Technical Analysis/Trading Approaches

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Trading Approaches[edit]

Trading can be characterized as short-term decisions made in accordance with information gleaned from technical analysis. Traders usually move in and out of the market at a rapid pace in hopes of repeatedly extracting small profits. Trading is helpful in that it serves the useful purpose of enhancing liquidity. Full time traders often use multiple computer screens to monitor prices closely throughout the trading day. For people who cannot spend all day in front of a computer monitor, one option is to anticipate substantial price moves so that the associated risk of taking a position is justified by the upside profit potential. "( Source: Pattern Recognition and Trading decisions, SatchWell,Chris 2005).

Trading Terminology[edit]

Position

Long - (Meaning the underlying stock is bought and one will profit if the price moves up)
Short - (Meaning the underlying stock is sold and one will profit if the price moves down)

Market outlook

Range-bound
Bearish
Bullish
Volatile

Based on the outlook of the stock there are various strategies which have to be used by trader to take position in the stock.

Outlook Entry Strategy Exit strategy Remarks
Range bound Buy Low Sell High Most of the individuals makes losses on following this when the market is trending
Bullish Buy High Sell Higher
Bearish Sell Low Buy Lower

Most of the novice in the stock market have a simple assumption that the market or the stock is range bound and hence try to use only one strategy. This does not lead to great profits.

Profit/Loss

Profit/Loss is calculated at the closer of the trade. Though people do keep track of marked to market profit or loss, but then unless the position is closed profit or loss must not be calculated as many of the profitable trades end up in loss if the position is not liquidated in time.

Trading Horizon[edit]

There are various type of trading time horizons.

  1. Hourly
  2. Daily
  3. Weekly
  4. Monthly
  5. Quarterly
  6. Yearly

Based on your time horizon, you the trader, will pick the size of history that needs to be studied. Usual practice is to use 5 times the trading horizon for your chart. That is, if you want to trade with Daily time horizon you must keep watch on the 5 day chart. This does not rule out the use of longer term charts, since there may be some longer term levels in place and need to be considered.

Trading and Risk[edit]

Trading in stock market of for that mater any market involves risk. Hence there is a need for the mitigation/management of such risk.

One can quantify the risk in each trade as product of amount of money one may lose and probability of losing.

ie Risk = (money one can lose) x (Probability of losing)

Technical analysis is used to reduce risk by reducing the Probability. Though Technical analysis reduces the probability of losing the money, it do not make it ZERO. Meaning that all the predictions made based on Technical analysis might not come true. (This essentially happens because of person might have made some assumptions during technical analysis and that have gone wrong)

Importance of Selling[edit]

In trading your Profits or Losses are totally determined by when you buy, and, when you sell. These decisions are considered the most important decisions an independent trader can make. "Buy timing" and "Sell timing" are the two critical reasons so many investors decide to become "traders". They take their portfolios away from managing brokers and move to self directed accounts at a retail broker(s). Many investors became traders after the 2000 DOTcom bubble burst, and reports of 80+% of stock or fund holders lost as much as 50% of their account value due to the poor decisions of managing brokers. Becoming an independent trader can be a profitable decision, if you learn TECHNICAL and FUNDAMENTAL analysis techniques, and chose the strongest stocks, using stock screeners.

Stop Loss[edit]

Stop Loss is the most important Risk Management Tool available with the trader in achieving the goal of making profit from the trades.

When doing technical analysis the prediction of the stock price movement is made with particular assumption is mind. Stop Loss is the particular price which if achieved, makes the assumption false. This gives indication to the analyst that the stock price is not moving as per his/her prediction. Also this is trigger to liquidate the trading position.

When using stop loss what one tries to do is to limit the loss so in the equation of risk you have restricted the amount you are willing to lose on the trade which you have entered in.

High level of discipline is needed in this. Once a Stop Loss level is decided one must not tempt to revise the stop loss to increase loss. Stop loss should only be revised in a direction where it can reduce the loss. Read about Trailing stop loss for more on the rules to revise your stop loss.

Trading Strategy System[edit]

There are various mathematical strategy tools developed which can be used to give the triggers about when to take trading position and when to come out of the position. One can even simulate the said strategy over long historic data of the stock prices to understand how the strategy will perform.

Trading Risk Management[edit]

In the long run the profit that you make in the stock market is function of following four parameters

  1. Average profit you make on the winning trade (P_a)
  2. Average loss that you make on the losing trade (L_a)
  3. Number of Profitable trade (n_p)
  4. Number of Losing trade (n_L)

Profit = P_a * n_p - L_a * n_L

If we dissect the above equation we can say that to improve your profit where one needs to focus.

  1. Increase average profit on winning trade.
  2. Reduce Average loss on your losing trade.
  3. Increase Number of profitable trades.
  4. Decrease Number of losing trades.

Now after looking at this equation you can clearly figure out that it is not important if you are right or wrong. It is important how much you lose when you are wrong and how much you gain when you are right.