Mastering technical analysis smarter, simpler ways to trade the markets

Mastering Technical Analysis A Guide to Simple Specific Trading Strategies for Honest Proven Results: Profit from Powerful Backtested Strategies for the Stock Market, Options Trading, and Forex Alan Northcott http://www.masteringtechnicalanalysis.com/ Copyright Notice Copyright © 2014 by Alan Northcott All Rights Reserved Reproduction or translation of any part of this work beyond that permitted by section 107 or 108 of the 1976 United States Copyright Act without permission of the copyright owner is unlawful Requests for permission or further information should be addressed to the author Alan Northcott 924 S Easy Street, Sebastian, FL 32958 www.AlanNorthcott.com This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold on the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services If legal advice or other expert assistance is required, the services of a competent professional person should be sought First Printing, 2014 Printed in the United States of America Table of Contents ABOUT THE AUTHOR THE NEWBIES SERIES DISCLAIMER AND RISK DISCLOSURE WHAT IS TRADING? STOCKS AND BONDS THE STOCK EXCHANGE STOCKBROKERS SHORT SELLING TYPES OF ORDERS WHAT CAN I TRADE? Futures Options Forex Contracts for Difference Spread Betting Binary Options SHOW ME THE MONEY THE PSYCHOLOGY OF IT ALL TECHNICAL ANALYSIS AND THE DOW THEORY MARKET ACTION WHAT IS TECHNICAL ANALYSIS? THE PRINCIPLES OF TECHNICAL ANALYSIS The Market Discounts Everything The Market Exhibits Trends History Repeats Itself TRADING V INVESTING TECHNICAL ANALYSIS V FUNDAMENTAL ANALYSIS CRITICISMS OF TECHNICAL ANALYSIS Efficient Market Hypothesis Is It Self-Fulfilling? THE DOW THEORY The Six Tenets Doubts about Dow SUMMARY CHARTING BASICS TYPES OF CHART Line Charts Bar Charts Candlestick Charts Real Life Chart Samples ARITHMETIC AND LOGARITHMIC PRICE SCALES VOLUME OPEN INTEREST WEEKLY/MONTHLY CHARTS TRENDINESS USING LONG-TERM CHARTS IN TRADING WHAT ABOUT INFLATION? FUTURES CHARTS WAYS OF USING CHARTS SUMMARY TREND CONCEPTS WHAT IS A TREND? The Parts of a Trend SUPPORT AND RESISTANCE Reversal of Roles The Psychology Behind Support and Resistance The Strength of Support and Resistance TREND LINES Strength of the Line Getting All the Action Using the Trend line Breaking the Line Role Reversal Price Targets The Trend Line Fan Trend line Steepness Adjusting the Lines THE CHANNEL LINE PERCENTAGE RETRACEMENTS SPEEDLINES INTERNAL TREND LINES SUMMARY REVERSAL AND CONTINUATION PATTERNS REVERSAL PATTERNS Head and Shoulders Reversal Pattern Triple Top and Bottom Reversal Patterns Double Top and Bottom Reversal Patterns Saucers and Spikes CONTINUATION PATTERNS Triangles Broadening Formation Flag and Pennant Wedge Formation Rectangle Formation The Measured Move Head and Shoulders Continuation Pattern SUMMARY VOLUME AND OPEN INTEREST VOLUME On Balance Volume OPEN INTEREST Strength or Weakness? Other Indications Options Commitments of Traders Report REVERSAL DAYS GAPS Breakaway Gap Runaway Gap Exhaustion Gap Island Reversal SUMMARY MOVING AVERAGES SIMPLE MOVING AVERAGE EXPONENTIAL MOVING AVERAGE WHAT PRICE? HOW TO USE MOVING AVERAGES Using One Moving Average Using Two Moving Averages Using Three Moving Averages MOVING AVERAGE ENVELOPES BOLLINGER BANDS Targets Volatility CYCLES WEEKLY RULE MOVING AVERAGE OPTIMIZATION SUMMARY OSCILLATORS AND SENTIMENT INDICATORS USING OSCILLATORS IN TRENDING MARKETS Momentum Indicator Commodity Channel Index Relative Strength Index Stochastic Oscillator Williams %R Moving Average Convergence/Divergence OSCILLATOR VARIABLES THE IMPORTANCE OF CONTRARY OPINION INVESTOR SENTIMENT SUMMARY FURTHER CHARTING CANDLESTICK CHARTING Basic Shapes of Candlestick Reversal Patterns Continuation Patterns Pre-qualifying Patterns Candlestick Trading Principles POINT-AND-FIGURE CHARTING Constructing the Point-and-Figure Interpretation THREE LINE BREAK RENKO KAGI ICHIMOKU ICHIMOKU CLOUD CHARTS CONSTRUCTION TECHNIQUES Turning Line Standard Line The Cloud Lines Lagging Line INTERPRETATION State of the Market Signals Time Periods Different Time Frames SUMMARY ELLIOTT WAVES AND CYCLES OF TIME THE BASICS OF WAVES CORRECTIONS Zigzags Flats Triangles THE RULE OF ALTERNATION CHANNELS FIBONACCI NUMBERS Fibonacci Retracements Fibonacci Time Targets SUMMARY OF ELLIOTT WAVE THEORY CYCLES OF TIME Cycles The Basics of Cycles Cycle Principles Cycles to Watch For How to Find Cycles How to Use Cycles Translation SUMMARY MONEY MANAGEMENT AND COMPUTERS MONEY MANAGEMENT MONEY GUIDELINES DIVERSIFICATION USING STOP LOSSES RISK V REWARD THE WAY YOU THINK POSITION SIZING TRADING TACTICS The Breakout Trend lines Support and Resistance Retracements Gaps ORDER TYPES Market Order Limit Order Stop Order Trailing Stop Stop Limit Order Order Modifiers Less Common Orders SUMMARY TECHNOLOGY Putting Together the Tools What Software? What's Your Setup? Mechanical Systems SUMMARY HOW TO BUILD A TRADING SYSTEM THE APPROACH THE CONCEPT THE RULES Entry Sizing Exit SPOT CHECK BACK TEST PAPER TRADE TRADING JOURNAL SUMMARY Trading Reminders Trading Rules THE STOCK MARKET RELATIVE STRENGTH ANALYSIS HEALTH OF THE MARKETS CHARTING VOLUME INSIDER TRADING FUTURES WHAT IS A FUTURE? TRADING FUTURES MARKET EXAMPLE COMMODITY POINTERS OTHER FUTURES Bond Futures Interest-Rate Futures Index Futures Single Stock Futures