You need to know how to pick direction in order to profit from the market. There are two schools of thought that market speculators follow in order to speculate on the future direction of a security: Fundamental Analysis, and Technical Analysis.
Traders should be mostly applying Technical analysis to pick the short-term direction of a security, which is the focus of this article.
Technical analysis, in short, is studying past price action to predict future price action. It is often the study of charts, a graphic of past price action, and applying principles and mathematical indicators to garner what may happen next.
An apt simile to applying Technical Analysis is that of an artist applying principles to canvas to paint a picture. In this case, the picture is hopefully the future direction of a stock.
Like colour, shape, line, and texture for and artist, these principles can be categorised into four elements: Trends, Patterns, Indicators, and Entry Signals.
Trends
Trends are arguably the foundation of Technical Analysis. “The trend is your friend” is a maxim for good reason; trading with the trend will likely increase your chance of success. They are the lines and shapes of the painting.
Trends show the overall direction of which way the stock is moving, whether it be up, down or sideward. Because trends are measured over a specific period of time, it is likely the security shows multiple, sometimes conflicting, trends. The shorter-term trader focuses on the shorter-term trends.
Trends are formed when peaks and troughs of the graph either move gradually higher, lower, or stay the same. For example, if higher peaks and troughs are forming, the stock is in an uptrend for that period. It makes sense that if you placed a bullish trade, provided the up-trend holds you should profit, and because it has held so far, there is no reason to suspect it won’t going forward. There is an obvious flaw with this thinking, but by apply further principles a trader can solidify their view.
When reading trends, we draw straight trend lines which hope to connect either the troughs for uptrends, or the peaks for downtrends. By connecting the peaks or troughs with a straight line, we are essentially creating both a resistance or support line respectively. This creates a rule – in the past the stock has rebounded off the line several times, therefore providing hope it will do so again in the future. In addition, because the lines are straight, we can project them into the future.
Above is LLC:ASX. From the large falls we saw earlier in the year, LLC started up trending until it changed trend in June. The change in trend became more apparent when both the uptrend line was broken, and the stock started to form lower peaks and troughs. The downtrend is demonstrated with the downtrend line that connects the peaks and acts as a resistance against excessive price appreciation. The uptrend line is no longer relevant, and typically unnecessary to keep shown on the chart. It is preferable to trade with the trend, so a bearish trade would be preferable at this stage on LLC. Of course, further principles should be applied to shore up a view before jumping in.
Support and Resistance
Trends are a form of a support and resistance; uptrend lines support the stock from falling, and downtrend lines resist against the stock from rising. Support and resistance levels can also be flat and typically drawn at the price point where the security has reversed after falling or rising for a period. These price points that cause the security to reverse can be both a level of resistance and support in the past.
Traders should identify key levels of support and resistance as they often act as targets for the stock. Trends, support, and resistance levels create a rule which traders can follow: if the share price has reversed from here before, then it should so again in the future. This can be an indication to either enter a trade, or a target to get out if in one.
There are a multitude of resistance and support levels on almost every stock a trader would look at. Typically, look for levels which have seen several reversals. The more reversals that price point has caused, the more relevant it should be to a trader and affect their decision making.
At roughly $11.00 LLC has experienced several price reversals. When the share price was below $11.00, that price point acted as resistance. When it has traded above $11.00 the price point acted as support.
Patterns
Most patterns appear once trend, support, and resistance lines are drawn in. These patterns describe what the stock is doing holistically and is a step closer to having a complete picture.
In the above example, the downtrend line is converging on the key support level of $11.00. The Downtrend line is forcing LLC lower, but the support line is keeping it elevated. These lines form a triangle pattern, forcing the stock to its point where it must eventually break. Once broken, the stock should continue in that direction for some time.
Other triangle patterns exist, along with channels, islands, flags and a multitude of other technical patterns out there that traders use.
Entry Signals
With the combination of lines to form patterns, traders should have a good idea on how the security is trading and should feel more comfortable forming a view on its future direction. The question often then falls to when to get it in, and following that, when to get out. Entry signals help a trader time their entry into a stock and can be as complicated or as simple as a trader wants them to be.
In the image above, LLC is clearly rebounding from the downtrend line, with the support at $11.00 the next short-term target. The selling coming in today helps provide an entry signal to confirm the rebound from the downtrend line.
A trader wanting more confirmation in this context may wait for another day of selling to provide stronger entry signals. Though with something gained, something is lost – in that by waiting for further confirmation the trader will have lost some potential profit, or the fall may put the share price too close to $11.00 and the trade is missed.
Indicators
Mathematical Indicators are overlays or graphs that assist traders in solidifying their view. There are a range of indicators, with traders favouring some over others depending on their preferences. A mistake many new traders make is to rely on their indicators or put too much emphasis on them to make decisions. Instead, indicators should be only a confirmation tool and really left at the end of process. It is like the finishing touches on a painting.
Be mindful that using too many indicators can lead to conflicting views and by extension, analysis paralysis.
In the image above, the chart of LLC has an additional chart comprising of the blue and red lines. These are known as the Stochastic Oscillator and can help a trader confirm directional movement, the momentum behind the stock, and divergence. It also has to horizontal lines that show an overbought and oversold area.
Other simple yet effective indicators that a common are Bollinger Bands, Moving averages, and the RSI. There is extensive writing on each of these indicators with various ways to use them and read them to assist traders in picking direction.
Ultimately traders don’t have a crystal ball but utilising technical analysis well can provide confidence in trading the short-term direction of a security. In addition, investors should consider using technical analysis to better time their entry into securities.
This article has covered the four main elements of technical analysis, but like any painter worth their salt, it is important to learn, practise, and find a style that works for you. If you are new, it is important to have a structure that you can follow in the beginning, and with the inherit risks of short-term trading, learning from a professional is best. Once you have your structure you can develop your skills and evolve your analysis and trading as a whole.
TradersCircle runs education workshops that provide in-depth learning on Technical Analysis. We provide step by step trading rules for short term trading with the aim of generating an income stream. Join us next week for a live trading webinar where we will cover this topic more in depth using real life examples, click here to book your spot.
