This book was recommended to me by Mr. Arun Lama. Lama is a former technical analysis instructor at Merolagani and is currently involved with Global IME Capital. He has cleared all three levels of the Chartered Market Technician (CMT) exam.
This book has everything from the basics to breakouts and stop-loss, moving averages, chart patterns, Elliot wave theory and Fibonacci sequence, risk management, to more recent branches like Kagi, Renko, Kase, Ichimoku, Clouds, and DeMark indicators.
What’s more, the book has been selected by the Market Technicians Association as the official companion to its prestigious Chartered Market Technician (CMT) program.
Furthermore, this book offers a fresher look into technical analysis compared to Technical Analysis of Stock Trends by John Magee and Robert D. Edwards that I recommend reading.
This article is not a book summary–I feel bored to death writing summaries. Instead, this article is a collection of the most helpful technical analysis lessons I learned while reading.
Valuable Excerpts from the Book
Rather than trying to consider all the factors, the technical analyst believes that all these factors are already factored into the demand and supply curves and, thus, the price of the company’s stock.
The art of technical analysis—for it is an art—is to identify trend changes at an early stage and to maintain an investment position until the weight of the evidence indicates that the trend has reversed.
Economic information, company information, and other information affecting prices is often vague, late, or misplaced but prices are readily available, are highly accurate, have historic records, and are specific. What better basis is there for study than this important variable?
Furthermore, when one invests or trades, the price is what determines profit or loss, not corporate earnings or Federal Reserve policy. The bottom line, to the technical analyst, is that price is what determines success and, fortunately, for whatever reasons, prices tend to trend.
Main Assumptions of Technical Analysis
1) Price is determined by supply and demand.
2) Price discounts everything.
3) Prices are non-random.
4) History will rhyme itself.
5) Patterns are fractal.
6) Emotions are affected by earlier emotions through emotional feedback.
The market is not saying what the condition of business or economy is today. It is saying what that condition will be months ahead. This is why stocks seem to gain during economic downturns or suddenly begin to lose when everything else seems just fine.
Dow Theory Hypothesis Proposed by Robert Rhea:
1) The primary trend is inviolate.
2) The averages discount everything.
3) Dow’s theory is not infallible.
Market Sentiment
When everyone thinks alike, everyone is likely to be wrong.
Market sentiment is the sum of opinions of all market players regarding the market or a particular stock.
There are informed players, uninformed players, and liquidity players in the market. Informed players decide based on logical judgment and analysis. The uninformed players stick to positive feedback trader sentiment. Meanwhile, the liquidity players enter or exit the market irrespective of the trend and in accordance with the need for liquidity or excess of it. Liquidity players can be ignored because they do not impact a trend.
The idea is to get out of the herd of uninformed players and be one of the informed players. This is called contrarian investing, as if one follows what everyone else is doing, he will save ridicule, embarrassment, and shame from them but end up burning his portfolio.
In fact, when the majority of market players believe a certain way about the trend, the trend is most prone to reversing direction.
To be a contrarian, an investor must sell (be pessimistic) when the overall market mood is grossly optimistic and buy (be optimistic) when most investors are pessimistic and in a panic.
Practice and mental anguish are the backgrounds of any successful technical analyst. The most expensive education in the world is likely the money lost in incorrect, sloppy, and undisciplined decisions. All market participants make mistakes, but the regimented professionals correct theirs quickly.
Trend Analysis
The most important essence of technical analysis is that prices trend and a trend usually tends to continue rather than reverse.
All profitable technical analysis strategies enable one to enter at the start of a trend and exit when it is on verge of ending. This sounds easy but is extremely hard to replicate because identifying the direction of a trend is the most subjective and fuzzy part of technical analysis.
When analyzing the trend of a particular time frame, it is a must that the analyst analyze the trend in the next-longer time frame and the next-shorter time frame.
Most-recent reversal points and support/ resistance zones are more important than older ones because human memory fades quickly.
About jumping the gun
Remember that a trading range is somewhat like a battleground, where the buyers and sellers are warring for dominance. Most chart patterns are combinations of trend lines and, thus, are battlegrounds. Before the battle is over, it is almost impossible to determine who will win. It is usually wiser, and more profitable, to wait rather than to guess.
Donchian Breakout Method: The Simplest Technical Analysis Strategy
Buy when the highest high of the past 4 weeks is broken, and sell when the low of the past 4 weeks is broken.
Things to consider when drawing a trend line:
1) Use logarithmic charts for better accuracy in the long term.
2) Use line joining lows as a trend line in an uptrend, and the line joining highs as a trend line in a downtrend.
3) Understand that accelerating trend lines may occur due to speculation or panic.
Interestingly, in an accelerating uptrend, the mathematical calculation for the time it takes to reach the zenith (infinite slope) is the latest time to expect a reversal.
In the case of downward fan lines, an upwards reversal can be expected after the formation of 3 fan lines.
4) Should we use closes or highs and lows to draw a trend line?
