Rookie Corner: The Technical Tango Part III
Welcome back into the fray!
We have gone thru several pieces of the technical puzzle and we have a few more to explore before we start putting the big picture together. In our last session, we talked briefly about trends and we talked about the three phases of any market which gives us context to the trends that we are seeing. This time around we will dive deeper into the importance of trends and what we need to do with the trend information we have. In addition to the trend discussion, we are going to nail down how we gain insight into the psychology of how trends and price points are formed. This psychology is something we can use to help us recognize when those trends or price points may repeat themselves.
In continuing on with our discussion about trends, I would be remiss if I didn’t stress the importance of the trend itself. We talked about how we recognize when a trend is forming and that is a series of higher highs and higher lows for an uptrend and a series of lower highs and lower lows for a downtrend. The question is why do we need to know or care about what the trend is? There is an old saying in the trading game and it goes a little something like this….” the trend is your friend”. This nugget of wisdom comes courtesy of a lot of painful experiences of many past traders that have gotten caught trying to fade a trend or pick a top or bottom. Think of a trend as the waves from the ocean, is it harder to flow with whatever way the waves are going or is harder to try and fight the tide? I think we can all agree that is it easier to go with the flow than to fight against the tide. The first way will take you where you want to go and the other will just make you tired and put you in peril. This is absolutely true in trading. If you”fight the tape” you will have a heck of a time trying to win in the trading game. As I stated in last weeks epilogue there are counter-trend traders but these are very experienced individuals who fully understand and embrace the perils of counter-trend trading.
The trend is important because it gives us the basis in which we look for trades. A typical question always arises, which trend do I follow? If you look at the chart below you can see that there is both a downtrend and a new uptrend, so which one do we go with? The answer to that depends on your reference to time. If you were taking a shorter term trade then it would make sense that you make the trade in the direction of the shorter term trend. It also comes down to the timeframe of the chart you are using. For example, if you are doing a two-week trade on this particular equity then you would most likely be looking at the new uptrend and looking at the daily chart. A trader can find the trend on one timeframe and confirm that trend on a shorter-term timeframe chart, in this case, you could look at the hourly chart to confirm that the short-term uptrend that you see in the daily chart is actually happening in the shorter-term chart. This technical confirmation gives us better odds that our trade will go in the expected direction. A good practice to get into when doing your technical analysis is to look at multiple timeframes to get perspective on the bigger picture of the trend and we must remember that the longer-term trend has more credibility as it takes longer to form. For instance, if I am looking to do a trade on a daily chart then I want to check the weekly chart to see if the trend I am looking at in the daily is the same as the weekly then I know this trend is stronger. I can then look at the hourly chart to get a decent entry into the trade.
In addition to the uptrends and downtrends, we want to find price levels that are significant so that we can pick our spots for trades and put the odds more in our favor of the trade going our way. These spots are referred to as support and resistance. There are psychological price levels where market participants think that a particular stock is either too expensive or a bargain. When these levels are reached they tend to repel the force that brought them to that level. Take a look at the chart below and you can see an example of support and resistance. Think of support as a floor that holds prices up and resistance as a ceiling that holds prices down. Support and Resistance don’t hold forever but they can present some stiff resistance to price moving through a particular price level. The green circles represent resistance points and the blue circles represent support points. These kinds of price levels occur very frequently and we will use those levels for our trading spots as it can give us an indication that the price is about to turn.
In next weeks blog, we will go through some real-life examples of support and resistance and we will go over exactly how we can use this to our advantage. We will also get into the basic technical patterns that I mentioned as some of those patterns rely on levels of support and resistance to form. Until then spend some time going over charts and see if you can identify solid levels of support and resistance. An extra little tidbit is that support and resistance tend to form more often at 5 and 10 dollar price levels.
Until we meet again my friends…..happy trading and the trend is your friend!