Let’s get this out of the way — technical analysis is not sorcery. But a thoughtful application of seemingly arcane TA principles can help you navigate a murky market. First, though, you need to know what to watch.
Click to EnlargeYesterday the S&P 500 closed right near its 200-day simple moving average. The closing print for the S&P 500 was 1377.51, and the 200-day sma closed at 1380.71. As we are once again at this crucial support for the S&P 500, I wanted to take a moment to discuss when big such technical indicators are worth watching — and how to manage a position around them.
I often ask myself whether technical analysis works because traders are all looking at the same indicators, resulting in a self-fulfilling prophecy, or whether the indicator actually reveals some underlying truth about the mechanics of the market. Ultimately, it doesn’t matter — it works. And we can dramatically improve our results if we know which indicator to apply to which index or stock.
In the case of the S&P 500, the 200-day sma has a strong tendency to act as support or resistance, so it’s worth paying attention to.
Click to EnlargeThe two charts at right are of the S&P 500 (SPX) and the Nasdaq 100 (NDX), both marked with their respective 200-day simple moving averages. If you look at the trading action each time the index gets near the moving average you will note how much choppier the Nasdaq 100 reacts. In other words, the NDX shows significantly less respect to its 200-day sma than the S&P 500 does.
And that leads me to the main point — technical indicators are not created equal for all stocks. Every stock or index has its own characteristic, and we have to figure out which indicators work best for the stocks we follow. This applies to moving averages, momentum oscillators, trendlines and many more technical indicators.
Click to EnlargeBack to our current example of the S&P 500 and its 200-day simple moving average. How does one manage a position around such a crucial level without getting stopped out at exactly the wrong time? The indicator has a good track record of acting as support or resistance, but we need to consider the risk of a little overshooting past the moving average that stops out investors with weak hands before reversing right back away from the 200-day sma. To avoid that unpleasant result, keep your stop orders a bit below the indicator in question.
Even if you’re not technically inclined, it’s useful to keep an eye on the big indicators — if nothing else, it’s useful to know what other traders are watching for. And if you match up your index with the right metric, you’ll be ahead of the game.