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June 24, 2017
 
 

Course #203: Technical Analysis

Introduction

There are many books and Web sites that try to explain TECHNICAL ANALYSIS (TA). Dan and I have read our share of them and a few are very good. But why is this course any better than the others?

This online course is a blend of concepts, theory, real-world applications, examples and our own experiences specifically designed to help you make money in the markets and keep the money you make! We believe this course will provide you with the necessary tools to help you create wealth in the stock market. After each lesson you can apply what you have learned by studying the charts of your own stocks and studying the major indexes.

In order to profit consistently over time while investing (or trading) you have to gain knowledge and experience, which will help you keep those profits. You must have discipline. And you must be willing to take calculated risks. Calculated risks!

In the lessons that follow we will share our experiences with you. And with time you will be able to develop your own philosophy, methodology and discipline. You will enable yourself to identify and take the calculated risks in the markets that stack the odds in your favor. And you will discover how to control risk toward the end of making and keeping a profit. Sure, it's fun. But let's not lose sight of why we're doing this!

EXACTLY WHAT IS IN THIS COURSE?

First we will describe some of the most common, popular and broadly useful tools of the chartists and technical analysts. Then we will dig a bit deeper into a number of technical indicators and oscillators. Finally, we'll share some of the proprietary indicators available at 21st Century Investor, specifically those used in The Agile Trader.

JUST WHAT IS THIS TECHNICAL ANALYSIS STUFF?

Before we dig into the many concepts and tools used in Technical Analysis (TA), we need to be able to answer a couple of basic questions:

  1. What is Technical Analysis (TA) and how do you use it?
  2. How is it useful?

1. What is Technical Analysis and how do you use it?

TECHNICAL ANALYSIS (TA) involves tracking price, volume and time data from trading instruments usually on charts or spreadsheets in order to understand the behavior of those instruments. The goal of understanding the behavior of the instruments is to determine the most advantageous points at which to buy and sell instruments in order to make money. But not just to make money -- also to limit risk. TA is used in trading commodities, stocks, stock indices, futures, currencies, bonds and virtually anything else for which data can be collected and organized. Indeed, the Japanese began using a kind of TA as far back as the mid-1800s while trading rice.

Chartists look for identifiable patterns in the collected data and make their best efforts to predict near-term future behavior based on the patterns. Markets have certain kinds of regular "customs" or "laws" which we try to identify and use to forecast the future.

In this course we will deal primarily with stocks and stock indices. The principles of charting apply to all markets, although there are some variations in what works best or least depending on the properties of the markets under scrutiny. For instance, the long-term pattern of certain commodity markets are essentially flat while the long-term pattern of the stock market appears as an exponential curve.

But what are we really doing? What are we measuring? We are measuring buying and selling. We are keeping track of buying and selling over a particular period of time and how much buying and selling moves the price of the instruments.

Who is doing this buying and selling? Professional money managers who work for large mutual funds, hedge funds, wealthy individuals, pension money and insurance companies. There are also traders on the floor, super computers spitting out program trades and people sitting in their basements making trades on their computers. Millions and millions of decisions are being made all day long in every corner of the globe. And when you aggregate the whole mess you see that some sort of society has formed in a marketplace. That market is arguing, constantly voting with its dollars on the subject of fair value and struggling mightily to achieve a dynamic consensus. So what we're really doing is measuring complex aggregates of arguments based on human social behavior. In an academic sense a very specific kind of statistical sociology. To be practical we want to figure out what the markets will do so we can trade them profitably.

Ultimately, we have only three elements to analyze: price, volume and time. We try to find meaningful and effective ways of slicing and dicing the data. We might slice the data one way to try to discover momentum. We might dice it another way to discern support levels. Data is analyzed one way to discern the direction in which money is rotating, and studied yet another way to define sentiment. But price, volume and time are the only raw data elements that we have to work with; everything else starts from there.


2. WHAT IS TA USEFUL FOR?

If a picture (chart) is worth a thousand words then what is the picture (chart) telling us? Are the prospects bullish, bearish or is the picture uncertain? Charts can help us determine direction and a potential price target. Knowing when to buy and sell can lead to potential profits.

Ultimately it boils down to signaling when to buy and when to sell. There are plenty of ways to measure when it's time to buy and when it's time to sell. There are breakouts, breakdowns, measured moves, bounces and failures (of trend lines, moving averages, etc.), one-day candlestick patterns, three-day candlestick patterns, Fibonacci retracements, Fibonacci price targets, parabolic stop and reverse signals, sentiment measurements, oscillator signals and more. An infinite supply of tools exist, bound only by the limits of human imagination.

