3 Technical Indicators to Start Using Today

09/26/2011 7:00 am EST

Focus: MARKETS

Dave Whitmore

Senior Strategist, Trading Education, E*Trade Financial

Moving averages, the relative strength index, and stochastics can improve your market-timing decisions, recommends Dave Whitmore. In part one of his interview with MoneyShow.com, he also discusses the importance of having a clear strategy every time you enter a trade, and of understanding your own risk tolerance.

Kate Stalter: Today I’m speaking with Dave Whitmore. He’s the senior strategist of trading education for E-Trade. Dave, E-Trade recently sent out a news release that had some tips for investors in the volatile market. One of those that I found interesting was “remain calm and maintain perspective.” Give us some perspective on the technical performance of the indexes lately.

Dave Whitmore: Whenever you get a market that shows big sudden moves, whenever we see big jerks in volatility, one of the pieces of advice that any prudent investor should follow is to try to maintain perspective about what’s going on.

One simple way to do that is to look at charts and various time frames. It’s a simple exercise, but it’s an important one to do to. Take a look at a chart; most of us probably are looking at a one-year daily chart. Flip your chart program over and take a look at a weekly chart, and pull back and look at a weekly across three years or five years. You can get a very different perspective.

For example, in today’s market right now, the one-year daily chart, indeed, it looks like we could have entered a downtrend. The 50-day moving average seems to be moving down, but when you pull back and look on a weekly chart, you’ll see that this down move is somewhat contained within the same kind of volatile movements that occurred a couple other times in the uptrend.

In fact, some of the technical indicators look a little bit oversold. If you were to look at, say, the RSI and the stochastics, for example, on the weekly chart. They look like they’ve bounced off oversold conditions.

Step number one is to think in term of perspective.

Kate Stalter: Which key technical indicators are some of the basics that traders should begin to use? You mentioned moving averages a moment ago, for example.

Dave Whitmore: Right, so I made three references there. First of all, moving averages. A moving average will smooth a jagged trend, and one of the techniques is when the moving average is moving in a direction, as the 50-day moving average is right now—it’s moving down—that’s deemed to be a downtrend.

The other two technical tools that I referenced are the RSI and the stochastic. These are mathematical calculations that simply measure how far the price is stretched from some sort of an average or a mean. It will express when positions might be oversold, meaning they are due for a bounce back, or overbought, meaning they’re due for a pullback.

On the longer-term chart, both the RSI and the stochastic are moving up and out of oversold territory, so that’s the kind of different perspective that you get by using the longer-term chart as compared to the daily chart.

|pagebreak|

Kate Stalter: One of the other tips that E-Trade offered in the press release was “review risks.” Talk a little about how to do that.

Dave Whitmore: First of all, whenever you enter the position I hope you reviewed your own risk tolerance, and your sense of what the trade you were putting on, or the position you were putting on, was going to do.

First, you need to understand the risk that’s inherent in any position that you have. There are a variety of tools for that. We have a risk analysis tool right within the E-Trade Web site. We use a company called RiskGrades, and they will give you a numerical representation of how much risk is in a specific position.

Then you should also know what was the expected risk and what it was you put on, when you put that trade on.

Finally, you have to know what you can tolerate. Again, this goes back to questions that should have been answered before you entered the trade. If you’re a trader, what you might need to consider is: Are you using the right vehicle for the investment or trading hypothesis that you had?

I mean, let’s face it, to say you were, for example, bullish on technology could have been effected in a variety of ways, each of which would have differing degrees of risk. Maybe one is just to buy a big popular technology stock. Maybe another one is to buy a technology ETF.

Maybe another one is to buy one of those instruments on margin and leverage your position, and finally you could have used options to implement the position. All of these have differing degrees of risk, even though they’re all bets on the same particular idea. Traders and investors have to think about these things differently.

But for a trader, it’s not just were you correct in your hypothesis on what the underlying was going to do, but did you choose an instrument, did you choose a degree of leverage that fits with your risk tolerance? If things are reacting differently than what you thought, it’s time to reassess that, educate yourself, and learn about what those different instruments are, in order to effect a trade.

Kate Stalter: It seems like just boiling that down to the most basic: Go into every trade with some kind of plan, not just buying. It seems like a lot of traders don’t have an exit strategy.

Dave Whitmore: Having a signal to you that tells you a stock is going up, for example, is not a strategy. The strategy is having a signal, a catalyst, if you will, whatever event makes you decide that an idea is either bullish or bearish for you.

But the strategy comes with defining how you’re going to enter that trade, how much of your capital is going to be committed to that trade, and as you just pointed out perfectly, how are you getting out? What is your target? Where is your pain point? That would be where you put your stop-loss, that’s the bailout, that’s the jump-out point.

You need to, on each trade, have a sense of the ratio of that. How much upside potential is there, and how much risk am I willing to take? That’s one of the most basic steps of assessing the risk in a trade. Every investor needs to do that.

Related Articles on MARKETS