Contracts for Difference and Spread Betting Contracts for difference (CFDs) and spread betting have become very popular in the countries that allow them — which is most of the world, with the notable exception of the USA, where the Securities and Exchange Commission (SEC) does not permit them They are leveraged financial products that are available on a large range of different financial instruments They were invented in the 1990s, primarily for hedge funds and institutional investors, but spread to retail traders later in the decade The fundamental idea of a CFD is that it is a contract between two people which stipulates that one will pay to the other the difference between the current value of an asset and its value at a future date When you trade in CFDs you never own the assets, which is one of the things that makes this an efficient way of gaining profits from share price movements Spread betting is very similar, which is why it is included here, but the regulations are slightly different You may be required to establish that you know what you're talking about when you set up a CFD account, but less experience is required to place spread bets The second part of this Chapter runs over trading guidelines and good sense, and summarizes the principles to be borne in mind when trading How Does It Work? CFDs are traded on margin, and typically for shares the margin required is about 10% of the value You may also pay a commission of 0.1% of the contract face value for opening and closing the position, but this varies between brokers Because you never own the shares, you don't have to pay stamp duty in those countries that would otherwise charge it But the real advantage of CFDs is not the saving in stamp duty, but the leverage available to trade any underlying financial instrument You can find many global stocks, commodities, treasuries, currencies and indices all available from the same CFD broker, saving time and complication CFDs have also been used to hide insider dealing, because the disclosure rules only apply to ownership of the securities, and not to this type of financial interest In the UK this was tackled with new regulations in June 2009 CFD Trading In practice, you will have an account at a CFD provider, and although there is no standard contract in the industry they all tend to be the same in most matters To trade you simply open a position with the provider There is no fixed expiry date, so the position remains open until you choose to close it The charges for CFD trading include the bid and ask spreads, commissions which are sometimes charged, and interest charged on a "long position" Interest is charged every day that the position is held overnight Thus CFDs are not designed as long-term investments With CFDs it is just as easy to open a "short position", and that pays a nominal amount of interest to your account The other important fact is that the CFDs are marked to market each day This can expose you to a margin call if there is a downturn The CFD market most closely resembles futures, except there is no time decay as there is no set expiration date Technical Analysis As CFDs and spread betting are available on a wide range of financial products, the analytical methods that are most appropriate will depend on what the underlying is You can take out contracts for difference on many major stocks on many global stock markets, so you would apply technical analysis directly to the stocks to help with your selection You will need to be a little careful about the downside risk when using CFDs, as opposed to investing directly in stocks A sharp move downwards and the consequent margin call could affect you badly, whereas you have more leeway to ride out fluctuations if you own the shares Once again, you will need to adjust your money management to take account of the leverage employed, the margin and the marking to market It is important when trading derivatives that you not overstretch yourself, and if you use all the leverage available, you may find that you get into trouble You should always be aware of the losing position that will cause you to exit the trade, and make sure that this does not cripple your account However good you think the trade will be, you must always be prepared to cut your losses quickly before too much damage is done to your resources The following examples are ways in which CFDs can be used in your trading, and some of the most recent financial instruments invented Some people find they need little else for their trading career, given the versatility and range of choices offered Commodity CFDs Whenever you hear the term commodity, you probably think of the futures market Trading commodities using CFDs has some advantages for a speculator Many commodity CFDs have the futures market as the underlying, rather than the commodity itself This means that there is an expiration date associated with the underlying which your broker will deal with in one of two ways — either he will automatically roll it into the next month contract, or he will cash settle the existing contract and offer to open one on the next month for you Unlike futures, with a CFD you have absolutely no possibility that you will receive physical delivery, because it will always be cash settled You not need so much money, as the margin percentage is usually lower with CFDs, and