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.
- 1.Map the TrendsStudy long-term charts. Begin a chart analysis with monthly and weekly chartsspanning several years. A larger scale "map of the market" provides more visibilityand a better long-term perspective on a market. Once the long-term has beenestablished, then consult daily and intra-day charts. A short-term market viewalone can often be deceptive. Even if you only trade the very short term, you willdo better if you're trading in the same direction as the intermediate and longerterm trends.
- 2.Spot the Trend and Go With ItDetermine 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 tradeand 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 theintermediate trend, use daily and weekly charts. If you're day trading, use daily andintra-day charts. But in each case, let the longer range chart determine the trend,and then use the shorter term chart for timing.
- 3.Find the Low and High of ItFind support and resistance levels. The best place to buy a market is near supportlevels. That support is usually a previous reaction low. The best place to sell amarket is near resistance levels. Resistance is usually a previous peak. After aresistance peak has been broken, it will usually provide support on subsequentpullbacks. 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 subsequentrallies -- the old "low" can become the new "high."
- 4.Know How Far to BacktrackMeasure percentage retracements. Market corrections up or down usually retrace asignificant portion of the previous trend. You can measure the corrections in anexisting trend in simple percentages. A fifty percent retracement of a prior trend ismost common. A minimum retracement is usually one-third of the prior trend. Themaximum retracement is usually two-thirds. Fibonacci retracements of 38% and62% are also worth watching. During a pullback in an uptrend, therefore, initial buypoints are in the 33-38% retracement area.
- 5.Draw the LineDraw trend lines. Trend lines are one of the simplest and most effective chartingtools. All you need is a straight edge and two points on the chart. Up trend lines aredrawn along two successive lows. Down trend lines are drawn along two successivepeaks. Prices will often pull back to trend lines before resuming their trend. Thebreaking of trend lines usually signals a change in trend. A valid trend line shouldbe touched at least three times. The longer a trend line has been in effect, and themore times it has been tested, the more important it becomes.
- 6.Follow that AverageFollow 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 isimminent. A combination chart of two moving averages is the most popular way offinding trading signals. Some popular futures combinations are 4- and 9-daymoving averages, 9- and 18-day, 5- and 20-day. Signals are given when theshorter average line crosses the longer. Price crossings above and below a 40-daymoving average also provide good trading signals. Since moving average chart linesare trend-following indicators, they work best in a trending market.
- 7.Learn the TurnsTrack oscillators. Oscillators help identify overbought and oversold markets. Whilemoving averages offer confirmation of a market trend change, oscillators often helpwarn 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 areoverbought while readings below 30 are oversold. The overbought and oversoldvalues for Stochastics are 80 and 20. Most traders use 14-days or weeks forstochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences oftenwarn of market turns. These tools work best in a trading market range. Weeklysignals can be used as filters on daily signals. Daily signals can be used as filters forintra-day charts.
- 8.Know the Warning SignsTrade MACD. The Moving Average Convergence Divergence (MACD) indicator(developed by Gerald Appel) combines a moving average crossover system with theoverbought/oversold elements of an oscillator. A buy signal occurs when the fasterline crosses above the slower and both lines are below zero. A sell signal takesplace when the faster line crosses below the slower from above the zero line.Weekly signals take precedence over daily signals. An MACD histogram plots thedifference 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 differencebetween the two lines on the chart.
- 9.Trend or Not a TrendUse ADX. The Average Directional Movement Index (ADX) line helps determinewhether a market is in a trending or a trading phase. It measures the degree oftrend or direction in the market. A rising ADX line suggests the presence of a strongtrend. A falling ADX line suggests the presence of a trading market and the absenceof a trend. A rising ADX line favors moving averages; a falling ADX favorsoscillators. By plotting the direction of the ADX line, the trader is able to determinewhich trading style and which set of indicators are most suitable for the currentmarket environment.
- 10.Know the Confirming SignsInclude volume and open interest. Volume and open interest are importantconfirming indicators in futures markets. Volume precedes price. It's important toensure 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 interestconfirms that new money is supporting the prevailing trend. Declining open interestis often a warning that the trend is near completion. A solid price uptrend should beaccompanied by rising volume and rising open interest.Technical analysis is a skill that improves with experience and study. Always be astudent and keep learning.
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