by Ian Harvey
Introducing the Technical Trading Style
Technical analysis is widely used to augment many different trading philosophies, but in a broad sense, can also be thought of as a trading style in its own right.
Technical traders study price movements through the use of charts. By identifying particular known patterns, often in conjunction with technical indicators, supporters of this technical trading style, believe it is possible to gauge the prevailing market sentiment and, therefore, gain some insight into how the price is likely to change.
Head and Shoulders
One of the best-known formations is the head and shoulders, where a high (the left shoulder) is followed by a higher high (the head) and then a lower high forming the right shoulder. This pattern often heralds a breakout from the neckline — the line linking the lows on either side of the head.
Another popular pattern to look for is a congestion area, which is essentially a consolidation phase following a move. The majority of these tend to resolve themselves in the same direction as the preceding trend.
Technical traders, using this technical trading style, generally use indicators in conjunction with the charts to help gauge the strength and direction of the underlying price movement. An indicator is solely designed to help interpret the price movements; it is not in any way intended to be a substitute.
Which Indicators and How Many to Use….. is extremely important for the success when using this technical trading style.
Traders should not be misled by the precision and, in some cases, the complexity of the formulae used to calculate the indicators because the final interpretation inevitably remains more of an art than a science. One aspect of this is learning just which of the hundreds of indicators to actually use.
The mere fact that there are so many indicators reveals the truth of the matter, namely, that some work better in certain circumstances than others. As there is no universally accepted view as to which ones are the best, most traders, using this technical trading style, gradually develop their own short list of favorites that they become familiar and confident with.
As tempting and as easy as the technical analysis software makes it to keep adding extra indicators to the charts, it is most certainly not a case of "the more the better." Few technical trading style traders use more than two or three in a single analysis because any more would just be likely to confuse the issue.
The final selection is largely a question of personal preference and experience, but most would agree that it makes sense to pick indicators that complement each other rather than those that measure the same phenomena. For example, there would be little point in using both Stochastics and RSI because both measure momentum and have overbought / oversold levels.
One of the most popular and intuitive indicators is the ”moving average”. This simply calculates the average (usually closing) price of a security over a specified period of time. Moving averages are lagging indicators and are used to emphasize the direction of the trend. For example, when a stock moves below its moving average, it is a negative trend and vice versa. Views differ as to the best periods to use, but, for longer-term traders, the 50- and 200- day moving averages are among the most widely watched.
Combining Moving Averages and the Relative Strength Index
A chart combining two moving averages provides one of the most popular ways to identify a trading signal for the trader using this technical trading style. If the shorter (faster) moving average moves above the longer (slower) moving average, this represents a buy signal, while a sell signal is given when it dips below.
1. Go short when the fast moving average crosses to below the slow moving average.
2. Go long when the fast moving average crosses to above the slow moving average.
3. No action is taken as the MA's have not crossed.
4. Go short.
5. Go long.
6. Go short.
7. Go long.
The system reduces whipsaws but still signals losing trades during a ranging market. Trailing Stops may help to eliminate unprofitable trades.
The number of signals generated depends on the length of the moving averages -- the shorter, the greater the number of signals but the more that will be false. Because of this, moving averages are best used in conjunction with another indicator, such as the popular Relative Strength Index (RSI).
The RSI compares the number of days that a stock finishes higher against the number that it ends lower. In value, it ranges from 0 to 100 with, in general, a stock being considered overbought if it reaches 70 — a sign to consider selling. Similarly, if a security approaches 30, it is usually regarded as a buy signal. In a true bull or bear market, these numbers tend to be changed to 80 and 20, respectively.
The majority of analysts use a 9- to 15-day RSI. The shorter the number of days used, the more volatile the indicator but, also, the more susceptible it becomes to big surges or falls in stocks dramatically affecting the RSI, potentially resulting in false buy or sell signals.
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