also because you not have to take the standard lot size of the futures contract You are not usually charged commission, and the broker will profit from the spread between the bid and ask prices Gold CFDs Given the recent interest in gold following the financial turmoil, the gold CFD gives the trader a direct play on the metal, rather than investing in mining and exploration Depending on your broker, you may find you can choose a CFD on the spot price of gold, or can trade on the gold futures price The standard size of contract may be 10 ounces or 100 ounces, and margin could be as little as 3% of the value The only way in which this is not as good as holding physical gold is that you are charged interest daily, so you need to time your move into gold CFDs to coincide with an uptrend However, you don't get stuck with any storage or security issues Oil CFDs A trader's favorite, the volatility of the oil markets gives plenty of opportunity for the active trader to profit Prices vary not only with obvious supply and demand caused by perceived shortages or oversupply, but are also seasonal You will find crude oil CFDs available on the New York market (NYMEX) and CFDs on Brent crude are traded on the Intercontinental Exchange (ICE) Usually the CFDs are based on 100 barrels, and the margin rate for commodities is commonly 3% As an example, suppose you wanted to take a bullish position on US crude, and you were quoted $78.25-$78.50 If you bought five crude oil CFDs with a margin rate of 3%, this would work out to $1177.50 (taking the higher price of $78.50), and with this margin you would control $39,250 of oil Later that same day, oil was quoted at $80.75-$81.00, and you decided to close your position You would close at $80.75, for a total value of $40,375 Your profit on the trade is $1125 Gas CFDs It is true that most people think of oil when they consider trading in the energy sector, but natural gas CFDs are less volatile and more predictable Your CFD broker should be able to write gas CFDs on both the UK and US markets Gas CFDs are usually traded with the futures market as the underlying, unlike oil As noted above, using CFDs to trade on the futures market needs that you are not restricted to the large lot sizes demanded on futures, and you will usually get a better margin rate These two facts make CFD trading on natural gas much more accessible than taking out a futures contract Index CFDs You will find that brokers offer CFDs on indices around the world, which means you can take part in the world markets Using CFDs you can get exposure to the ups and downs of any particular country's economy Effectively you are trading on a basket of stocks for the country you choose The margin rate is low, around 3%, and there is no commission as the broker profits from the spread It is a good way to gain exposure to a foreign country’s markets Sector CFDs CFDs allow you to profit wherever you find a growth area, regardless of where in the world it may be As it is as easy to go short as long, you can also profit from a declining economic sector With sector CFDs you take an overall view of the economy, choosing for example healthcare as a solid growth industry They save you having to analyze the individual companies, and you only need to see the big economic picture to select profitable areas to trade With sector CFDs, you automatically have diversification, which reduces volatility compared with single stocks The only point to watch with sector CFDs is that they tend to have a bigger spread than CFDs on individual stocks If you're considering a sector that is dominated by one or two large companies, it may well work out cheaper to trade CFDs on the individual companies rather than taking up the sector CFD Inflation CFDs UK traders now have the opportunity to profit from trading on inflation, as given by the monthly Consumer Price Index (CPI) This is offered by only one broker at present, GFT Global Markets UK Ltd., who also offer an inflation CFD on the European rate of inflation given by the Eurozone Harmonized Indices of Consumer Prices (HICP) As there is only one broker making the market for these, liquidity can be low The spread on these is about 0.1, and margin requirement 5% You have a choice of going long or short on them The CFDs are paid out on the basis of the initial published CPI figures, ignoring any subsequent revisions If you are concerned about rapidly increasing inflation devaluing your portfolio, you can use these CFDs as a hedge to avoid big losses Carbon Trading CFDs Another very recent idea, and one that is both volatile and political, is a contract for difference with an underlier of the futures contract on emissions values The carbon pollution program allows users to emit a certain amount of the gas, for which they get a permit If they subsequently improve their performance (reducing the emissions) then they can sell their excess permitted allowance to others who need it The price of carbon emissions has varied from to 30 Euros per ton in the last couple of years, with a typical value of about 13 Euros at the end of 2009 Incidentally, a VP at Shell recently estimated the actual cost to eliminate one ton of carbon dioxide is more like 72 Euros So with that as a background, Saxo Bank has launched a CFD product based on emissions futures They require a minimum trade of 25 