Making money in the financial markets requires a profitable system that avoids blowing up your account when losses do occur, and is repeatable across different market cycles. There are many different roads to the goal of creating wealth from the financial markets. Ultimately, you must find a system that matches your personality and lifestyle. One constant that is true of all investing, however, is that it is a game of incomplete information. Stocks were first traded face to face, literally in the street, with no formal rules in place. Today, there is considerable regulation on the markets. However, despite all of the mechanical and procedural changes to the markets over the past 200 years, market participants are still faced with the challenge of incomplete information: nobody knows tomorrow's stock prices, next week’s geopolitical event, next quarter’s corporate earnings, or next year’s inflation. So what are we to do?
Understanding the markets means understanding two things: underlying fundamentals drive stock prices in the long-term, and market psychology determines how we get there. Technical analysis provides tools to properly evaluate the combination of fundamentals and market psychology. There are countless technical indicators to choose from, any of which, if used properly, can be used to make money. The key is proper usage. The fact is that there is no single ‘super-indicator’ that is right 100% of the time. However, under certain specific conditions, a single indicator will have excellent predictive value.
Before discussing how to use technical analysis indicators, it is important to understand how each is constructed. A few well-known indicators include moving averages, RSI (relative strength index), and stochastics. A moving average is nothing more than the mean average price over a given time period. A 50-day moving average is the mean average price of the last 50-days’ closing prices. A 200-hour moving average is the mean average price of the last 200 hours’ closing prices. Moving averages indicate trend direction and are beautiful in their simplicity.
Relative strength, also known as RSI, is a bit complex to construct, but is basically a measure of the size of gains on positive days relative to the size of losses on negative days over a given time period. RSI is therefore an indicator of the strength of a given trend.
Stochastics determine the most recent closing price’s relative value within the price range of a given time period. The indicator is derived by taking the recent close minus the lowest low of the range, dividing the result by the highest high of the range minus the lowest low of the range, and multiplying that result by 100. This number is then smoothed by using a three-day simple moving average. Stochastics measure the short-term momentum within a trend.
Technical indicators are broadly categorized as either oscillators or trend indicators. Moving averages are an example of trend indicators, as they indicate the direction of the prevailing price movement for a given time period. Other trend indicators include price channels, MACD (moving average convergence/divergence), and trend lines. Trending indicators, when used properly, define whether the trend is up, down, or nonexistent for a given timeframe. Moving averages, and all trending indicators, by definition lag the most recent market price, and the longer the moving average, the greater the lag. The word ‘confirmation’ is often heard in tandem with trend analysis. This is because the definition of a trend, the prevailing tendency of prices to move in a given direction, implies passage of time. Therefore, the day that a trend begins, there is no repeatable way to know that it has begun – a trend can be identified only after it has been in place for some time.
Oscillators, on the other hand, are designed to be predictive of future near-term price action. Oscillators are numerous, as everyone seems addicted to the search for the holy grail of profitable short-term trading systems. Here are a few: stochastics, RSI, Bollinger bands, and commodity channel index. Oscillators can be used effectively in tandem with trend indicators to help determine when to enter the market, how much risk to assume, and when to reduce position size.
Taken alone, neither trend indicators nor oscillators have much use. However, when oscillators are used in combination with trend indicators, you can develop the elements necessary to create a robust trading system. Most important to all trading systems is money management, or the practice of allocating the right amount of money at the right time, and reducing by the right amount as well. Effective money management can be aided greatly by an understanding of market volatility. A useful measure of volatility is standard deviation, which is the average of price movement above and below a mean across a given timeframe. Standard deviation is neither an oscillator nor a trend indicator, though it displays characteristics of both at times. The autumn of 2008 brought tremendous volatility, the likes of which has only been seen twice in the last 80 years: during October 1987, and the 1929-1932 Great Bear Market. Without an understanding of volatility, many traders, funds, and financial institutions large and small blew up last year. However, those with even just a basic understanding of volatility knew that last autumn was not a time to remain heavily invested, whether long or short. The S&P had several 20%+ movements up and down between October and December of last year, and the standard deviation of the market ballooned to four to five times that of the historical mean. Being on the wrong side of even just one of those moves would have been quite devastating if you were leveraged even just two times your equity. However, if you reduced your money at risk in proportion to the increase in volatility, a 20% loss on only 40% of your assets would still leave you with 92% of your assets remaining.
A word of caution on indicators: there is no holy grail in technical analysis. Any given indicator will occasionally work some of the time, just as a broken clock is right twice a day. Oscillators seduce novice market participants with promises of absurdly high accuracy rates and other such nonsense. The fact is that picking tops and bottoms is not repeatable and is likely to lead to ruin. Following trends, on the other hand, while perhaps difficult for those with a big ego, is a much more repeatable and long-term profitable mode of market participation. It is arrogant and fruitless to believe that you can correctly predict the end of a market trend or to determine the end of a market trend as it is occurring – such endeavors are not reliably repeatable. If you cannot answer the question, ‘Are the odds in my favor, and does the historical data support this,’ then you have no business putting money at risk. An understanding of trend indicators, oscillators, volatility, and money management together allows for the creation of a system that is profitable, repeatable, and sustainable.
Here a couple of free charting resources:
www.stockcharts.com
www.bigcharts.com
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