3 Components of a Good Technical Trade
11/24/2014 11:00 am EST
Those who trade equities or options using technical analysis should consider three distinct factors before executing any trade, writes John Lansing, contributor to Investorplace.com and editor of Parabolic Options.
When trading and investing, one of the hardest decisions to make is determining which stocks to buy or sell. Even if you have a broker who recommends stocks for your portfolio, it's often wise to do your own research rather than buy on a hot tip. While your broker is supposed to be looking out for your best financial interests, in the end, it's still your money, and you should always know where your money is going.
Depending on the type of investing technique you choose-fundamental analysis vs. technical analysis-your research process will vary greatly. If you choose the technical investor route, check out some important research tips below so you can find the best stocks at the best prices.
Technical analysis is all about the stock and its patterns. Technical traders don't care if the Fed cuts rates, the housing market tanks, or where the latest unemployment numbers are hovering.
Technicians look at the patterns to find stocks that are about to move and then use the charts to figure out which way the stock is headed, how fast it is going to go up or down, and how far it is going to travel.
Technical analysis is looking at the past prices and trading volume of a stock or other security to uncover patterns and determine when to buy or sell. Unlike fundamental analysts, who like to see a company's balance sheet and earnings reports to decide if it would make a good buy at current prices, technical analysts just want to profit from moves in price, regardless of the fundamentals.
You need to consider three things when researching a stock through technical analysis: direction, speed, and distance.
Direction is which way the price is going: up or down. Speed is how fast the price is moving. Sometimes a price makes a big move in one trading day, and other times, it could take ten, 20, or 100 trading days. Distance is how far the price will go, regardless of whether it's moving up or down. You could measure it in dollars, but it's usually more useful to measure it in percentages like 10%, 15%, or 30%.
To make technical analysis a little easier to understand, let's take a closer look at these three components:
Direction: It's easy to see trends once they're over, but the only way you can profit is to identify the direction of the trend before it has run its course. That's why traders look for bullish trend reversals and bearish trend reversals. As the names imply, a bullish trend reversal signals an uptrend, and a bearish trend reversal signals a downtrend. The rule of thumb is to go long on a bullish uptrend and either go short or close your position on a downtrend.
Speed: That's determined by looking at Elliott waves, which indicate two basic types of waves: motive and corrective. The motive waves occur in groups of five waves labeled 1, 2, 3, 4, and 5, and corrective waves occur in groups of three waves labeled A, B, and C.
A motive wave is an impulse that moves prices in the direction of the underlying trend. You know you're in a motive wave when waves 1 and 4 do not overlap. That is, the prices in wave 4 do not retrace any of the prices in wave 1. Typically, wave 3 of a motive wave is the fastest of all the waves.
A corrective wave, on the other hand, occurs when prices move against the underlying trend. The result is that wave 4 will overlap wave 1. Or in other words, retrace some of the prices in wave 1.
It's very important to identify waves correctly, or you'll end up losing a lot of money.
Distance: This is measured by chart patterns. Chart patterns were identified decades ago in the form of geometrical shapes such as triangles. The shapes are plotted with the highest and lowest points of five-wave structures in the chart. Two examples would be an expanding triangle, which originates at a point and makes higher highs and lower lows, and a contracting triangle, which makes lower highs and higher lows and eventually comes to a point.
It doesn't matter whether it's a stock, an index, an ETF, or a commodity. Patterns are patterns. All they do is measure distance. The success and failure of them all depend on what the primary trend is. If you're trying to play a bullish pattern in a bearish market, the chance of that playing out successfully significantly decreases.
See also: 3 Signs a Stock Is Worth Trading
In the end, it's up to you to decide what type of trader you are, be it fundamental or technical. Both methods have yielded incredible success to those who do their homework, and being savvy in both can only help boost your stock and options trading returns.
Don't forget, even if you work with a broker who provides stock recommendations, you would be wise to do your own research before issuing the buy order. Smart investors know what they're buying and why they're buying it.
Using this type of technical analysis, I came up with a trade recently that should reap you some nice profits: Buy to open the iShares Dow Jones Transportation ETF (IYT) July 87 puts near $2.00.