tonnes, and a 10% margin, which makes it a very reasonable trade, if somewhat hard to predict Final Notes Principles to Follow Take an Overall View of the Market While it is obvious, it needs saying If you are trading in a bullish market, then the majority of your trades should be long If the market is bearish then most trades you take should be short If the market is not trending, then make sure that any strategy taken is appropriate, such as buying at support and selling at resistance Above all, realize that you not have to be in the market most of the time, and if the market is not the right type for your trading strategy, then you should stay away or develop an alternate strategy for the market conditions Before Trading, Know Your Maximum Loss Never take a trade without figuring out in advance an acceptable level of loss I suggest 2% of your trading account, but some traders are more conservative than this In a famous saying by a top American trader, he compared people who risked losing 3% on a trade to "gunslingers" Know When You Are Wrong So in conjunction with the above principle, you must know exactly when you are wrong, if the trade goes against you You can only be objective before you enter the trade, so you must write this down and stick to it You also have to realize that a number of trades will go against you even though they were good trades, and deserved to be taken The good trade is one where you followed your tested trading plan, cutting your losses if necessary, or achieving a good profit A losing trade does not mean you did anything wrong, only it made a loss because of the way the markets unfolded Similarly a winning trade does not always mean you did things right, because sometimes markets forgive a bad action Relying on that is not a trading strategy! Know Your Expected Profit Based on technical analysis you should be able to determine the minimum expected move, and hence a profit potential of a trade Some trades just not have a good enough potential compared to the downside, and should not be taken Stack the odds in your favor by looking for at least a to reward to risk ratio, and preferably a to ratio Conserve Your Capital Above all, remember that your aim is to still be trading next year, when your experience will make you a better trader The only way to get there is to protect your capital from any major setbacks This is much more important than aiming for a profit, which will come automatically if you trade correctly Keep a Trading Journal You can't expect to get it all right from the start, so keeping a trading journal and reviewing it regularly is important to help you improve It is a good idea not to critique your trades too quickly, as you may still have the cloud of emotion, but you shouldn't wait too long before review if you are to make regular progress The following are the items that you should include in your journal -What you bought and sold What time you did a trade, as some people are better at certain times Why you did the trade, what was the thought process? How strongly you felt about the trade were you sure of it? What was your profit goal? What was your stop loss level? How much you made or lost How long the trade lasted Armed with all this information, you can narrow down what types of trades work best for you, whether you are hanging on too long to a losing position, and all sorts of relevant facts which will allow you to get better at trading Learning to trade is a process, and as you never stop learning keeping a journal will allow you to make continual improvements to your effort Trading Strategies Finally, a recap on some proven strategies that will work in most financial sectors The first two work in an uptrending market, the next two are for a bear market, and the last one works when the market is going sideways These are general strategies, and they can form the basis for developing your own trading plan, setting exact criteria for the entries and exits which should be back tested in the markets you are trading Buying Dips This is an effective strategy for all types of financial instruments This involves buying into an established uptrend, so it doesn't capture the whole trend, but is less risky than trying to that The steps involved are – Establish that the market is going up Check that the sector is going up The particular financial security is going up Wait for a short-term dip in price Wait for the short-term dip to end Calculate trade size and stoploss Enter trade long Exit trade if failed or on profit First confirm the upward trend by long-term moving average, or by looking at the charts if it is obvious The short-term dip can be defined as the daily low being less than the previous two days’ lows, or you could use an indicator such as the RSI showing oversold for the last three days To determine when the dip has finished, look for the price to rise above the previous day’s high, showing that the uptrend has recommenced The stoploss, or protective stop, should be placed below the lowest low of the last three days, as if this level is breached, the dip has not finished after all You could exit the trade when the uptrend appears to be over as signaled by a change in a moving average direction, or by using a trailing stop Buy Relative Strength An alternative way to profit from an uptrend is to buy into the strongest of the