Welcome to another blog post by me, LJ Nissen. In this guide we are going to be talking about technical analysis for beginners.
(This is part 1 of a series of articles. You can find part 2 here. If you want to learn more about Technical Analysis of individual precious metal charts, you can do that here.)
When I first started out trading a few years ago there weren’t too many resources available for rookie traders.
Sure, there were tips on which stocks to trade and how to do it with technical analysis, but not from a point of view where the whole situation was considered.
As a result I made enumerable mistakes where I lost almost all my money – doing what I otherwise really wanted to do.
The situation felt awkward.
After many years working in a very interesting field – scientific research – I had finally found my passion, but now I couldn’t do it because I didn’t have the resources.
It felt frustrating so in this article I wanted to change that.
Here I want to help you find your way around the technical terms used when trading stock.
I would like to give you a bottoms-up guide of the whole process.
A process that will span everything from your personal finances and online brokers to methods of trading that are good for beginners.
So let’s dive in!
Where you are at
If you don’t mind, I’m going to start with a few assumptions that I make about you.
The reason for me doing so is that it helps me as author of this guide to help you with technical analysis.
The assumptions are probably not completely correct, but close enough for you to have an interest in what I write:
- I’m going to assume that you still have your day job. That is a good thing, because it limits your trading to a level where you can consider it a hobby and not a full time job. It also pays your bills – at least food and rent -so that you don’t have to pay those from your trading account.This is positive from a trading perspective.
- My second assumption is that you’ve already dipped your toes into the stock market. Maybe you have made a little bit of money investing or trading and now you are eager to learn more. The money you have made may not be too much, but enough to whet your appetite. And now you want more of the same, but you don’t know where to find the information needed to continue.
- My third assumption will be that you don’t yet have the skills in technical analysis needed to become a successful trader. Of course, they are important if you want to become a trader, but how do you get them if you haven’t had anybody teaching you? Don’t worry! I will go through those in this article.
I’m also going to assume that you at least have a basic understanding of how the internet works.
Even if these assumptions are off by far you will get value out of this article anyway. So please continue reading!
Part 1 – The basics
One big advantage that you have when you are betting on the race track over somebody trading is that you always bet a fixed amount.
You go up the counter and put a 20 dollar bill to bet on a specific horse in a specific race and then you watch the horses run.
What will happen if your horse does not win?
You will only have lost your 20 dollars.
When you are trading you do not have that advantage. If a trade goes against you, you can lose more money than anticipated.
That is why trading the stock market can be a very dangerous game if you have people that are financially dependent on you.
So what you need is a system where you know in advance how big your gains and losses will be.
What the systems does is that it takes the emotion out of your trades so that you can focus on executing them.
There are several systems that you can use.
What I will propose in this post is a system that works for me, but it may be that you have come up with a better one.
The point being that you need to limit your losses and maximize your gains and the only way to do that is by being systematic about your trades.
That is the only way to make money consistently.
My first advice if you are only starting out is to start small.
My recommendation would be to start with a minimal account of 10000 USD.
In that way you will have a good balance between making gains and limiting losses.
The amount is small enough so that you can live with the losses that you will inevitably make while learning.
At the same time the amount is big enough so that you can feel the gains when you make them.
That is the main reason why I don’t like to trade with demo accounts.
After all what’s the point in trading if you don’t reap the rewards?
The problem if you are using a too small amount is that you will not be able to reap the rewards of a good trade when you make it.
Similarly if you are using a too big amount to start with you will feel stressed every time a trade goes against you.
This is the mindset that you need to learn:
Not all of your trades will be beneficial and some of your trades will go against you.
Of course, the opposite is also true in that you can also expect some gains, but this should not be a cause for being cocky.
Another thing that is crucial when trading is to keep a record of each trade.
That can be a hand written journal in a file or in electronic form. It really doesn’t matter.
That way you can go back and review what had happened to a particular trade, when you got out of the trade or if you were stopped out.
In this way trading is a lot like doing experiments in the lab (my former profession).
The most important thing in research is the lab journal and the same goes for trading.
In the journal you should always note things like date and time, points of entry and exit and how much money you had put into that particular trade.
I cannot stress the importance of the journal strongly enough. Please keep one for your own sake.
That way you can go back to your trades, review them and see what worked and what did not work and why.
Now, companies usually report their earnings four times a year and the price swings happening after those results have been published can be violent.
Those price swings are not coming from the results themselves but from the expectations of the results.
For example, if the market expects company ABC to have consistently good earnings, but ABC misses slightly on earnings growth, the sell-off that can follow may be violent.
Under those circumstances you don’t want to hold your stock and it is better to get out.
Part 2 – The specifics
If there is one thing that I have learnt in life it is that we all need systems in order to function.
It can be a system of movements that you are performing every day when you are in your car or it can be a system when dealing with your daily chores.
It doesn’t matter what it is. We all need systems to make life easier.
This is especially true when you are trading.
Well, for one you need a system that will limit yourself to the downside as well as to the upside, but the bottom line is that you need those rules in order to function.
What does not work is to live life without the constraints of rules. Then everything from cleanliness in the house to a healthy food intake will start to fall apart.
So what rules can be applied to trading?
In essence, we need a system where we can:
- Limit our losses, and
- Maximize our gains.
It is as simple as that.
Trying this out, the best thing that I’ve come up was developed by Quint Tatro of Tatro Capital.
Experimenting with this back and forth, the method is what I now call the “3-step” method.
What you do is that you set aside a small percentage of your account for each trade.
That will be a small amount in the order of magnitude of 0.5% of your total account.
It is very important that you do not exceed this amount under any circumstances.
Remember that your money is the life blood of this business.
By using technical analysis you will then be able to identify where to get in and – most importantly – where the particular trade is no longer viable.
