their intuition, one thing common to all of them is that whether they can articulate them or not, they all have a set of well defined rules they trade by. They consistently generate very nice profits.
If you are considering buying technical analysis software be very skeptical of systems that advertise tremendous results. They have probably been over-optimized to show excellent back-tested results and won't work when you try to use them. Of course the company will have a whole list of reasons why it isn't working well at that particular point in time. However, excuses don't do you any good when you're losing hard earned money. Drawdowns are money out of your pocket. You will never make it back.
Last, what works for one trader may not work for another trader. If it works for you - that's all that counts.<<< |
