This is why technical analysis works
Friday, 1 November 2019
By Murray Dawes
- Prices often oscillate around a central point
I have recently started sending you a weekly market update video on Monday’s called ‘The Week Ahead’. You’ll find it after the main article in Port Phillip Insider.
My goal with the videos is to give you some real-time analysis of markets using my proprietary technical analysis system.
I want to show people who are sceptical of technical analysis (TA) that it works. Past price action does affect future trading.
The long-term fundamental situation will end up driving the price. No argument there. But if you don’t understand how short- and long-term traders are positioned and where their stop-losses probably are, you are flying blind in my view.
I have little time for classical technical analysis. Most of it sounds great after the fact, but we all know Harry Hindsight is the best trader in the world. I don’t think lagging indicators such as moving averages, MACDs or RSIs work as a primary tool for making decisions about entering a stock. The market is way too fast. There are too many traders falling over themselves trying to make them work for there to be an edge trading them.
People talk about technical analysis as if it is one concrete set of rules that all technical analysts follow. Nothing could be further from the truth. There are many different theories out there and I must admit, I reckon most of them are a bunch of hocus pocus.
Overnight the Dow Jones Industrial Average closed down 140.46 points, or 0.84% to 27,046.
The S&P 500 lost nine points, closing at 3,037.
In Australia, the S&P/ASX 200 is treading water at 6,638 after selling off 150 points over the last few days.
On the commodities markets, West Texas Intermediate crude oil is US$54.34 per barrel. Brent crude is US$59.70 per barrel.
Turning to gold, the yellow metal is trading at US$1,513 (AU$2,188) per troy ounce.
One bitcoin is worth US$9,135.
The Aussie dollar is continuing to rally after the US rate cut, up 0.17% to 69.07 US cents.
So how on Earth does a novice wade into the jargon filled world of technical analysis and make any sense of it?
If your response has been to say it’s a bunch of BS, then my job is to get you thinking about it at a deeper level so you can reap the benefits of trading in this way.
Even if you are an investor you can use TA to help you get into powerful positions in your investments. Wouldn’t you rather be in a stock knowing that the only outcome you will receive is to either make money or breakeven? Even better, you can work yourself into a situation where you will either make some money or a lot.
If you understand how most traders behave and can pinpoint where they will stop out of their positions, don’t you think it could be handy? You can enter a position after they have stopped out and pushed the price down to major support.
When viewed in this way TA has nothing to do with predicting the future and everything to do with risk management. Sounds boring, but it’s far more fun making money than losing it.
I may have spent months following a company, reading reports and arriving at a positive fundamental view of the company’s prospects. But at the end of the day, all that matters once I enter is my stop-loss and initial target.
If I am going to get stopped out of a stock I want to make sure that I’m wrong. There is nothing worse than choosing a stop-loss level based on how much money I am willing to lose rather than choosing a price where I am proven wrong.
I want to feel happy when I stop out. I want to think to myself ‘thank God I got out there because now it can drop like a stone’. If that means I can’t put a very big position on because I won’t be proven wrong until the stock falls 40%, then so be it. I’d rather be in a small position that ends up making me a 100% return than having a big position that loses 20%.
If you don’t know how to work out where you are proven wrong, then you need to start watching a few of my videos. There are plenty of hints in there.
It may take some time for me to educate you about my way of viewing price action. There will be new concepts that you haven’t heard about before. It may sound a little confusing at first, but I assure you it isn’t once you get the hang of it.
If I were to give you the elevator pitch for my TA method, it is that I am interested in where prices often change direction and how they change direction. I also believe that prices are usually trading in a range or ‘mean reverting’ (i.e. they spend a lot of time gravitating back to a central point) and I use this fact to get into powerful trading positions.
My initial targets are usually at or near one of these central gravitational points around which prices oscillate.
Prices often oscillate around a central point
Source: Port Phillip Publishing
Click to enlarge
If my odds are high that the central ‘point of control’ will be hit, then that’s where I need to take some money off the table. Who knows what will happen once the high probability event has happened? I certainly don’t.
You could say that my technical analysis approach is based on having a fairly good idea about what the short-term direction of prices will be. I accept that I don’t know what will happen after that, so I want to be free carried from that point on. That’s it.
No big sweeping statements about the future. No gazing at a crystal ball. Just a clear statement that I believe there is a greater than 50% chance that prices will get to ‘A’ before they get to ‘B’.
Once the initial target has been hit, I take a third of my profit and adjust my stop-loss to a breakeven level for the whole trade. This is a very important aspect of the whole system. It immediately lowers pressure to near zero. But it also gives the market plenty of room to move from that point forward.
If you haven’t already worked it out, markets are volatile. Incredibly volatile.
Coping with the volatility both mentally and financially is all important. If you have ever traded the stock market, you know the feeling of being tossed around like a rag doll. Intense feelings of joy as your stock passes the 100% mark collapses into fits of panic after a bad announcement. Do you get out? Do you hold on? Double up? Take part profit?
Making decisions during volatile periods is wrong. You don’t want to be reactive. You must be proactive. Every decision you make should be the result of your trading plan and not current volatility.
That’s why I happily take a third profit at my initial target no questions asked. It doesn’t matter if a great announcement came out that morning. I don’t care. I want to get to the point where I will either make money or breakeven as quickly as possible.
The payoff on my trades once I have taken some profit are like a free ‘in the money’ call or put option. In other words, I get to have a free look at what happens in future without risking my initial capital.
My goal is to build up as many of these seeds as possible and then sit back to see what unfolds.
Trading in this way keeps stress levels low. You make far better decisions when you are feeling calm than when you are fretting over every tick up and down in a stock.
Technical analysis can be a very useful tool. It’s not a prophecy about future market direction. It’s just an analysis of where the market is in and out of balance. That knowledge is then used to plan trades with the best risk/reward characteristics.
You can have a look at the video I sent out on Monday here. In it I pointed out that I was waiting for a daily sell pivot in the ASX 200 and if it occurred I thought we would see a correction. Prices are down 150 points over the last few days with the daily sell pivot confirmed on Wednesday. Was it just a bunch of mumbo jumbo or was I spot on? You decide.
Editor, Alpha Wave Trader