3 Keys For Using Technical Analysis

First, welcome to my first Substack Post! It’s my goal to help you sharpen your chart reading skills regardless of whether you are an investor or trader. I’ll be sharing regular posts discussing edges, setups, and other ways to improve your trading/investing.

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I wanted to kick things off by talking about what technical analysis is, what it isn’t, and how to incorporate it into your strategy irrespective of your timeframe. I’ll be discussing 3 Keys to using Technical Analysis effectively to aid your trading.

Technical analysis has been used for centuries to study the trends of price and volume data in different markets. It may have started with Josseph de la Vega in the Dutch markets or with Munehisa Homma, a rice trader in Japan. Whatever the specific origins, it is now used regularly by traders around the world in stock and crypto markets.

The main goal of Technical Analysis is to provide an edge in the markets, meaning to identify distinct and repeatable signs and characteristics that a trader/investor can incorporate into their case to buy or sell.

This is the same goal as Fundamental Analysis and you want to think of these as complementary tools (not warring factions) that you can use to collect evidence and build a case for a particular stock or security.

Technical analysis is not a magic predictor of prices one week, one month, or one year from now. Instead, it is about using price and volume data to determine high probability trades and identify areas where the risk is worth the reward. 

These spots are created because of the action of institutions based on their perceived value of different companies. Because of the size of institutional positions, their buys and sells take weeks and months to complete which creates trends we can surf as retail participants. We just have to learn how to identify their institutional footprints on the charts and pick spots to ride the wave.

In order to approach this the right way, here are 3 keys to properly using technical analysis:

Key 1: Keep it Simple and Repeatable

The best traders I’ve interviewed on the Market Chat Podcast all have 2 things in common when it comes to technical analysis. The first is that they keep their charts very clean with as few indicators as possible, not much more than Price and Volume.

This allows them to focus on what matters and keep a high data to ink ratio. Indicators can be helpful, but at the end of the day they are all lagging derivatives from price/volume and it’s best to focus on the actual price action.

When I started out trading I was very guilty of adding this indicator and that indicator to my screens, so much so that I suffered from analysis paralysis with so many signals to take into account. I was searching for the perfect combination of signals, the Holy Grail. Now I know that there is no such thing as a perfect indicator and that in truth successful trading is all about probabilities and managing risk.

Nowadays I still use a few indicators, but I try to keep my chart clean and focused on only the actionable signals.

Keeping it simple also means focusing on timeframes relevant to your strategy. For any long-term investors reading this you should be focused on weekly and monthly charts. Swing traders can look more short-term but be careful about looking too much at intraday charts, they can provide false signals that are invalid on a higher timeframe.

Another important key that I noticed in common with my interview guests was that they use very simple and repeatable setups. They focus only on 1-3 chart patterns such as a Volatility Contraction Pattern or a Power Earnings gap and master that particular setup.

”I don't fear the man who has practiced 10,000 kicks. I fear the man who practiced one kick 10,000 times."

- Bruce Lee

You should study a setup intensely, and strive to make it a consistent source of income in the markets before even considering trying to add another pattern.

In short, focus on keeping a clean chart, and executing well on just a few repeatable setups that occur over and over again during long-term uptrends of True Market Leaders.

Key 2: Use Multiple Timeframe Analysis and Follow the Trends

The goal of a successful trader is to align your positions with the strongest trends in the market and ride them until they bend. To do this it’s best to consider multiple timeframes in your analysis. Stocks do not rise and fall in straight lines, instead, they oscillate up and down within longer-term trends. 

When you go long a stock, you want to trade with the direction of the market not fight it. Remember, the trends of stocks are created by the net buying and selling of large institutions, we just have to follow in their footsteps. Technical analysis is not about identifying the precise low or high of a stock’s move, but confirming a trend and riding the majority of it. 

“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth-or the first. These two are the most expensive eighths in the world.”

-Jesse Livermore

For my personal style, I focus on stocks trending above their long-term moving averages say the 200-day, and buy as they break out of consolidations and pullbacks within their long-term move. On a monthly chart I want to see a strong uptrend, on a weekly, a proper consolidation, and on a daily a strong push on volume through pivot points. I don’t want to be early and try to catch a low, instead, I want to join the trend early on when it is already underway with momentum

Key 3: Think in Probabilities

Another misconception about technical analysis is that it allows you to predict price action. This is not the case. Instead, it is about building a case, following the evidence, and entering when the risk-reward and probabilities are worth it. Every setup no matter how great it looks can fail which is why you must always protect your downside with a stop loss (A subject for a future post).

Market conditions can also have a significant impact on trade probabilities. During pullbacks and corrections, setups that consistently worked during strong uptrends in the past such as breakouts will be sold into and fail. Be aware of this and know when your methods are most effective.

As traders, we want to set the odds and be the casino. Each trade is one of the thousands we will make exploiting our edge. With a repeatable process, our historical performance will be consistent if we execute properly. That is why we must be disciplined and never let one trade get out of hand. When we ignore our rules and ignore risk management we are no longer trading but gambling, and we must avoid that at all costs.

Key Takeaways

So remember, technical analysis is a tool to help guide your stock selections and entry points. It is not infallible yet when used correctly can help you find incredible trends while also protecting your downside. Keep your charts clean, keep your setups simple and repeatable, follow the trends, and always think in probabilities.

Each day in the markets provides new information on the EKG machine that is our stock charts. This new information can make or break a case, leading you to buy or sell a position, but you must be ready to interpret the charts and execute based on the results and your historical studies of price action.

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Later this week I’ve got some exciting articles planned including a breakdown of my interview with Oliver Kell the US Investing Champion of 2020 and also the start of a Trading Rules Series.

See you there!

Richard