First steps
Which way is the market moving? How far up or down will it go? And when will it go the other way? These are the basic concerns of the technical analyst. Behind the charts and graphs and mathematical formulas used to analyze market trends are some basic concepts that apply to most of the theories employed by today's technical analysts.
Map the Trends
Study long-term charts. Begin a chart analysis with monthly and weekly charts
spanning several years. A larger scale "map of the market" provides more visibility
and a better long-term perspective on a market. Once the long-term has been
established, then consult daily and intra-day charts. A short-term market view
alone can often be deceptive. Even if you only trade the very short term, you will
do better if you're trading in the same direction as the intermediate and longer
term trends.
Spot the Trend and Go With It
Determine the trend and follow it. Market trends come in many sizes -- long-term,
intermediate-term and short-term. First, determine which one you're going to trade
and use the appropriate chart. Make sure you trade in the direction of that trend.
Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the
intermediate trend, use daily and weekly charts. If you're day trading, use daily and
intra-day charts. But in each case, let the longer range chart determine the trend,
and then use the shorter term chart for timing.
Find the Low and High of It
Find support and resistance levels. The best place to buy a market is near support
levels. That support is usually a previous reaction low. The best place to sell a
market is near resistance levels. Resistance is usually a previous peak. After a
resistance peak has been broken, it will usually provide support on subsequent
pullbacks. In other words, the old "high" becomes the new "low." In the same way,
when a support level has been broken, it will usually produce selling on subsequent
rallies -- the old "low" can become the new "high."
Know How Far to Backtrack
Measure percentage retracements. Market corrections up or down usually retrace a
significant portion of the previous trend. You can measure the corrections in an
existing trend in simple percentages. A fifty percent retracement of a prior trend is
most common. A minimum retracement is usually one-third of the prior trend. The
maximum retracement is usually two-thirds. Fibonacci retracements of 38% and
62% are also worth watching. During a pullback in an uptrend, therefore, initial buy
points are in the 33-38% retracement area.
Draw the Line
Draw trend lines. Trend lines are one of the simplest and most effective charting
tools. All you need is a straight edge and two points on the chart. Up trend lines are
drawn along two successive lows. Down trend lines are drawn along two successive
peaks. Prices will often pull back to trend lines before resuming their trend. The
breaking of trend lines usually signals a change in trend. A valid trend line should
be touched at least three times. The longer a trend line has been in effect, and the
more times it has been tested, the more important it becomes.
Follow that Average
Follow moving averages. Moving averages provide objective buy and sell signals.
They tell you if existing trend is still in motion and help confirm a trend change.
Moving averages do not tell you in advance, however, that a trend change is
imminent. A combination chart of two moving averages is the most popular way of
finding trading signals. Some popular futures combinations are 4- and 9-day
moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the
shorter average line crosses the longer. Price crossings above and below a 40-day
moving average also provide good trading signals. Since moving average chart lines
are trend-following indicators, they work best in a trending market.
Learn the Turns
Track oscillators. Oscillators help identify overbought and oversold markets. While
moving averages offer confirmation of a market trend change, oscillators often help
warn us in advance that a market has rallied or fallen too far and will soon turn.
Two of the most popular are the Relative Strength Index (RSI) and Stochastics.
They both work on a scale of 0 to 100. With the RSI, readings over 70 are
overbought while readings below 30 are oversold. The overbought and oversold
values for Stochastics are 80 and 20. Most traders use 14-days or weeks for
stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often
warn of market turns. These tools work best in a trading market range. Weekly
signals can be used as filters on daily signals. Daily signals can be used as filters for
intra-day charts.
Know the Warning Signs
Trade MACD. The Moving Average Convergence Divergence (MACD) indicator
(developed by Gerald Appel) combines a moving average crossover system with the
overbought/oversold elements of an oscillator. A buy signal occurs when the faster
line crosses above the slower and both lines are below zero. A sell signal takes
place when the faster line crosses below the slower from above the zero line.
Weekly signals take precedence over daily signals. An MACD histogram plots the
difference between the two lines and gives even earlier warnings of trend changes.
It's called a "histogram" because vertical bars are used to show the difference
between the two lines on the chart.
Trend or Not a Trend
Use ADX. The Average Directional Movement Index (ADX) line helps determine
whether a market is in a trending or a trading phase. It measures the degree of
trend or direction in the market. A rising ADX line suggests the presence of a strong
trend. A falling ADX line suggests the presence of a trading market and the absence
of a trend. A rising ADX line favors moving averages; a falling ADX favors
oscillators. By plotting the direction of the ADX line, the trader is able to determine
which trading style and which set of indicators are most suitable for the current
market environment.
Know the Confirming Signs
Include volume and open interest. Volume and open interest are important
confirming indicators in futures markets. Volume precedes price. It's important to
ensure that heavier volume is taking place in the direction of the prevailing trend.
In an uptrend, heavier volume should be seen on up days. Rising open interest
confirms that new money is supporting the prevailing trend. Declining open interest
is often a warning that the trend is near completion. A solid price uptrend should be
accompanied by rising volume and rising open interest.
Technical analysis is a skill that improves with experience and study. Always be a
student and keep learning.
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