TA is good for giving you buy and sell signals. Are they always correct? Absolutely not. Can you derive a trading system that is right more often than wrong? You bet. Can you derive a trading system that nets larger average gains than losses? Absolutely. Can you find a method that tends to make money? That's your goal.

TA is also useful in controlling risk.

An important benefit of TA is that it can provide you the discipline to get out when you're on the wrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a trade and to get stubborn. That is also potentially the worst thing you can do. Believe me. I have made this mistake. You think that if you ride it out you'll be okay. And the most seductive thing is that often times you will be okay. However, there will also be occasions when you won't be okay. The stock will move against you in ways and to an extent that you previously found virtually unimaginable.

Now, the next part I'm going to write in caps. And I want you to read the whole thing. Don't skip over the second and third iterations.

IT IS MORE IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS! IT IS MORE IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS! IT IS MORE IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS!

Okay, we say this is so, but why is this the case?

This is true because of the asymmetry between zero and infinity.

What does that mean? Unless you are someone very special you have finite capital. Most likely you have very finite capital. With a market of thousands of stocks you have a functional infinity of opportunities.

If you lose an opportunity, you will have thousands more tomorrow. If you lose your capital, will you get thousands more tomorrow? Most likely, no. You will have also lost your opportunities. Your capital is worth more to you than your opportunities because you must have capital in order to take advantage of tomorrow's opportunities.

It's simply supply and demand. Waste what's plentiful, preserve what's scarce.

Preserve your capital because your capital is your opportunity.

This is why:

It is more important to control risk than to maximize profits!

We spend time on this because we want you to be aware that one of the most important things TA can do, if practiced with discipline, is give you specific parameters for managing risk.

Wall Street history is littered with the corpses of geniuses who trounced the market -- those who overstayed their welcome and were subsequently wiped out. (Do the names Long Term Capital Management (LTCM) and Stanley Druckenmiller ring any bells?) LTCM (populated by two Nobel laureates among a number of very smart people) went bankrupt betting on what almost always happens would happen "this time." Why did they go bankrupt? Was it because what usually happened DIDN'T happen that time? Well, it didn't happen...not right away...but that's not why they went bankrupt. Their liquidity ran out. The market remained irrational longer than they could remain solvent. They went belly up because they didn't know when to quit, because they didn't manage their risk.

And Druckenmiller (a much-vaunted Wall Street savant) was fired as manager of George Soro's fund group when the tech bubble burst. Again, this is not just because he was on the wrong side of the market when the bubble burst but because he didn't manage risk when he was on the wrong side of the market. (In the major reversal section we discuss major reversal patterns that can help identify chart patterns that can reverse a major trend and presage a 100% retracement. Any investor who has mastered this section would knows to protect himself!)

You can be right a thousand times, become very wealthy and then get wiped out completely if you manage your risk poorly just once.

One last time: That is why it is more important to control risk than to maximize profits!


ON A MORE PERSONAL NOTE

TA can be overwhelming. How do you know what to look for? How do you organize your thinking in a market of 9,000 stocks (and more) trading billions of shares per day? How do you learn your way around?

We want to approach TA the same way you might teach someone his or her way around a city. Just having a map is great, but it's not really a substitute for walking the streets of Paris or New York.

When I (Adam Oliensis) was 19 I visited my sister who had moved to Manhattan. The most fun I had was putting on my running shoes and jogging - first through the East Village, then uptown through Chelsea and into midtown Manhattan. I jogged up 6th Avenue at lunch hour in the midst of the hustling crowds and traffic and skyscrapers and into Central Park. I ran by the lake and the ball fields then suddenly found myself standing between Tavern on the Green and the Sheep Meadows. I walked into the field and sat down for a while viewing the city: I saw 5th Avenue to the east, Midtown to the south, and the sun now angling down toward evening in the west. I felt as if I knew the city intimately and was no longer a stranger. You can't get that feeling from just a map.

That's how we would like for you to learn about TA in this course. In addition to sharing theories and practices of TA (the map of the city) with you, we'd also like to share our hands-on experience using TA. (We've eaten at all the Chinese restaurants in the neighborhood, so we know which ones are good and which ones not so good.) We want you to learn the neighborhoods in a way that will save you from wasting your time (eating at the crummy restaurants) and help you to develop more than a general understanding. We want you to develop a useful understanding of what tends to work and what doesn't. This knowledge is what we intend to share with this online course.

Okay, now that you know something about TA and how it can empower you in the markets, let's get to it!

Adam Oliensis & Dan Hassey

Course Outline


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