Why Technical Analysis Is Much More Than Just Chart Reading
Editor's note: The essence of technical analysis is simple...
It's about understanding the behavior of markets and history. It's much more than just trendlines and charts. It's understanding the past to profit in the future.
We're continuing this weekend's Masters Series with more insights from Ten Stock Trader editor Greg Diamond. This essay is adapted from a Digest series that first ran in April 2018.
You'll learn about several of Greg's favorite technical indicators and chart patterns. And as you'll see, it's how he finds the best trading opportunities for his subscribers each week...
Why Technical Analysis Is Much More Than Just Chart Reading
I'll be honest... It took me a while to grasp technical analysis, too.
But time and time again, I've witnessed the incredible power of understanding what is happening now... just like my former boss told me.
One of my goals at Ten Stock Trader is to educate subscribers on this incredible value.
I want you to see much more than the trendlines and patterns, and understand that we are studying the behavior of market participants... We are learning from history.
There's nothing wrong with wanting to know WHY a certain stock will move... But I am much more concerned with WHEN that stock will move and WHAT the price will do (i.e., how much it will go up or down).
And think about what really matters in investing – WHEN you buy and WHEN you sell. The WHY is less important when it comes down to the goal of investing...
Did you make or lose money?
That's all that matters.
Perhaps the greatest value technical analysis provides is that it is both a trading strategy and a risk-management system wrapped into one.
Today, I'll explain this strategy and system in more detail... I'm highlighting several of my favorite technical indicators and patterns that I use often in Ten Stock Trader.
There are hundreds of technical terms and uses out there. The indicators I'm discussing below are what I have found to be the most useful. As I said, I use them frequently. Make sure to familiarize yourself with this list.
If you're confused by any of the information I mention below, don't worry. I'll walk my Ten Stock Trader subscribers through everything in detail when the time comes.
This is most likely a brand-new way to look at the market for most people, so it's going to take some time to get used to. But once you understand the basics, I promise you'll begin to see the market in an entirely new way.
Let's get started...
First up is price divergence...
I look for price divergence across major indexes. This is a common focus in my weekly updates and in my live feed. When one index makes a new cycle low (or high) while another doesn't, this creates divergence.
That's usually a sign of a reversal on the horizon. It can be tricky to spot this pattern, but it's a valuable analysis to understand. A massive divergence occurred just before the crash in February. Take a look...
Notice the divergence between the Dow Jones Transportation Average in black and the Dow Jones Industrial Average in blue. The green circles marked a lower high in the Transports' price, while the black circles marked a higher high in the Industrials' price... setting up the divergence.
Obviously, this is an extreme example considering the massive crash that happened in the markets because of COVID-19. But such a big divergence provided a big warning that something was wrong – the two indexes were not in sync. There won't always be a big crash that follows a divergence like this, but when important indexes like the two above start to diverge, you can bet that a round of volatility is coming.
Next up, let's look at moving averages...
Moving averages are constructed by taking an average of a time series over a given period. The 50-, 100-, and 200-day moving averages ("DMA") are widely followed averages to determine support and resistance points.
Many trading systems are geared around these averages in some capacity.
In early 2018, the 200-DMA on the S&P 500 Index was at a big support level (meaning the S&P 500 hadn't dipped far below it in a while). You can clearly see it in the chart below...
Now, let's talk about price symmetry...
The market tends to trade in equal legs or movements, especially in corrective patterns.
Specifically, in a bull market, a correction usually has three legs, where the length of the first leg is equal to the third leg. Here is a perfect example of price symmetry from the S&P 500 in 2017...
Notice the first leg in each pattern is about the same size as the third leg. Also, notice how after the third leg was complete, the market rallied.
Spotting price symmetry is important.
The relative strength index ("RSI") measures the momentum of a stock's price... It uses a scale from 0 to 100.
A reading of 30 tends to be at or near oversold levels, and a reading of 70 tends to be at or approaching overbought levels. You can see the RSI and how it hit the 30 level at the bottom of this chart in the S&P 500 in 2018. And then, prices rallied thereafter...
Similar to price divergence is RSI divergence...
This metric looks for differences between the price of an asset and its RSI level. It can signal buyers losing momentum on the upside, or sellers losing momentum on the downside...
Look at the circled points on both the chart and RSI indicator in the bottom panel. See how the trend in price is rising while the same points on the RSI are declining?
This is divergence – and it was a warning sign of buyers losing momentum. Look how prices fell for another two months in 2017 after this signal triggered.
One of my favorite trading strategies is ratio analysis...
I'm constantly looking for the biggest trends in play as they relate to other asset classes or sectors of the stock market.
As a trader, I want to own what goes up and sell short what goes down. Within the domestic equity markets, certain sectors behave differently given the current environment. Sector ratio analysis cuts through the weeds of individual companies and graphically shows what sectors are outperforming the overall market.
Take this example of the Technology Select Sector SPDR Fund (XLK) versus the iShares U.S. Real Estate Fund (IYR) from a few years ago...
