The technical trader may be sane and reasonable or an outright crackpot, but both types are technical traders. You’ll also run into poseurs who claim technical expertise but really only know one or two things, and although those one or two things may work for them, the danger is real they won’t work for you. As for the academics with systems perpetually in test mode, they may be technical analysts, but they aren’t traders.
Until you put cold, hard cash down on your technical trading ideas, you aren’t a trader. You may be the smartest guy in three counties, but if you can’t make money trading, you’re just a smart guy, not a trader. In fact, the ability to focus is far more important than brainpower in technical trading. Whatever their styles, successful technical traders all have one thing in common — they’ve built a trading plan that uses the technical tools that suit their appetite for risk, and they follow it. A plan contains not only high-probability indicators, but also money management rules. This list discusses ten secrets that successful technical traders utilize. Remember them as you start trading.
Appreciate probability
Technical analysis works because stock market players repeat the same behaviors, but history never repeats exactly. The probability of any particular pattern or indicator repeating itself — getting the same outcomes — is never 100 percent. If you want to be a technical trader, you have to gather the data from your trades carefully and apply expectancy rules in order to have any hope of long-run success. You must keep track of your win-loss ratio and the other metrics of the expectancy formula. To trade without having a positive expectancy of a gain is gambling. It’s not trading. You may have a slight edge from using a few indicators, but you don’t really have control of your trading. Position sizing and other aspects of money management are useful, too, but if you don’t have positive expectancy on every trade, in the long run you will lose.Backtesting matters
You need to examine the trades your indicators would have generated over some period of time — a minimum of six months, and a year is better — to get a fair estimate of the expected gain/loss. You have to write it down and do the arithmetic. Technical analysis entails a scientific mindset and that means keeping records. I keep an Excel spreadsheet on every trade and update it every day. It takes less than ten minutes per day, and it’s a small price to pay to know exactly what indicators were working that day and what indicators didn’t work. Betting your hard-earned cash on an unproven set of indicators is wishful thinking, not informed trading. Indicators give you an edge, but not a winning lottery ticket.The trend is your friend
The single best way to trade is to follow price trends. If you buy when an uptrend is forming and sell when the uptrend peaks, you’ll make money over the long run.If you can’t see a trend, sit back and wait for the trend to appear. Nobody is holding a gun to your head forcing you to trade. To stay out of the stock market when the security isn’t trending is okay — as is getting out of the trade temporarily when a pullback occurs. A security purchase isn’t a life-long commitment. You’re not being disloyal or unfaithful to your security if you sell it during a pullback.
It doesn’t matter if your security — Apple, Amazon, or whatever —is the best security of all time. The essence of technical analysis is to analyze the price action on a chart to arrive at buy/sell decisions. You determine whether the security offers a trading opportunity by looking at indicators on the chart, not on the fundamental characteristics of the security itself. You’re welcome to trade only high-quality names, but in practice, you can make just as much gain from a real dog of a stock as from the market’s darlings.Entries count as much as exits
The buy-and-hold strategy has been discredited many, many times. Buy-and-hold is never the optimum methodology. Look back at the two big stock market crashes in recent history — the tech wreck that started in March 2000 and the financial crisis collapse that started in October 2007. It took 13 years for the S&P to recover and hold a level above the high of March 2000; in other words, if you owned the entire 500 stocks in the S&P, you would have made no net gain for 13 years. Debunking buy-and-hold is why you often see “it’s when you sell that counts.” But, obviously, when you buy counts, too. You can have a so-so trend identification system, but if you get in at a relative low, you will thrive, whatever your holding period.Stops aren’t optional
Stops are different from the embedded buy/sell signals in indicators. A moving average crossover doesn’t know how much cash loss you’ll be taking as it lollygags its way to the sell signal. You have to decide ahead of time how much loss you can tolerate, either in cash or percentage terms, and just accept it when stops get hit (without remorse or anger). A good stop is not so tight that you forego any real chance of achieving the expected gain, nor so loose that you give back a big chunk of previously earned gain. You need to acquire skill at crafting stops that combine your security’s behavior patterns with your risk appetite — a double set of conditions.Don’t trade without stops. There are no acceptable excuses for failing to use stops.
