No matter if you are bullish or bearish, if you are a value manager or growth, if you focus on fundamentals or quantitative signals, price is still the most important piece of financial market information. Price is where the rubber hits the road. Technical analysis is the study of price signals. Many investors it as voodoo, but I have always valued the discipline. I find it a useful technique to answer, “what is the market telling me?” We can get so caught up in our views of the market that we do not take enough time to answer this important question.
My knowledge of the discipline has been haphazard, picking up little pieces of information here or there. I recently read Brian Shannon’s book because I wanted to brush up on my execution skills. I am never going to be a technical trader, but I believe that there are technical techniques that allow investors to risk manage their exposure more effectively. The proof is in the pudding but I found the book powerful because I think it will assist me in achieving this goal.
Shannon provides a clear and simple framework through which to assess financial markets and make risk-adjusted investment decisions. I think it has already caused me to be more patient and observational. I know that these are powerful skills in all facets of our lives. Philosophical platitudes like this resonate with me. I view financial markets as the ultimate teacher. Just like in life, we can never be entirely correct in financial markets, but we have to make risk-adjusted decisions given the information available, learn from the feedback, adjust our principles and wake up tomorrow to fight another day as better versions of ourselves.
The notes which I will return to:
No one makes money in markets all the time.
Consistent outperformance comes to those who understand market structure and respect ever present risk.
Success comes down to discipline.
Identify low risk high profit trades and manage them with constant focus on risk management.
Risk management is the number one rule of a trader.
The lowest stress way to profit in markets consistently is through trend following.
You only need a handful of strategies to be able to attain consistent trading profits. More only confuses the issue.
The trading edge comes from clearly and objectively observing market action and implementing trades based on what the market dictates without ego.
You must be willing to fully accept responsibility for your actions.
You will never find true satisfaction if you expect perfection and make excuses when perfection evades you.
You cannot be bullish or bearish if the price action tells you something different. Trading requires healthy scepticism.
A professional trader prepares for all possible scenarios before entering a trade and is never in a position to fall prey to an emotional decision.
There are no wrong approaches to the market, only wrong approaches for certain personalities.
Keep it simple!
Only place your money at risk when you have a perceived edge.
Always ask these questions: where has the stock come from? Where is the long term support and resistance? Where does the stock have the persistence to go?
Foundations of technical analysis:
- The market is a discounting mechanism
- Prices move in trends
- History repeats
In trading, emotions are the enemy. If emotions are influencing market actions, take a step back and refocus attention on price action.
4 stages of a stock: (‘stock could’ be replaced with ‘security’, ‘asset’ or ‘market’)
Short-sellers realize some profits. Cash is slowly enticed back into the market. Buyers are fighting for control of the trend. Neutral period offering no edge.
Moving averages cross above and below each other, which signals indecision. Volume begins to slow.
Response to negative news eases. “who is left to sell?” Negative news wears off over time.
Large institutional holders who were unwilling to liquidate while prices declined will lose hope of price increases as the consolidation plays out. They could become consistent sellers, keeping a lid on prices. On the demand side, value players will methodically absorb supply.
Higher lows start to emerge at the end of the accumulation phase, trading volumes increase, more frequent tests of key resistance levels and flattening/rising longer-term moving averages.
Clearing the highs of stage 1 establishes a higher high and the buyers are in firm control of the market. The initial move is accompanied by large volumes as lots of participants are caught off guard and chase the higher prices. The early stages will go unchallenged by profit-takers as most longs are strong holders who were accumulating during the previous phase. Early moves of a rally have much lower failure rates, rather than the late moves.
The uptrend is marked by greed of the long participants who crave greater profits. The importance of fear is overlooked in uptrends. Short sellers are fearful of their equity being wiped out, which motivates them to chase prices higher, which risks unlimited losses. Fear of missing out FOMO encourages undisciplined traders (the sheep) to “graze in the market” after a meaningful short-term rally, just as the stock begins to experience a short-term correction.
Institutions drive strong upward momentum because they can have a big impact on price. Momentum traders emerge after a stock has been in an uptrend and pullbacks have been resolved to the upside. Amateur traders soar through the market with self-confidence like eagles. Professionals are looking for signs of weakening trends, like a hawk. Professionals play a defensive hand, looking to take profits when the stock displays signs of tiring. Think of the patience required in poker.
Professionals prefer a staircase pattern. Corrections allow for an uptrend to continue by cleansing the market with stronger holders accumulating from short-term traders.
Uptrends persist when volumes are rising during the uptrend but falling during the pullbacks. By contrast decreasing volumes should be viewed with suspicion, and if volumes increase on pullbacks, then strength should be questioned. Falling volumes do not guarantee falling prices though. Sharp upside price movements are possible on low volumes if there is a lack of supply. Short sellers can be forced to cover during these phases.