strong, without waiting for a dip or retracement In this case, the steps are – Establish that the market is going up Check that the sector is going up The particular financial security is going up Check the strength relative to other securities Calculate trade size and stoploss Enter trade long Exit trade if failed or on profit The difference from the previous strategy is that you not wait for dip, but you check that the security you are interested in is behaving strongly For instance, this can be established by checking that the performance is better than the market by at least 10%, and better than the sector by at least 1% over the past week or two, and you can substitute your own levels by backtesting You can exit this trade on a protective stop set below the lowest level for the past few days, or if in profit you can set a trailing stop, or exit if the security falters and fails to outperform the market for a couple of weeks Selling Rallies This strategy is the opposite of buying dips, and applies in a bear market It involves taking a short position, selling on temporary strength in an otherwise downtrending market Here are the steps involved – Establish that the market is going down Check that the sector is going down The particular financial security is going down Wait for a short-term rally in price Wait for the short-term rally to end Calculate trade size and stoploss Enter trade short Exit trade if failed or on profit We would again look at the moving averages or by inspection determine that there was an established downtrend, both in the market as a whole, in the sector, and in the security The signal that there is a short-term rally would be that the price was higher than previous few sessions, or that the RSI has been overbought for three sessions The rally can be considered finished when the price falls below the previous lows The protective stop would be above the previous highs, and the exit would be on a trailing stop or if a moving average turns up, signaling the end of the downtrend Sell Relative Weakness Another opposite strategy, this one is similar to the buy relative strength We not wait for a rally in a downtrend, but choose the strongest downtrending security by a process of refinement The steps are – Establish that the market is going down Check that the sector is going down The particular financial security is going down Check the strength relative to other securities Calculate trade size and stoploss Enter trade short Exit trade if failed or on profit The meaning and indications of these steps will by now be obvious Buy Support and Sell Resistance This is an alternate trading strategy that you use when a market is not trending clearly, but moving sideways It is short-term, with the price going between the support and resistance, and you need a sufficient difference between these two to make it worth trading However, it has the advantage that your target price is clear, which allows you to make the appropriate calculations of profitability Check the overall market is going sideways Ensure the sector is going sideways Confirm the security is going sideways Look for definite support and resistance levels Wait for the price to approach support or resistance Determine protective stop level Calculate position size Go long at support or short at resistance Use a trailing stop to follow the trade within the range The question with this strategy is how to define going sideways This is probably easiest by visual inspection, particularly as you will need to examine the charts closely to determine the support and resistance levels The protective stop will be placed underneath the support level when buying long at support, or over the top of the resistance level when selling resistance To exit the trade in profit you can trail a stop below the previous couple of sessions for a long trade, or above the previous for a short trade If the price is reaching the other side of the range, you can tighten the trailing stop to below or above the last session only, and this will allow you to retain the best profits Other Titles by This Author Other titles by Northcott – The Complete Guide to Investing in Short Term Trading The Complete Guide to Using Candlestick Charting The Complete Guide to Investing in Gold and Precious Metals The Complete Guide to Investing in Derivatives The Complete Guide to Making Environmentally Friendly Investment Decisions The Complete Guide to Investing in Real Estate Tax Liens & Deeds The Mutual Funds Book The Hedge Funds Book Asset Protection for Business Owners and High Income Earners Everything You Need to Know About Asset Allocation (Links take you to pages on the Technical Analysis - A Newbies Guide website) For full reviews, see book listings on www.amazon.com ... ME THE MONEY THE PSYCHOLOGY OF IT ALL TECHNICAL ANALYSIS AND THE DOW THEORY MARKET ACTION WHAT IS TECHNICAL ANALYSIS? THE PRINCIPLES OF TECHNICAL ANALYSIS The Market Discounts Everything The. .. going to soon, the technical analyst has the advantage Dealing with the actual price movements that are happening and using them to anticipate the next moves is the territory of the trader The. .. company’s stock is going to lose value in the short term, and “go short” on the shares This gives a further range of choices to the trader as opposed to the investor, when looking for a market to follow