TA Basics Part Two

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Analysis

Technical Analysis Basics II

Part I of this series included information on support and resistance, and on ways to determine the underlying bias of the market or individual stock through the use of trendlines, channels and moving averages. Also included were details on when the trend may be overextended through the use of oscillators. The next logical step is to incorporate this type of information into possible trading tactics.

Breakouts

Assuming that we have a good feel for a particular stock in terms of the overall trend, how can technical analysis be used to help enter a position, add to a current position or exit the market? This is where this type of analysis is best used to assist the trader. As an example, XYZ has begun to consolidate within a limited range after an extended advance. No damage has been done to the underlying bias so an investor is looking for an opportunity to enter on the long side. Three options are available. The first is to enter in anticipation of breakout. The investor is able get a lower point of entry but there is a higher probability of a loss being sustained even if the trend is not altered as a more extensive correction could be underway. The second option is to enter on a breakout (preferably on strong volume). While this increases the odds of a successful trade the penalty is a higher entry price. The third option is to watch for a pullback after the breakout. The problem using this more conservative method is that the stock may run too far too fast after the break and ultimately not present a good opportunity to enter. The key is to have flexibility and not use just one method to enter but a combination of them to take your full position. In this example, if confidence is high of a short-term resumption, enter prior to the break and add on or pyramid your position following the breakout.

Trendlines - Support and Resistance - Stops

Trading with the use of trendlines, whether using a daily chart for someone planning to hold a position or an intraday chart for a day trader, can be very useful for an early entry point for a trade based on a penetration. An important key is to have confirmation from other aspects of your technical analysis. By the same token, these lines can also be used for entry points when they hold firm, again with confirmation. Support and resistances, whether particular chart points or percentage retracements (reversals of a previous move) can be the most effective way to enter/add on to a position or to exit a trade. Stops are a classic money management tool to limit losses when the market moves against your position and are best used at or slightly beyond a key floor or ceiling. Depending on the overall volatility of the market or if you are dealing with a stock that can move significantly on an intraday basis, such as the genomics, looser reins will be required to prevent a premature exit.

While the flexibility mentioned above can ease the pain when the trade goes against you, other technicals such as the momentum indicators, moving averages or pattern analysis can raise confidence of success. A similar method is to have a trending and a trading portion for your total position. If a stock reaches a price objective, profits would be taken on the trading portion. If the underlying technical condition remains intact then trendlines, chart supports or retracements could be used to reenter your trading portion.

Money Management

Management of your money can be the difference between long-term success and being forced out of the market. The following are not hard and fast rules, as individuals should tailor to their own needs and preferences, but some consideration needs to be given to these aspects. The first is the tradable percentage of your total capital. The general guideline here is to invest a maximum of 50% of your capital. The next question is the size of each particular trade. A range of only 10% to 15% of the total is often given as typical to prevent a situation where one blow up wipes you out. As far as how much to risk, 5% of capital is considered the norm. A variation on this theme would be to use a percentage decline on the individual trade (position dips 7% or 10% and you exit regardless). The use of technical analysis for entry, exits and stops in conjunction with money management can keep traders in the game to benefit from the winners even if they have been on a losing streak.

Jim Schroeder

MARKET PLACE