DO NOT BE BLINDED BY GREED AND INFATUATED WITH THE ASSETS AND VOW TO NEVER SELL.
Be wary if a stock gaps sharply lower. Surprises can change market momentum suddenly. Rather sit on the sidelines and wait for resolution.
Do not short a stock just because it has gone up too much. Sharp rallies can continue at the end of market cycles.
The further a stock travels from support, the riskier purchases become.
At the crest of the upside momentum, favourable news stories emerge.
Just like in the accumulation phase, moving average cross overs represent indecision. The start of the distribution often sees large volume as bulls and bears jockey for control. Big volumes without further increases in prices is a classic sign of distribution. What appears to be a distribution does not always lead to a fall in prices. If the long-term moving averages continue to rise, the benefit of the doubt goes to the buyers.
It is common for the good news to come out at the top of the market, after a large rally, so “who is left to buy?”
Look out for falling highs, flattening/declining moving averages and tests of support on heavier volumes.
Formation of a market top usually takes less time than a market bottom. Do not short the stock until it is clear that sellers are back in control of the market. The longer is takes for a top to form, the bigger the decline. “the bigger the top, the bigger the drop”
Large holders who have been net sellers get nervous of negatively impacting prices. Buyers will still be present, but they become less aggressive and start lowering their bids. Some previous buyers turn into sellers.
There have been many attempts to classify exactly what constitutes a bear market, but it simply boils down to this: an environment where the path of least resistance is lower. Sellers are clearly in control, creating a condition where lower higher and lows prevail. Supply> demand leading to falling prices in the search of liquidity.
Declining prices bring about the strongest emotional responses.
Do not catch the falling knife. Wait until it has fallen before you pick it up. Good valuation or significant price declines are not enough to pick a bottom. Nobody rings a bell at the bottom but humans endlessly try to pick the bottoms, searching for bargains. Retail traders provide a “slope of hope”, crushing dreams and finances.
For long participants, the decline has two types of fear: 1) fear that their equity will be wiped out (this is a good fear to react to) and 2) fear of being a stupid/loser seller of the stock that is about the turn higher
Short selling is powerful but dangerous. Short sellers get greedy as they see the equity in their account balances increase. Short-term rallies come suddenly and quickly during downtrends. Short sellers can be quick to cover during rallies, leading to sharp bounces in price.
Do not trust gaps higher in a downtrend as they have a nasty tendency over reversing.
Climatic selling can signal the eventual end of the decline as stubborn longs liquidate in disgust. Some sidelined participants may think it is a good idea to sell short as it becomes “obvious” that the stock is in trouble.
Support & Resistance
Stock prices are inelastic – demand can increase as the price moves higher. Higher prices can encourage holders to reduce supply as they wait for aggressive buyers to bid prices higher before selling. Markets are a competitive auction. Shifts in supply and demand cause a price to move higher or lower in search of an efficient price to satisfy demand. These shifts in supply and demand are far more important than trying to understand every potential reason that could cause participants to change their perception of value.
Levels of consolidation when there is a balance in the facilitation of trade are known as support and resistance levels.
Amateurs focus on the exact tops and bottoms, which are fleeting and insignificant. Making money is not about picking tops and bottoms but being involved in an existing trend at a level that exposes you to minimum risk relative to the perceived potential profit.
The transfer of power between bulls and bears can occur rapidly but it is more likely that it will be gradual.
We can never understand the exact catalyst that causes participants to buy or sell at every given time, but greed and fear are at the root of these decisions too. All participants are movitated by the desire to make money and are afraid to lose money at some level. Varying levels of fear and greed are what prevent prices from moving in either direction for too long before prices consolidate.
Resistance levels are formed by passive selling and broken by aggressive buying
Support levels are formed by passive buying and broken by aggressive selling.
The market has a memory. Once broken support acts as resistance and visa versa. It is not the breaking of the level that is most important but the subsequent action which confirms or rejects the movement that matters most. Have a plan in advance for the moves that fail. An intelligent use of stops can guard against the possibility of larger losses if the move fails.
It is common for amateurs to point to a level on a chart where prior important price action took place and proclaim a support or resistance level, but in a trending environment those levels will be breached with regularity. The strength and importance of support and resistance levels is influenced by three factors: 1) the time it takes to form, 2) the volume traded during formation and 3) how recently it has developed. The more time and volume, the larger the group of participants whose idea of value will be positively or negatively influenced upon a break of the level.
The more times a level of support or resistance is tested, the more likely it is that a violation of that level will occur.
Support and resistance levels not only allows us to uncover potential turning points but the help to objectively determine potential risk/reward for a stock before committing capital. Whenever making a trade ask, “where has it come from, and where does it have the potential to go?”
Once a trend is established, it is more likely to continue than reverse. The trend is “the path of least resistance”.