That point will be your stop.
Now, whatever happens always respect your stops.
That point cannot be stressed enough.
You don’t want to find yourself in a situation where you lose copious amounts of money and only seeing the losses getting bigger and bigger by the hour and minute.
Now the advantage of doing this is that you can then calculate how much you would lose if the trade goes against you and you reach your stop.
That way you know exactly how much you are betting. In this way, trading gets similar to the race track.
So let’s get into some numbers.
What I prefer is to use a spreadsheet for this purpose, but you can do it any way you want.
The calculations will look something like this:
Figure 1. Spreadsheet of entry and exit points when using the 3-step method of trading stocks.
In Figure 1 you can see how we plan our trade.
We will get in at a particular price, in this case 9 USD.
Now if the trade does not go in our favor we will be stopped out 8.5 USD.
What we will then do is to calculate the differential between our entry point and our stop and add that value to our entry point.
In this case it would be:
9.0 USD – 8.5 USD = 0.5 USD.
If we add this to our entry point we will have what I call 1x.
Then when we set up our trade we can define at which point we will get out.
What you will then do is to get out at three instances: 1x, 2x and 3x.
We take one third off at each exit point.
Now we have set up a system that:
- Will have made sure that you have defined the amounts involved before acting on the trade.
- Allows you to take the emotion out.
These are the two main characteristics that we want from a trading system: The ability to know how much money there is at stake and to be able to sleep at night.
The method may seem awkward at first but when you get used to it, it becomes second nature.
Please take a few moments to familiarize yourself with the steps before implementing them.
Part 3: The technicals
Now we have come to the part where I will introduce you to the technical patterns involved in trading.
Of course the charts themselves are not a prediction of how the market will behave, they will merely lay out what is probable based on experience.
The moving average
My favorite technical indicator is the Moving Average.
What the moving average does is that it takes the average opening and closing values and plot them in a curve that will be displayed in the chart.
When looking at charts I usually display three moving averages which are good for different purposes.
I’m using the 10-period, the 20-period and the 50-period moving averages.
In Figure 2 there is an example of what I mean.
Figure 2. Weekly chart of the exchange traded fund GLD in August of 2015. The 10-, 20- and 50-period moving average are shown in yellow, red and blue, respectively.
When I look at a weekly chart, the intermediate term movements will be determined by the direction of the 50-week moving average.
Similarly, the 10-week moving average will tell you more about the direction in the short term.
Now, the 10-week moving average is for all intents and purposes similar to the 50-day moving average.
If your stock is trading above the 50-day moving average it is a bullish sign near term.
If, on the other hand it is trading below the 50-day moving average it is bearish.
The 10- and 20-period moving averages are useful for looking at the movements that are extremely near term and personally I don’t find them to be particularly useful.
Resistance and support
One thing that must be grasped with chart movements is the concept of resistance and support.
This goes back to the mass psychology of the markets and tells you when the last trader is changing his or her position.
A resistance zone will appear when there are enough traders willing to sell stock at a particular level.
Similarly, a support zone appears when traders are willing to buy at a particular level.
Let me illustrate what I mean with a chart.
In the chart, a support zone is found at the 100 USD level and similarly a resistance zone is found around 200.
Figure 3. Chart of the ETF BOIL illustrating the concept of resistance and support zones.
When a support or resistance zone is then finally broken, the chart will move out of the zone without hindrance and the moves can be violent.
Again, mass psychology can explain what happens.
There is no one willing to buy the ETF beyond the 230 level and once it drops below support at the 100 USD level it will quickly move down to a new support level around 40 USD.
The pennant
One of the more effective chart patterns is a reflection of the above, the pennant.
In the pattern, a resistance zone and a support zone is gradually merged together reducing the volatility in the trading of the stock.
What it means is that buyers and sellers are gradually moving closer to one another and when one of those finally gives way the move will be particularly violent in either direction.
Figure 4. Daily chart of the dollar index, DXY0, illustrating the concept of a pennant.
Resistance and support zones are here represented with converging straight lines.
Head and shoulders
Head and shoulders patterns appear when discrete moves out of resistance/support zones can be observed.
The chart may first have broken out of resistance only to find itself with a new level of resistance higher than the first where it is then trading for a given amount of time.
If it cannot hold this level and falls back to the first level it will find that the old level of resistance is now support and the chart will move sideways for some time.
What then happens is that this support zone is gradually giving way and when it is up the chart action will be particularly violent.
The fall can then be semi-quantified in that the move from the first resistance zone to the second (left shoulder to head) will also apply to the right shoulder.
In Figure 5 there is an illustration of the chart action.
Figure 5. Head and shoulders chart action. The zone of resistance of the left shoulder is represented to the left, the head in the middle and the right shoulder to the right. The distance, d, between the left/right shoulder and the head can be applied to quantify the size of the move.
Conclusion:
In this article I’ve been talking about the need to start small if you are an aspiring trader and want to start out with technical analysis.
If you are a beginner I suggest you to use somewhere between 8000 and 10000 USD in your trading account.
That amount is big enough so that you limit your losses when they occur and at the same time lets you dip your toes into the gains that can really be made.
What I’ve also been talking about in this article is the need for a system that takes the emotion out of your trades.
The best system that I have come up with is what I call the 3-step method of trading stocks.
What it does is that when a particular trade is identified a small percentage – usually 0.5 % – of your total trading account is committed.
The first thing that you then do is that you identify your stop which will be the point where you will have to admit failure and move on.
Not to do this is a very dangerous game so always respect your stops!
You will then measure the distance between the stop and the entry point in the chart to identify the 1x, 2x and 3x points which will be your exit points.
I have also talked briefly about different chart patterns. What they mean, their limitations and how you can use them to your advantage.
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Published August 20’th 2015.
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