Friday, September 4, 2009

The 12 Commandments Of Technical Analysis

There are no hard and fast rules about technical analysis, But Here Are 12 Guidelines that will help you succeed.

1. Always assume the current trend is in force until the majority of evidence indicates otherwise.

The biggest mistake most traders make is selling too soon. The second biggest mistake is buying too early. You want confirmation from multiple sources before you take action. Stocks always move in funny lines and unless you have the discipline to ride out the smaller jiggles, you will be furiously trading without ever capturing longer, sustainable trends. Trends are persistent so give yourself the opportunity to ride those trends for all they are worth.



2. The more frequently a trendline is touched, the more valid that trendline becomes.

Trend-lines are fickle but can also be very faithful. The best trend-lines will regularly tell you they love you by repeatedly touching the prices, over and over again. The more a trend-line is touched, the more dependable that trend-line is.


3. The longer a trendline is in force, the more valid that trendline becomes.
This is a corollary to the above principle. Trend-lines that have been in-tact for an extended period of time are usually very reliable. Some traders mistakenly think that something that has gone up for a long period of time cannot continue much longer. Not true. Long trend-lines are very dependable and very worthy of your consideration. Of course, nothing last forever but jump on board and enjoy the ride until it reverses. One thing about long trend-lines -- once they are broken, it is usually time to get very worried.



4. Uptrends live above 50 and downtrends live below 50.

Stocks that wiggle back and forth between positive and negative RSI readings are bad news. Persistency is the quality you should admire most in a stock so concentrate on those that have a recent track record of staying in positive territory and avoid those stocks that cannot generate enough buying pressure to stay above 50.



5. Generally, you should avoid making new purchases when RSI is in overbought territory and avoid selling existing positions when RSI is in oversold territory.

Like a rubber band that is stretched too far, stocks that rise into overbought territory are usually ripe for a near-term pullback. Conversely, stocks in oversold territory should experience a bounce. In both cases, the best time to take action is as soon as they move out of these extreme readings. One caveat is that the more volatile the stock, the longer they can survive in overbought/oversold territory. Volatile stocks can move fast and continue moving fast so change your guidelines to extremely overbought or extremely oversold for these types of stocks.



6. Trendlines get broken all the time. RSI will tell you if you should re-draw your trendline or if a trend reversal is developing.

One thing you need to get used to is that trend-lines are never as straight as you want them to be. Every time a trend-line is broken, you need to make a decision whether a trend reversal is developing or whether you should re-draw your trend-line to incorporate the new low. Do not take a guess - ask your RSI friend what to do. A trend-line break accompanied by a positive RSI reading tells you that things are still okay and that it is time to draw a new trend-line. A trend-line break accompanied by a negative RSI reading tells you that a trend reversal is possible (not absolute) and that you need to be wary of a potential sell.



7. Breakouts above resistance are usually good times to buy.

Breakouts below support are usually good times to sell. Breakouts are to technical analysis what voters are to politicians - they are supposed to get your attention. Whenever you see a breakout, you should assume that there has been a powerful shift in investor perception. Either a lot of new buyers have jumped on board or a bunch of sellers are running for the exits. In either case, a significant change has occurred and you should take action. The Stock Market is pretty smart. Things go up or down for good reasons. Breakouts deserve your attention.



8. Always look at three factors before buying or selling - trendline analysis, support/resistance lines, and momentum indicators.

The point of all this technical analysis stuff to play the odds. Nothing is guaranteed but a lot of things are probable. You want to find those circumstances when the odds are most in your favor. The way you improve your odds is when you have confirmation from several sources. You want to find stocks with clear trends, favorable support/resistance characteristics, and positive momentum indicators.



9. Your best buys will usually occur after a stock recovers from a deeply oversold reading.

Your buys will usually comes from two sources - stocks that are already moving up (buying high and hoping it goes higher) or finding trend reversals (buying low, hoping to sell higher). If you are looking for bottoms, your most profitable buys will come from stocks that are recovering from deeply oversold readings. This does not mean that you should automatically buy stocks that are deeply oversold. It does mean that when a deeply oversold stock does turn positive, it usually produces big gains.



10. Resistance, once broken, becomes your new support level.

Conversely, support, once broken, become your new resistance level. Pretty straightforward stuff but often overlooked. This principle is important because it helps you identify your mistakes. Buying on breakouts is usually a very good idea. However, if a stock does a quick turnaround and drops below that old resistance (now support) you may have been pushed into a bad trade. Making mistake is not fun, but not admitting them when they happen is very expensive.



11. Let your winners run and cost your losses.

During the course of your trading career, you will have many opportunities to capture a quick buck. While it may be tempting to grab a quick 10% gain, you should not sell until there is compelling reasons to do so. You will probably have a lot of small, profitable trades but there will always be that one or two trades each year that makes you a bunch of money. The success of your year will depend upon that one or two monster trades. On the other extreme, holding on to your losers will probably result in deeper losses. You will screw up - guaranteed. We all do, but the important thing is to cut your losses and look for the next monster trade. Stocks go up and down for good reasons. Do not try to figure out why. Just go find a new, more friendly sandbox to go play in.



12. Expect 1 out of every 3 trades you make to be losers.

Technical analysis will constantly test your faith. Not only should you expect to lose money on about 1 out of every 3 trades, you find that your losers usually come in bunches. You might have 10 good trades in a row and then 5 dogs. It is easy to lose your faith when everything you touch seems to turn into dust. However, if you minimize the impact of your mistakes by quickly cutting your losses, you will be able to prosper as a technician.


These are time-tested principles that will help you sway the odds into your favor. Apply discipline, logic, and probabilities to your stock picks and you should do very well. Re-read these principles frequently. I do and I find it helps me avoid the big mistakes. I hope it help you too.



WARNING:
The above information is provided for general information only, and is not intended for trading purposes. You should carefully consider whether any trading in which you expect to engage will be suitable for you given your financial objectives and financial condition.