Foreign books and videos sometimes suggest drawing trendlines from the closing prices ignoring the intraday highs and lows. This is because they believe intraday highs and lows are most often caused by intraday traders.
However, since there are no intraday traders in Nepal, we should assume that transactions at any price level in a day are done by somebody who has the intention to hold the stock for a significant enough period of time. I sometimes use closing prices to draw a trendline if it touches multiple reversal points (which a high-low trendline would not.). Other times, the line joining the highs or lows gives a better indication. However, the short answer here is that use one that seems cleaner or justifiable depending on the particular stock movement and condition.
Nonetheless, during a breakout, I like that the author mentions that intraday false breakouts may occur, and price may revert back to the non-breakout zone. In this case, the trend line, support, or resistance level may have to be redrawn to account for it.
Breakouts, Stops, and Retracements
To maximize profit, we must join a trend at its earliest, safest point and ride it until it shows signs of changing direction against us. A trend will begin often from a breakout of a support or resistance level and sometimes from a trend line.
Methods of Breakout Filter:
1) Close Filter
Intraday false breakouts may occur, and the price may revert back to the non-breakout zone. In this case, the trend line, support, or resistance level may have to be redrawn to account for it.
Thus, a breakout is only significant if the price closes above the resistance level or below the support level. Otherwise, the price may revert back to the consolidation zone, and buying early may cause the trader to face a false breakout or a delayed breakout.
Some traders also wait for two trading closing days above the previous resistance level to minimize the chances of entering a false breakout. While this increases the chances of a profitable trade, the trader may risk losing a big chunk of the upwards move.
In the words of the book,
Some traders even wait for two bar closes beyond the breakout level for confirmation. This increases the risk that some part of the move subsequent to the breakout will be missed; on the other hand, it increases the possibility that the breakout is real.
2) Point or Percent Filter
This method assumes a breakout is real only if it closes 1-3% above the breakout level.
3) Time
2-candles beyond the breakout zone.
4) Volume
Usually, a breakout is accompanied by a high-than-usual volume.
4) Volatility
There are three methods of determining the volatility of a stock: Beta, Standard Deviation, and Average True Range.
The ATR is the most efficient of them.
Can a breakout be anticipated before it occurs?
Yes, in a consolidation, if the volume seems to rise in every upwards push and fall in a downwards drag, it can be understood that investors are interested to take the price upwards.
An increase in volume with a trend is supportive of that trend. Thus, when prices are oscillating, for example, beneath a resistance zone and volume increases on every small up leg and decreases with every small down leg, the odds favour that the price will eventually break up through the resistance zone because the increased volume expresses increased interest on the buy-side.
My note: With this, I finally got my concern addressed:
“A trade-off always exists between the higher risk of entry prior to the breakout and the higher reward of a cheaper entry price.”
More about it:
This trade-off between risk and reward is a constant problem for the analyst and the decision as to which breakout method to use is entirely at the analyst’s discretion, based on individual reward/risk tolerance.
Deciding on the most comfortable relation between risk and reward is a problem that will arise in almost every technical situation, from breakouts to money management, and it is one of the reasons that evaluating technical systems is so difficult.
Breakouts
Indeed, the general rule is that a strong upward trend requires retracements of less than 50% of the previous trend. The same is true for downward trends. Should the retracement in an upward trend decline more than 50%, the trend line in the long upward trend would be in jeopardy.
Anticipating retracement levels, therefore, can be somewhat hazardous, and the trade-off between the amount of retracement desired and what may actually occur is usually unanticipated. Thus, a rough estimate from previous retracements, support and resistance zones, and the location of the longer trend line is probably the best information for an estimate rather than the mechanical percentage numbers derived from various formulas.
A breakout signals that a significant change in supply and demand equilibrium has occurred.
False breakouts are common and there’s always a tradeoff between risk and reward in when to anticipate a breakout.
In the case of support and resistance zones where there’s no clear line, the extreme level can be considered the breakout level. Meanwhile, breakouts are more clear on the trend lines (since they are literal lines) but there’s always a possibility of false breakouts.
Furthermore, intraday price movement may give an illusion of a breakout, but it is wise to wait for the day’s market close. If the price returns to the non-breakout side, you will need to redraw the new breakout level and move on.
Additionally, some people use the percentage filter (3% is common) or the time filter (remain beyond the breakout zone for X number of days) before they consider the breakout valid.
While breakouts are often accompanied by an increase in volume, some breakouts also occur with diminished volume and still remain valid. The volume then rises later during the surge.
Pullbacks and Throwbacks
A pullback is a retracement that happens when the price retraces back to the breakout zone after a downwards breakout. Meanwhile, a throwback is a retracement that happens when the price retraces to the breakout zone after an upwards retracement.
Throwbacks provide a less-riskier opportunity to benefit from a breakout.
However, a pullback or a throwback will decrease the extent of the eventual move in the direction of the breakout.
