that I use to make successive triple-digit-percentage returns over the years is technical analysis.
Technical analysis is the practice of anticipating price changes of a financial instrument by analyzing prior price changes
and looking for patterns and relationships in price history. It is founded on the principle that stock prices move in trends.
Prices do not continue in a trend in perpetuity. When prices change direction, the move seldom comes cleanly and unequivocally.
Prices tend to move back-and-forth, zigzagging up and down, as investors try to analyze the market and arrive at new price expectations
for the stock.
Taking the Guesswork Out of Investing
I don’t have any secrets or special insight into what the markets, stocks or options are going to do. Quite simply, I’m just
a math geek at heart. Patterns and probabilities are my comfort zone, as analyzing charts opens up my trading account to endless
possibilities.
The more you know about the securities you’re trading, the better your returns will be. Understanding how they’ve traded in
the past, what their trigger points are, what the classic chart formations mean and the time they take to play out, and which
signals mean a stock is going to stumble or soar, means that there’s no reason to guess where a stock’s heading next.
And when you’re anticipating a significant stock move in a short period of time, well, what better way to play it than by buying
options? In this time of market uncertainty — where it used to take certain stocks a year to move 20% and now it might only take
a week or even a day to cover the same amount of territory — there’s no reason why you shouldn’t be trading (in particular,
trading options) to take advantage of those quick swings that can lead to even quicker profits.
The Basics
Often when people think of technical analysis, they can feel overwhelmed with the vision of charts and unfamiliar phrases like “candlesticks,” “moving
averages” and “trendlines.” Just as there are thousands of stocks available for trading, so too are there myriad ways to analyze
the way they trade.
So, what kinds of indicators do I use to generate triple-digit trading profits?
In a nutshell, all I’m really looking for are signals that help me determine the speed, direction and distance of an underlying
stock so that I can uncover the best options to take advantage of the expected movement.
Consider the next 10 tips your primer on getting started with technical analysis.
Tip #1: Play the Trend
At the core, there are really only two trends that comprise technical analysis: continuations or reversals. So, technical analysis
helps us identify whether an underlying security’s movement (whether it’s a stock, option, bond, ETF or commodity) will remain
the same or change.
Technical analysis essentially holds that the history of a price action helps to define and shape future events. So, for example,
if traders supported a stock on light-volume pullbacks to the 50-day moving average, they are likely to do so again.
Tip #2: The Smallest Changes Can Equal the Biggest Movements
Sometimes, spotting even the smallest deviation in a stock’s “normal” (or expected) trading pattern can make a huge difference.
And as you well know, a new “normal” is being defined practically every day, but there are decades of history that tell us how
stocks reacted to similarly volatile conditions and events.
For example, if a stock doesn’t trade above a certain level within a defined time frame, it may be that it will instead experience
a new low. But if the overall market rallies and takes that stock up with it, the stock may instead run to new highs … simply
thanks to the market having a good day instead of a bad one while the stock was trading in a particular pattern. At a very organic
level, we use technical analysis to spot small changes in the charts before anyone else so that we can get positioned to enjoy
large-scale profits in our trading accounts.
Tip #3: Technical Events
Chart patterns and relationships can be used in a number of ways, including:
- Entering a new position (either a long position or a short position)
- Closing an existing position
- Indicating when a better time to take action may come
Technical analysts get these cues from what are known as “technical events.” Technical events occur when a significant pattern
has formed or a significant price activity has occurred in a financial security. They highlight price situations that may be worth
considering when researching an investment activity, and technical events usually occur when the price of a financial instrument
crosses a critical line or threshold.
Examples of technical events include the confirmation of a price, confirmation that a pattern has formed, or confirmation that
the price crossed a specific moving average.
Tip #4: Moving Averages
One of the most popular and easy-to-use tools available to the technical analyst, a moving average is an average price over
a specified period of time. You’ve probably heard of the 5-day, 10-day, 20-day, 50-day, 100-day and 200-day moving averages, but
the ones that may come in most handy are Simple Moving Averages (SMA) and Exponential Moving Averages (EMA). Both use closing
prices over a designated time frame to come up with the “average” price; the difference is that the EMA gives greater weight
to newer data.
In effect, moving averages smooth a series of data and make it easier to spot trends — something that is especially helpful
in volatile markets. So, while individual stocks or indices may experience wild intraday swings, the average price for the day
provides enough information to the technical trader to do longer-term analysis on how it will perform in the coming days, weeks
or months. And moving averages help traders spot the cornerstones of technical analysis, which are levels that form support and
resistance for the security’s price.