This chart reveals that buying XLK and selling short IYR would be a great trade. These are the types of trades we will continually analyze and work into our portfolio.
Another example of ratio analysis is used on different asset classes...
This chart shows what would have happened if you bought gold and sold stocks a few years ago. In other words, you would have lost a fortune.
This is ratio analysis at its best. It signals the best trends relative to other asset classes to allocate to your portfolio – and more important, the assets or sectors to avoid.
This type of analysis is also fantastic at signaling a change in correlations between asset classes – a critical component to understanding major shifts in economic trends.
One of the biggest aspects of technical analysis that gets overlooked is time...
As I noted yesterday, the history of the market repeats, usually in cycles.
Finding those cycles can be difficult, but using time as a roadmap for what to expect is critical for successful investing.
I've spent more than 15 years studying the history of the market and extrapolating the data to better understand when to expect a market move. These cycles aren't just something to watch... they're inflection points to trade.
The cycles are based on the work of W.D. Gann. I track these cycles all year, but as an example, I'll show you how I've incorporated this work into profitable trades since late this summer. Take a look...
In the previous chart, you can see two big inflection points based on my cycle work...
The first one occurred when the stock market hit a high in late August and early September. Based on my cycle work, I warned that "a correction is likely, own volatility." In Ten Stock Trader, I recommended buying calls on the iPath Series B S&P 500 VIX Short-Term Futures Fund (VXX), which rallies when the S&P 500 falls... And my subscribers recorded a 51% gain in just four days on this trade.
The second inflection point happened in late October, during election season. As I noted on October 31...
I don't know about the [red or blue] political wave, but from a market perspective, everything I see points to a bullish wave.
I recommended buying calls on the small-cap iShares Russell 2000 Fund (IWM) as a way to profit from the ensuing rally. And subscribers who followed my advice could've recorded a 62% gain in just five days on this trade.
These recommendations are just two recent examples of understanding cycles in the stock market – and more important, how to trade them successfully. I believe that another such cycle, a tradeable inflection point, just like the two examples above, will arrive starting on December 23.
I can sum up my approach to trading with a quote from one of the most successful hedge-fund managers alive. Famed investor Stanley Druckenmiller once said diversification is a dirty word. "Put all your eggs in one basket and watch the basket very carefully," he said.
That quote profoundly changed my thinking on investing and portfolio management.
I attended an exclusive, invitation-only conference at Goldman Sachs, where Druckenmiller and former President George W. Bush were the main speakers.
I'll save the details of the speech for a more appropriate time, but I want to emphasize how important this idea is... that being too diversified and having too many baskets with too many eggs in them can wreak havoc on performance.
In my experience, more positions means more problems.
That's why I'll only recommend a maximum of 10 positions at any one time in Ten Stock Trader. This allows me to use all of my energy and attention to a limited number of positions and it keeps things simple.
We trade exchange-traded funds (ETFs). I recommend these to track the major stock indexes like the S&P 500 or sector trades like financials through the Financial Select Sector SPDR Fund (XLF) And I recommend both long and short positions.
We also trade naked call and put options, along with more complex options strategies like "straddles" and "strangles." If you aren't familiar with these strategies, don't panic. The names sound sophisticated, but I explain each trade in detail.
Finally, we trade individual stocks. I analyze thousands of charts every single week. I'm looking for a combination of various factors (many of which I've outlined this weekend) to determine the best trading setups.
And finally, I saved the most important piece for last...
I'm talking about position sizing and risk management.
The instructions for each trade in Ten Stock Trader are based on a percentage of your portfolio... For example, if I say buy a 1% position in XYZ stock and you have allocated $100,000 to Ten Stock Trader, then you would buy $1,000 worth of XYZ stock for that trade.
I will always indicate the percentage allocation on every trade. It's up to you whether you want to allocate more or less, but I like to look out for novice traders.
I want you to see how the pros trade... Hit singles and doubles first, while learning the strategies and the right way to trade. Then, if you want to trade bigger, you can.
Some folks have a higher risk appetite, more capital to work with, more experience, or a combination of all three... so they can trade bigger than my position-size recommendations.
But I'll always recommend what someone just starting out should do. It's the right thing to do. It's what I would want if I were in your shoes.
Never risk your entire portfolio on one trade. Ever. Period. This is the No. 1 reason why investors go broke.
Thanks for reading my essays this weekend. I hope I've helped you get a solid foundation into learning how to trade like the hedge funds do. And I'd love for you to join me at Ten Stock Trader.
And one more thing... if you'd like to learn even more about technical analysis, I highly recommend visiting the Chartered Market Technician ("CMT") Association website.
Regards,
Greg Diamond
Editor's note: We hope you enjoyed this weekend's Masters Series... and that Greg has convinced even the most diehard fundamental investors among you about the value of technical analysis.
But if you're still hesitant, we encourage you to watch the brand-new presentation that Greg just released. In it, he warns about a major market move that's coming this month...
You see, Greg uses a strategy from the 1860s to predict important dates for the market. And he believes that what happens on December 23 will surprise a lot of people... and it will continue for the next three years. Get all the details right here.