Thus, although each may provide a second opportunity for action at the breakout level, the subsequent rise or fall generally will be less than if there were no pullback or throwback. Tactically, this implies that a breakout should be acted upon immediately; waiting for the retracement will diminish profitability, and you may very likely miss the entire price move.
Difference between two kinds of breakouts
A breakout above resistance or below the support usually signals a change in trend direction.
Meanwhile, trendline breakouts are warnings of possible change but not nexessarily of a reversal.
Should I wait for a retracement after a breakout or enter straight away?
Again, this question comes down to the tradeoff between risk and reward.
If you decide that you will enter only after a retracement, you run the risk of missing out on the upsurge if the price never retraces.
However, entering straight away may cause you to chase price and enter at a higher, unfavorable price.
Thus, this book suggests the wiser way may be to enter half or a portion of your trade after a breakout and enter the later portion after a retracement if it does happen.
Stop Loss
Stop loss is important because it is ridiculous to think that when entering a trade or investment, it will always be successful and the risk of loss should be disregarded.
If one is long on a stock and has placed a stop at a reasonable level below the current price, he should never cancel or reduce the stop order. Its purpose is to keep the investor honest. By changing or canceling the stop, especially when the security is trading at a loss, the investor is losing discipline
and reacting to emotional pressures having to do with not desiring to admit an error—a natural and strong human emotion, but unrelated to the rational assessment of the price action.
However, the stop-loss should be reasonable from the very beginning. Keeping a stop-loss too close to the price action may result in getting whipsawed.
Meanwhile, trailing stops that protect profit may be changed as the support and resistance level changes.
Exits always should be placed at logical levels of price based on the analysis of trend, support and resistance, volatility, and pattern, not on the peculiarities of a particular portfolio or on an
arbitrary rule.
In simpler words, the market does not care where you entered, so keep a stop loss at support levels or trendlines, not a few points below where you entered.
“Not every entry is correct and ends up with a profit. Indeed, many traders have more losing trades than winning trades, but they are able to profit because of the judicious use of their stops.”
Should you research news if your stock starts losing after you buy?
The need to know what is wrong is unnecessary because the stock price action itself is suggesting that something is wrong.
Stop Loss When Gaps Occur
A gap occurs when vital information is released that alters the existing market sentiment. The stop-loss should be placed below the opening of the gap. This is because, if the information is legitimate, the stock will keep rising. But if it was only an irrational reaction to illegitimate information, the gap will be filled, and the stock may reverse the direction of the breakout.
Stop Loss During False Breakouts
Some breakouts can end up being false breakouts, or specialist breakouts. In this case, the stop-loss should be kept at the low of the previous candle before the breakout candle.
Trailing Stops Using a Trend Line
This is the easiest method of establishing a trailing stop. Since trendlines are literal lines, the stop loss is a parallel line 3% above or below the trendline.
Moving Averages
Moving averages are one of the most successful methods to identify and profit from trends.
They are especially beneficial in detecting trend reversals.
However, the most sensible use of moving averages is just in detecting the existing trend of the security. If the trader depends on moving average crossovers for trading signals, a sideways market can become costly.
However, it should be noted that moving averages are lagging indicators – they show signals only after the actual reversal has already taken place.
While analyzing moving indicators, there’s always a tradeoff between the speed of the reversal signal and reliability (accuracy or fewer chances of false signals).
“A moving average provides no additional information on which way the trend will eventually break. Indeed, a moving average requires a trend for a crossover to be profitable. This means that the analyst must be sure that a trend exists before using moving average crossovers for signals.”
Moving Average Rules
1) If the stock price or index is above the 200-day moving average, the trend is considered upward and vice versa.
2) By the reversion to mean theory if the price is trading too far away from a moving average, it tends to come back to it. The 26-day moving average indicates the minor trends within a bigger trend.
3) Moving average crossovers are profitable but can generate too many whipsaws. In the words of the book itself,
“Though the crossover methods are profitable over time, the investor must have patience and enough capital to withstand a series of small losses until a trend develops.”
Bollinger Bands and its limitations
One would consider that the best way to use Bollinger Bands is to trade between the extremes, i.e. buy when the price touches the lower band and sell when it touches the upper band.
This sounds too good to be true. In theory, prices should remain within the Bollinger Bands 95% of the time.
However, Bollinger Bands have these limitations:
- The bands contract during sideways trends and dull phases, leaving little room to trade between the extremes.
- During the trending phase, price tends to stick and roam close to the band corresponding to the trend (higher band during uptrend, lower bank during downtrend), so the indicator does not give a trading edge anyway.
Thus, instead of trying to do range trading between the bands, Bollinger Bands have another utility.
The band is useful in detecting trend changes early. A breakout from a band that contains roughly 90% of price action suggests that the sentiment has shifted to the direction of the breakout.
Thus, just like in breakouts on trend lines and support-resistance levels, the position should be entered in the direction of Bollinger Band breakouts.
Also, volatility constriction in Bollinger Bands is often followed by a sharp price move.