Tip #5: Continuations and Reversals
As I stated earlier, trends tell us direction, and there are really only two trends to technical analysis: continuations and
reversals.
A continuation indicates that a stock may be taking a slight detour toward where it’s ultimately headed, but it will likely
resume its expected pattern.
A reversal is a breakout in a direction opposite to the previous trend. It marks a change in direction of the price of the stock.
The two different types of primary reversal trends are bullish trend reversals and bearish trend reversals.
Trends and reversals are the basic foundation upon which technical analysis is built. So, if you get these basic concepts, you’re
on your way to becoming an expert in technical analysis!
Tip #6: Support
Fortunately, the real-life definitions of support and resistance translate fairly accurately to the world of technical analysis.
They are simply areas where buyers and sellers have shown a better-than-average willingness to either buy (in the case of support)
or sell (in the case of the resistance).
They’re simple ideas, but remember that prices are ultimately decided by human emotions. This trading range may develop over
just a couple of months, or sometimes it can take a year or more to develop — it usually depends on the trading range the technician
is examining.
Support levels are usually the result of buyers being rewarded for purchasing a stock at a specific price. I hope that you can
think of a time when you bought a stock that immediately rallied. Chances are good that you felt very pleased, and then, after
selling that stock for a profit, you were probably more likely to consider buying that stock on dips (or pullbacks) at the same
price level.
The mentality behind support tends to be “if it worked once, it will work again.” When you have enough buyers entering at a
certain price, it becomes a support level.
Tip #7 Resistance
Resistance levels work inversely to support, but just as simply. Resistance points often occur after a stock makes a prolonged
advance after an important news event, such as an optimistic earnings outlook or a successful new product launch.
As the stock rises, early investors sell their holdings as they reap the gains they anticipated, but many investors arrive to
the party late and buy in at an already-inflated price. Then they are trapped, as the absence of new buyers leads to the stock’s
weakness at the high valuation, and its value begins to fall.
Then, every time the stock subsequently rallies to this level, those latecomers will sell their holdings to try and recoup losses,
thus forming a resistance level.
Tip #8: Volume
Support and resistance levels have a lot to do with volume. For our purposes, trading volume is the number of shares or contracts
traded for a security during a given period.
Point blank, volume should follow the trend. That is, in a bull market, volume should increase on rallies and contract on declines.
In a bear market, volume should grow on declines and contract on rallies. But what happens if volume doesn’t follow the trend?
Say, perhaps, that a stock advances and volume contracts. Or a stock falls and volume expands.
While it shouldn’t happen, when it does, it almost always leads to a sharp reversal, which means a profit opportunity could
be in store for traders. Changes in volume often equate to significant price changes.
Tip #9: Consolidations and Breakouts
Often, when investors are uncertain about a security’s value, volume will wither and the trading range will narrow as traders
move to the sidelines and wait for more information about the security’s outlook. As soon as they get the data they need to make
a move, they pile in, volume expands and the security sees a large jump in its price.
The time that was characterized by dwindling volume as investors waited is frequently called a consolidation, during which a
security moves a lot less than analysts expect. Conversely, a breakout is the period immediately following a consolidation, when
traders see the large price jump.
Statistically speaking, securities are in some stage of consolidation about 70% of the time and are making dramatic breakouts
the other 30% of the time. Being able to indentify volume phenomena can help you to spot potential breakouts and protect yourself
from consolidations.
More from Optionszone.com: The Key to Finding the Right Stock to Trade — Plus 6 Earning Trades
Tip #10: Oscillators
I look very closely at several oscillators. Simply put, an oscillator is a tool that is banded between two extreme values and
built with the results from a trend indicator for discovering short-term overbought or oversold conditions.
To understand how oscillators work, think about the movement of an oscillating fan, as they simply look at a limited range of
historical trading “area.” As the value of the oscillator approaches an extreme upper value, the asset is often said be overbought.
As it nears the lower extreme, analysts will often say it is oversold.
Oscillators are the most helpful when no clear trend is discernible in a particular security or even in the overall market,
like when we see sideways (or flat) movement.
Some of the more common oscillators that you may have heard analysts talk about are the stochastic, the Relative Strength Index
(RSI), the Money Flow Index (MFI) and the momentum oscillator. Personally, I primarily use three oscillators to provide signals
on direction: the Williams Percent Range, the Aroon Oscillator and the Price Percentage Oscillator (PPO).
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