Trading Stocks Based on Technical Analysis

When we look to take positions in stocks, we generally do so with an expectation of capital accumulation. We therefore expect the price to move a certain way, hopefully in our favor, over a certain period of time, where we’ll profit from the trade.

Some trades end up being profitable and some do not, and this isn’t done, or rather should not be done, randomly, since this would not represent an advantage to us. The idea here is to seek out such advantages, and the degree that we’re able to do this is going to determine our overall success in trading.

Trading has been described as a zero-sum game, although that’s not exactly true since the market grows like the economy grows, and it’s possible to gain over time simply by trading randomly, on the long side of things. This is the thinking behind index plays, buying a whole basket of stocks, representing a good approximation of the overall market, and as the market grows, the value of the basket will grow.

Trading Stocks Based on Technical AnalysisIt would be a zero-sum game if it were a closed system, but it is clearly not, as more and more money tends to be put into the market over time, even though there are ebbs and flows involved here.

There are some who feel that playing the market as a whole on the long side is the best approach, although it does require a long-term view to better assure that gains from the overall market accumulation of funds will be realized with a good degree of certainty. Income rises over time, and this results in more money invested, and depending on the prevailing economy, income will rise to various degrees, and will be allocated to the stock market in various proportions, as opposed to elsewhere.

So there is some macro technical analysis involved in stock trading decisions, and this actually does matter, even though the very long term views look to take this out of the equation pretty much. Individual traders don’t think very much about these things that much, but this does matter quite a bit, and is really the starting point where technical analysis is concerned.

In seeking to do this, we may rely on macro fundamental analysis, looking at economic indicators, to look to predict the direction of these inflows and outflows. We can also look at what’s actually happening in the market, the actual overall price movements that show us how much money is moving in and out of the stock market over time.

So we’ll look at charts to do this, and this is what technical analysis is, using data on charts to gain insight into future price movements of financial instruments. In terms of the overall market, we can simply use stock indexes to do this, and this is why it’s wise to look at charts of both individual stocks as well as indexes, to decide on our strategies with stock plays.

Taking positions with stocks involves betting on them to either go up or down in the future, and when the overall stock market is moving in the same direction, this can add to your probability of success. While how the underlying economy does certainly matter, there are a number of things that influence the overall market, and looking at the market directly to see what it is doing can provide some valuable insights.

Technical Analysis of Individual Stocks

Quite a few people think that we cannot successfully time either the market or individual stocks, although this is not a correct view. This is certainly not true these days with the minimal costs of entering and exiting trades, with the very small commissions and spreads that are involved.

Net of these costs, a random approach will provide the same results as a buy and hold approach or any approach that does not seek to time things based upon the market, but rather on other things such as when one is planning on retiring.

Any time we can time our trades and get an advantage over just holding something, and that advantage is greater than the costs of trading, we benefit. If the market were truly random, in other words entirely unpredictable, we could not gain such an advantage, but it’s clear that the stock market and stocks do not operate this way, as there is some degree of predictability involved.

Both fundamental analysis, looking at the underlying factors which may influence the price of a stock, how the business is doing for instance, and technical analysis, looking at the actual trading data of a stock, involve gaining information that can assist us in our trading decisions.

While it is made clear in the industry, as a disclaimer, that past performance does not guarantee future performance, it does influence it to some degree. Instead of measuring underlying conditions, technical analysis seeks to measure momentum, trends of inflows and outflows of money with a given issue.

From this, we can gather some insights into where a stock’s price may be headed over a given time frame. These trends in momentum are predictable to a certain extent, and although there is often a fair bit of uncertainty as far as where the price of a stock will move over a given time frame, the goal here is to gain enough of an edge to make trading based upon this analysis more profitable.

To do this, we look at price and volume patterns over time to look to establish trends. Trading stocks always involves speculating over future price movement, and technical analysis certainly is speculative, although in certain situations there is enough predictability present to allow us to take advantage of this.

Using Technical Analysis in Trading Stocks

Technical analysis is similar across all markets, and once one has mastered the skills involved in charting, this provides a solid foundation to interpret charts regardless of the stock or even asset class.

There are some things particular to each asset class though that you have to become familiar with, and with stocks, they do tend to be under accumulation or distribution in ways that may differ from other securities.

This to some degree depends how much liquidity there is with a security, and with stocks, depending on the stock, there may be more or less liquidity involved. The less liquidity there is, the more potential for volatility there is.

Volatility with stock prices can be a good thing, provided that it is fairly predictable. Together with liquidity, these are the three most areas of focus in stock trading. So we’re looking for stocks that move, the volatility, those who move more predictably, and those that have tighter spreads, ones that can be turned around with a minimum of trading costs.

The shorter the time frame, the more important liquidity is, because shorter time frames involve shooting for smaller gains, and the smaller the gains, the more impact trading costs will have on your results.

On the opposite end of the spectrum, if one is planning on holding a stock long term, one won’t really care about having to pay a little higher spread, because it will not represent a meaningful percentage of the win or loss involved over that time frame.

We then look back upon the performance of a stock to look for patterns that may be profitable, and this involves looking at the price movement itself as well as the use of various indicators that account for these price movements in various ways in order to generate trading signals.

Whatever tools we use, we’re looking for two signals, entry signals and exit signals. Essentially, we’re out to come up with a set of trading rules that are going to indicate when we enter and exit trades, and these strategies need to be based upon what tends to work generally, over a random approach.

The better we formulate our trading strategies over a random distribution of results, the better we’ll be at technical trading. Trading costs are subtracted from this if we’re profitable, or added to the losses if they are incurred, and this provides our net profit or loss results.

Mastering Technical Trading

Successful trading based upon technical analysis does require a fair bit of skill, experience, and discipline. All three are very important to acquire, especially the discipline part, which is probably the most difficult part to master.

It is also important to realize that the goal here isn’t to win all the time, it is to acquire a profitable edge. Even the best traders lose a lot of trades, and they aren’t afraid to lose them either, and will exit with a losing position with no hesitation if that’s the best move at the time.

It is also very important not to look at each trade and try to formulate one’s strategies based upon what happened with a single trade or a few trades, and this is a mistake many traders make. So they might have a good plan overall and see it not work in some instances and incorrectly adjust.

Instead, sound technical strategies have to be based upon a meaningful sample, what happens when you do this consistently, otherwise you’ll end up with a haphazard approach which can even have you acting in the opposite way you should, entering and exiting at the wrong times.

There are two main requirements to do this successfully, and that’s to get a good grasp of the theory behind this style of trading, coming up with a good plan, and then becoming successful in putting the plan into action. With real money on the line, it often isn’t as easy as some newer traders think to stick with the plan and not mess it up while in trades, although as we apply ourselves to becoming more disciplined, this skill can be improved as long as one understands the importance of this.

As one gets better at this, one can make decisions on the fly successfully, but it does take a good deal of experience to pull this off and this is not something less skilled traders want to be messing around too much.

Securities move in waves, and the goal with technical trading is to ride the waves. This is not unlike surfing in that regard, and we have some good tools to look to measure where the waves are going, but it takes some real skills to both know when to get on them and get off them.

There is no substitute for experience here, and newer traders generally have no idea how much, and will tend to significantly underestimate this requirement. You do have to put the time into this to master it, but it can be time well spent.

John Miller


John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

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