The highest probability trades come when there is an alignment of trends across multiple time frames. When there is doubt as to the direction of the trend, it is best to refer to the next larger timeframe. Longer-term trends exert more force.
The larger the volume on a break of longer consolidation levels, the greater the odds of a new trend being able to sustain the move.
Trends can experience consolidation, pullbacks (in an uptrend), snapbacks (in a downtrend) and reversals. One clue that the trend may be losing momentum is indicated by weakening volumes (declining conviction).
Trend lines are a useful tool to measure and quantify trends. The market does not make it possible to draw perfect trend lines – there is a degree of subjectivity when drawing them. Allow prices to pass slightly above or below a trend line.
Although trend lines often act as support or resistance, TOUCHING A TREND LINE DOES NOT GIVE REASON TO BUY OR SELL. Instead, it gives us reason to study the stock on a shorter-term time frame. Trends become weaker each time they are tested. Paradoxically, the longer anything becomes obvious to a large group of participants, the greater the odds of failure. When a trend is broken it should be taken seriously, but it typically only signals that the rate of change has slowed and that the slow is expected to experience a correction through time. This can be an excellent warning of a transition to a more neutral trading environment.
Some of the strongest trending moves develop near the tail end of a trend. A stock which has been trending for a long period will take on the perception of being bullet proof. As buyers chase prices ever higher, an unexpected large source of supply is bought to the market, which can trap long players.
When there is a chance of financial gain or loss with each purchase/sale, the market brings about and magnifies many emotions that do not normally come into play when buying a normal good. Trading volume helps us understand the intensity of those emotions. It provides an indication of commitment of participants.
Large volumes on rallies and low volumes on corrections during an uptrend are a sign of a strong trend. Clearly the buyers have the upper hand. Inversely, large volumes on price falls and low volumes on snapbacks during a downtrend are a sign of a strong trend. Clearly the sellers have the upper hand. Low volumes on rallies and large volumes on pullbacks during uptrends is a sign of an exhausted uptrend. The buyers are not in complete control. Inversely, low volumes on falling prices and large volumes on snapbacks during downtrends is a sign of an exhausted downtrend. The sellers are not in complete control.
Low volume during a breakout suggests close monitoring of the market, not necessarily a weak breakout. Volumes could catch-up to the breakout. Similarly, low volumes during a trend does not imply that you should bet against the trend. Rather watch the trend closely. Trends can run hard on low volumes. Big volumes without further progress in the trend is a sign of distribution – be on alert for trend reversal.
Limit orders add liquidity to the market and can be seen as passive, while market orders remove liquidity and are seen as aggressive.
Though volume is a good confirmation of conviction, do not wait for volume before making purchases. THE ONLY THING THAT TELLS US WHEN TO BUY IS PRICE ACTION. Volume is used to confirm or reject price direction, not as a timing signal. You can reduce position sizing and keep stops tight, if you are uncertain.
Moving averages are lagging indicators but the objective is not to use them as predictors. We are rather using them as a visual reference point to which price can be compared to better recognize trends and market structure.
Do not use moving averages as systems themselves. Moving average cross-overs are a sign of indecision. Trending action should be relied upon to make buy or sell decisions.
Investors watch moving averages which often leads tose levels to become somewhat important. The direction of key moving averages is more important than a close above or below them.
Time is one of the few variables over which we have any control. Avoiding sideways markets allows us to optimize time and mitigate against opportunity cost.
Some participants are attracted to markets to fulfill a need for constant activity and a relief from boredom. This is a dangerous motivation for trading. THE ONLY REASON TO TRADE IS TO MAKE MONEY.
The use of multiple timeframes to analyze a stock allows low risk high potential trades when there is trend alignment. The primary trend movements are like oceanic tides, which cannot be manipulated. The forces of supply and demand are too large for one participant to influence the collective reasoning of the crowd. Secondary movements are referred to as waves, which are reactionary movements within longer term trends. The third class of movements are short-term minor trends which are insignificant ripples.
The choice of timeframe over which to match these three trend movements is determined by individual factors including: availability of time, capital base, market experience, personal risk tolerance and patience level. Investors tend to see weekly as the primary trend, daily as the secondary trend and 30-minute as the minor trend.
No matter which timeframe you look at markets, a minimum of three timeframes should be referenced before a trade is made.
Looking at the short term does not imply that you have to day-trade but you can mitigate against risk by finding the right entry points for a trade. Stay focused on the timeframes relevant to style and DO NOT BE SEDUCED INTO TRADING MORE FREQUENTLY THAN SUITES YOUR STYLE.
How & when to buy
Maintaining discipline and emotional detachment is more important than trying to catch every move that you see.
- identify the stock. 1) trading above 10, 20 and 50-period moving averages, 2) moving averages stacked and 3) it’s a bonus if the longer timeframe chart has the same characteristic. The longer time frame is used for idea generation, not timing purposes. Is this asset/market/stock a viable trade candidate?
