As I often say about my wine savvy, I know just enough to be dangerous. For many traders, the same holds true with regard to charting and technical analysis, says technician Michael Kahn on TradingMarkets.
For example, they know enough to use an RSI (relative strength index) to gauge momentum but really don't know why they use a parameter of 14.
Trading teachers will tell us to find something that works and stick with it. I contend that unless you understand the "why" and not just the "what" you are setting yourself up for trouble down the road. After all, markets evolve and what worked yesterday may not work today.
This missive is not about deconstructing technical indicators. Rather, it is to get the reader to think about the spirit of the analysis and letting the charts speak to them. Any other method implies that traders are making the market conform to their own biases.
The market hates that and it will make you pay dearly for trying.
Let's start with RSI and the 14-parameter. Why do so many traders use it? The answer is that is the default setting on the first applications of charting software that came out a few decades ago. There was reason behind it as Welles Wilder, the creator of RSI, was using half cycles in his favored markets as the basis. But once software coders and inexperienced product marketing managers got something in their heads it seemed to be set for life. Even today, many software programs do not let the user change the default parameter to something different.
Of course, indicator parameters should be in sync with the market and time frame in which they are being used. But it goes beyond that. Because markets evolve, indicators can behave differently than they did when they were newly created. Today, "everyone" sees what they think are overbought and oversold levels at the same time and act accordingly. How many times in recent memory have signals simply failed just because everyone-the herd-is taking the same action?
Rather than over-think an indicator or even a chart pattern, here are some rules that will make your life easier and more profitable. They are all rooted in keeping it simple and more importantly letting the market do all the thinking. All you have to do is turn off the news and absorb the message.
Rule 1 - If you cannot see trends and patterns almost instantly when you look at a chart then they are not there. The longer you stare, the more your brain will try to apply order where there is none.
If you have to justify exceptions, stray data points and conflicting evidence then it is safe to say the market is not showing you what you think it is.
Rule 2 - If you cannot figure out if something is bullish or bearish after three indicators then move on. The more studies you apply to any chart the more likely one of them will say "something." That something is probably not correct.
When I look at a chart and cannot form an opinion after applying three or four different types of indicators-volume, momentum, trend, even Fibonacci-I must conclude that the market has not decided what it wants to do at that time. Who am I to tell it what it thinks?
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Rule 3 - You can torture a chart to say anything you want. Don't do it.
This is very similar to Rule 2 but it there is an important point to drive home. You can cherry pick indicators to justify whatever biases you bring to the table and that attempts to impose your will on the market. You cannot tell the market what to do-ever.
Rule 4 - Be sure you check out one time frame larger than the one in which you are operating (a daily chart for a very short-term trader, a weekly chart for a swing trader, a monthly chart for a position trader).
It is very easy to get caught up in your own world and miss the bigger picture getting ready to smack you. It can mean the difference between buying the dip in a rising trend and selling a breakdown in a falling trend.
Rule 5 - Look at both bars (or candles) and close-only line charts to see if they agree. And look at both linear and semi-logarithmic scaled charts when price movements are large.
Short-term traders can ignore the latter since prices are not usually moving 30% in a day. But position traders must compare movements at different price levels.
As for bars and lines, sometimes important highs and lows are set by intraday or intra-week movements. And sometimes intraday or intra-week highs and lows are anomalies that can safely be ignored. Why not look at both?
Rule 6 - Patterns must be in proportion to the trends they are attempting to correct or reverse. I like the trend to be at least three times as long as the pattern.
A three-day correction is not sufficient to get a six-month trend back on track. And a three-month pullback after a six-month rally is probably a new trend, not a correction.
Rule 7 - Patterns should have symmetry. A triangle should look like a triangle and not a mile high and an inch wide (or vice versa). A head-and-shoulders should look like a central peak with two smaller but equal peaks around it.
Rule 8 - Price rules but it is better when volume, momentum, and structure (patterns) agree. Sentiment is a luxury because it is often difficult to quantify.
No matter how strong the case built on indicators and the environment surrounding the market may be, there is no change in condition until price action reflects it. How many times has an overbought market become even more overbought?
Rule 9 - Always confirm one type of analysis with another type. For example, confirm RSI not with MACD but with on-balance volume or relative performance.
There are hundreds of indicators but only a handful of truly unique types. Be sure you do not try to prove your case with a variation on the same set of input data. Most momentum indicators are quite similar so be sure to look at least the three types listed in Rule 8.
Rule 10 - Don't get hung up if all your indicators do not agree. They never will all agree and you will end up missing every opportunity. Therefore, pretend you are a trial lawyer gathering a preponderance of evidence, not guilt beyond a shadow of a doubt.
Rule 11 - If a stop is hit you must honor it. All big losses start out as small ones. No exceptions. Feel free to re-analyze a trade that got stopped out to see if you would enter anew but never justify holding on to a loser.
Again, nothing here is rocket science but these rules force you to let the market talk. After all, that is our job as traders, reading the signs and acting accordingly.
By Michael Kahn, Contributor, TradingMarkets