Treat trading as a business
You should make the trading decision on the empirical evidence on the chart and not on emotional impulse. It’s human nature to bet a larger sum of money when you’ve just had a win. Likewise, you may become timid after a loss.A good technical trader follows his trading plan and disregards the emotions created by the last trade or by the emotions that swell up from being in trader mode. Trader mode can inspire competitive aggression, analysis paralysis, confirmation bias, and any number of other interferences with the rational application of your trading regime. You may not have a full-bore trading system, but you should trade what you do have systematically. A good trading regime uses rules that impart discipline in a conscious effort to overcome the emotions that accompany trading. Trading is a business, and business should be conducted in a non-emotional manner.
Eat your spinach
It’s not a personal insult when you take a loss. Ask brokers or advisors for the single biggest character flaw of their customers; they all say the same thing, “The customer would rather be right than make money.”You can’t control the stock market. The only thing you can hope to control is yourself. If you become unhinged by your losses, you haven’t built the right trading plan. You need to start over with different securities, different indicators, and/or a different win/loss ratio in your expectancy calculation.
Don’t let a winning trade turn into a losing trade. You can have a fine trading system with excellent indicators properly backtested for the securities you’re trading but still be a lousy trader if you don’t have sensible trading rules. A good trader differentiates between indicators (which only indicate) and trading and money-management rules (which manage the risk).
Technical stuff never goes out of date
Nothing is ever discarded in technical analysis. Books written 70 years ago are still useful today. Technical thinking never goes out of date; the technical analysis crowd just keep adding to it. Thumb through the index of Technical Analysis of Stocks and Commodities magazine. You can find multiple reviews, updated nuances, and suggested uses for old-timey indicators and new candidates alike.You’ve made a good decision to start your journey of technical discovery with this book. Start at point-and-figure or momentum and work back to moving averages. Start at candlesticks and move back to standard bars. Get a certain bare minimum of information under your belt before you start placing trades; the universe of technical analysis is flexible, and you can bend it in many different equally valid directions.
Although technical ideas never go out of date, they do go in and out of style. During the 1980s and enduring to today, Elliott Wave has been in style. In the 1990s, MACD was the fad of the moment. It’s still a splendid indicator, but not front-page news. Today ichimoku is all the rage. You should care about fads in indicators because to some extent, the number of technical traders using the star indicator of the day are making its outcomes a self-fulfilling prophecy.
Diversify
Diversification reduces risk. The proof of the concept in financial math won its proponents the Nobel Prize, but the old adage has been around for centuries: “Don’t put all your eggs in one basket.” In technical trading, diversification applies in two places:- Your choice of market indicators: You improve the probability of a buy/sell signal being correct when you use a second, noncorrelated indicator to confirm it. You don’t get confirmation of a buy/sell signal when you consult a second indicator that works on the same principle as the first indicator. Momentum doesn’t confirm relative strength because it adds no new information.
- Your choice of securities: You reduce risk when you trade two securities whose prices move independently from one another. If you trade a technology stock, you achieve no diversification at all by adding another technology stock. You’ll get a better balance of risk by adding a stock from a different sector.
Swallow hard accept some math
Appreciating the limitations imposed on trading by probabilities is one thing. Each indicator and each combination of indicators has a range of probable outcomes.Say you’ve designed a good set of market indicators that will likely generate a high return. But tweaks to your money management rules can double or triple that. Money management can be tricky and difficult, and it needs to be in a feedback loop with your indicator system. For example, should you increase your position in a winning trade? This is the position-sizing problem, and analysts are passionate about whether to do it or not.
Money management takes you into the realm of betting. In a nutshell, you have to know when to hold ‘em and when to fold ‘em. These decisions can be informed by your indicator probabilities, but the final decision is risk management in the face of other (non-indicator) factors that are unknown, known as the realm of game theory. Don’t be surprised to discover that the first originator of the theory of games modelled it on . . . poker. Refer to the Appendix for additional reading on the subject.
Money management is the central reason why it’s usually a mistake to buy someone else’s trading system, which was customized for the risk preferences of the designer — not you. To find your own risk preferences, you need to experiment with different money management rules. You can have a so-so system but magnify it into a splendid system with clever money management alone.