- identify risk & reward – Once that has been determined, you must assess if there is sufficient potential for reward relative to perceived risk, which is where the intermediate timeframe comes in. Support and resistance levels provide an indication of where stops and price targets should be placed and thus the risk/reward tradeoff. It is a mistake to base stop losses on anything other than previous levels of support. The most sensible stop for a new long position is simply based on the definition of a long trend, “higher highs and higher lows.” If price drops below the previous higher low, then sell.
Stops have no value if you do not act. It is easy for amateurs to manufacture reasons to justify continued holding of a stock. Do not pay attention to other pieces of information as you attempt to justify holding on to your position.
“stalking the trade” – After confirming that a decent trade setup is present with sufficient profit potential, you consult the minor trend for more precise entries.
Stages and action points:
- Anticipate: observe stock in accumulation. Looks for tests of resistance, increasing volume and higher lows. Set alerts. Observe order book to see where supply is offered.
- Participate: Once stock has broken short-term resistance and established a higher high, it is time to buy. Do not wait for volume to confirm. Prudent to take profits after an initial burst of buying activity (1/3 or ¼), which allows you to be in a position of strength. Raise stops to the new higher lows each time a small correction or consolidation take places. If pullbacks become deeper and bigger volumes emerge, caution should increase. As price targets are met, take further profits.
- Exit: an uptrend corrects in two ways. Price can violate the previous higher low on the short-term time frame. Or the market becomes indecisive and consolidates – often when moving averages cross. Either signal is a cue to exit long positions.
- Avoid: when stock shows lower highs and lower lows.
How & when to sell:
Mirror image of buying, but riskier because you run the risk of unlimited losses. Cutting losses must be taken very seriously when selling short, as must position-sizing, stop losses and risk management. Useful to be choosier with short candidates. Be more patient to let the market present you with lower risk opportunities. Smaller position sizing helpful. Focus on SURVIVAL.
A declining 200-day moving average is a good bear market indicator.
Bear markets tend to be more emotional because people are complacent when they are winning and become frightened when they are losing. Fear is a much stronger motivator than complacency. Fear from the longs shows its first signs as the stock experiences an unusually large drop on large volumes (5X larger than average trading volume over the last 20 days).
When a stock is sold short, those sellers represent future demand. The phenomenon of a rapidly rising stock with large short interest is known as a short squeeze. It is very stressful to be short a stock that is moving higher. If you find yourself in this scenario, put your emotions to one side and buy the stock back, take the loss and vow the never trade against the trend again.
Short-interest ratio, or days to cover, is the number of shares sold short (short interest) over average daily volume over the previous two weeks.
If you ever receive a margin call, then you need to work on money management.
Factors which may lead to a short-squeeze: 1) uptrend on the daily timeframe, 2) absence of hedging vehicles, 3) short interest elevated and 4) a price level where the majority of shorts were initiated.
For a professional, taking losses is an everyday part of the business. It is only large losses that must be avoided at all costs.
If you are unaccustomed to holding a position overnight, then reduce your position sizing
The mindset in the face of losses does a long way to determining your emotional state and thus your ability to produce good trading outcomes going forward.
Holding winners and cutting losers in the basic theory of money management.
Risk managers usually insist on no more than 1% or 2% of capital in any one trade. *How do I think through this given all my assets are in one asset class?
Scaling out incrementally from a position is prudent. There are 7 events which should motivate sales:
- Falling below/ rising above initial protective stops
- Gaps against the prevailing trend
- Hitting price targets
- Hard trailing stops
- Trailing stops
- Time stops
- Moving average crossovers
Bull markets foster bad habits amongst traders, bear markets bring about a remembrance and respect for risk.
Do not get caught up in meeting daily, weekly or monthly goals for certain percent or dollar returns. Focus on what you can control and how well you handle various market conditions.
No one is immune from greed and fear. Leveraging capital will also leverage these emotions, which increases risks.
Never trade out of frustration. The market punishes angry traders.
Your ego will heal from taking a small loss much quicker than your equity will recover from large draw downs.
Monitor emotions and decision making as closely as price.
Trade only when you have a proper mindset. If you are tired, hungover, or emotional, judgement will be clouded.
Rely upon yourself only.
Do not talk about trading positions and do not trust others who talk about theirs.
If you need other people’s advice about a position then you should already have exited it.
Exit positions when you can, not when you have to.
Lose your opinion, not your capital.
Defense wins this game. Think survival and discipline.
At the end of the day, focus on your thought process and how well you executed your plan.
Many traders experience large losses after a strong of profitable trades because they succumb to the feeling that the losses are not real; that they are just giving back profits. This is very destructive. Always take losses seriously, minimize them at your first opportunity.