Course #203: Technical Analysis
There are many books and Web sites that try to explain TECHNICAL
ANALYSIS (TA). Dan and I have read our share of them and a few are
very good. But why is this course any better than the others?
This online course is a blend of concepts, theory, real-world
applications, examples and our own experiences specifically designed
to help you make money in the markets and
keep the money you make! We believe this course
will provide you with the necessary tools to help you create wealth in the
stock market. After each lesson you can apply what you have learned by
studying the charts of your own stocks and studying the major
In order to profit consistently over time while investing (or
trading) you have to gain knowledge and experience, which will help you
keep those profits. You must have discipline. And you must be
willing to take calculated risks. Calculated risks!
In the lessons that follow we will share our experiences with you.
And with time you will be able to develop your own philosophy,
methodology and discipline. You will enable yourself to identify and
take the calculated risks in the markets that stack the odds in your
favor. And you will discover how to control risk toward the end of
making and keeping a profit. Sure, it's fun. But let's not lose sight
of why we're doing this!
EXACTLY WHAT IS IN THIS COURSE?
First we will describe some of the most common, popular and broadly
useful tools of the chartists and technical analysts. Then we will dig
a bit deeper into a number of technical indicators and oscillators.
Finally, we'll share some of the proprietary indicators available
at 21st Century Investor, specifically those used in
The Agile Trader.
JUST WHAT IS THIS TECHNICAL ANALYSIS STUFF?
Before we dig into the many
concepts and tools used in Technical Analysis (TA), we need to be able to
answer a couple of basic questions:
- What is Technical Analysis
(TA) and how do you use it?
- How is it useful?
1. What is Technical Analysis and how do you use it?
TECHNICAL ANALYSIS (TA) involves tracking price, volume and time
data from trading instruments usually on charts or spreadsheets in
order to understand the behavior of those instruments. The goal of
understanding the behavior of the instruments is to determine the most
advantageous points at which to buy and sell instruments in order to make
money. But not just to make money -- also to limit risk. TA
is used in trading commodities, stocks, stock indices, futures,
currencies, bonds and virtually anything else for which data
can be collected and organized. Indeed, the Japanese began using a kind
of TA as far back as the mid-1800s while trading rice.
Chartists look for identifiable patterns in the collected data and
make their best efforts to predict near-term future behavior based on
the patterns. Markets have certain kinds of regular
"customs" or "laws" which we try to identify and
use to forecast the future.
In this course we will deal primarily with stocks and stock
indices. The principles of charting apply to all markets,
although there are some variations in what works best or least
depending on the properties of the markets under scrutiny.
For instance, the long-term pattern of certain commodity markets are
essentially flat while the long-term pattern of the stock market appears
as an exponential curve.
But what are we really doing? What are we measuring? We are
measuring buying and selling. We are keeping track of buying and
selling over a particular period of time and how much buying and
selling moves the price of the instruments.
Who is doing this buying and selling? Professional money managers
who work for large mutual funds, hedge funds, wealthy individuals,
pension money and insurance companies. There are also traders on the
floor, super computers spitting out program trades and people sitting
in their basements making trades on their computers. Millions and
millions of decisions are being made all day long in every corner of
the globe. And when you aggregate the whole mess you see that some
sort of society has formed in a marketplace. That market is arguing,
constantly voting with its dollars on the subject of fair value and
struggling mightily to achieve a dynamic consensus. So what we're
really doing is measuring complex aggregates of arguments based on
human social behavior. In an academic sense a very specific kind of
statistical sociology. To be practical we want to figure out what the
markets will do so we can trade them profitably.
Ultimately, we have only three elements to analyze: price, volume
and time. We try to find meaningful and effective ways of slicing and
dicing the data. We might slice the data one way to try to discover
momentum. We might dice it another way to discern support levels. Data
is analyzed one way to discern the direction in which money is
rotating, and studied yet another way to define sentiment. But price,
volume and time are the only raw data elements that we have to work
with; everything else starts from there.
2. WHAT IS TA USEFUL FOR?
If a picture (chart) is worth a thousand words then what is the
picture (chart) telling us? Are the prospects bullish, bearish or is
the picture uncertain? Charts can help us determine direction and a
potential price target. Knowing when to buy and sell can lead to
Ultimately it boils down to signaling when to buy and when to sell.
There are plenty of ways to measure when it's time to buy and when
it's time to sell. There are breakouts, breakdowns, measured moves,
bounces and failures (of trend lines, moving averages, etc.), one-day
candlestick patterns, three-day candlestick patterns, Fibonacci
retracements, Fibonacci price targets, parabolic stop and reverse
signals, sentiment measurements, oscillator signals and more. An
infinite supply of tools exist, bound only by the limits of human
TA is good for giving you buy and sell signals. Are they always
correct? Absolutely not. Can you derive a trading system that is right
more often than wrong? You bet. Can you derive a trading system that
nets larger average gains than losses? Absolutely. Can you
find a method that tends to make money? That's your goal.
TA is also useful in
An important benefit of TA is that it can provide you the
discipline to get out when you're on the wrong side of a trade.
The easiest thing in the world to do is to get on the wrong side of a
trade and to get stubborn. That is also potentially the worst thing
you can do. Believe me. I have made this mistake. You think that if
you ride it out you'll be okay. And the most seductive thing is that
often times you will be okay. However, there will also be
occasions when you won't be okay. The stock will move against you in
ways and to an extent that you previously found virtually
Now, the next part I'm going to write in caps. And I want you to
read the whole thing. Don't skip over the second and third
IT IS MORE IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS! IT
IS MORE IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS! IT IS MORE
IMPORTANT TO CONTROL RISK THAN TO MAXIMIZE PROFITS!
Okay, we say
this is so, but why is this the case?
This is true because of the
asymmetry between zero and infinity.
What does that mean? Unless you are someone very special you have
finite capital. Most likely you have very finite capital. With a
market of thousands of stocks you have a functional infinity of
If you lose an opportunity, you will have thousands more tomorrow.
If you lose your capital, will you get thousands more tomorrow? Most
likely, no. You will have also lost your opportunities. Your capital
is worth more to you than your opportunities because you must have
capital in order to take advantage of tomorrow's
It's simply supply and
demand. Waste what's plentiful, preserve what's scarce.
Preserve your capital because
your capital is your opportunity.
This is why:
It is more important to
control risk than to maximize profits!
We spend time on this because we want you to be aware that one of
the most important things TA can do, if practiced with discipline, is
give you specific parameters for managing risk.
Wall Street history is littered with the corpses of geniuses who
trounced the market -- those who overstayed their welcome and were
subsequently wiped out. (Do the names Long Term Capital Management
(LTCM) and Stanley Druckenmiller ring any bells?) LTCM (populated by
two Nobel laureates among a number of very smart people) went bankrupt
betting on what almost always happens would happen "this
time." Why did they go bankrupt? Was it because what usually
happened DIDN'T happen that time? Well, it didn't happen...not right
away...but that's not why they went bankrupt. Their liquidity ran
out. The market remained irrational longer than they could remain
solvent. They went belly up because they didn't know when to quit,
because they didn't manage their risk.
And Druckenmiller (a much-vaunted Wall Street savant) was fired as
manager of George Soro's fund group when the tech bubble burst. Again,
this is not just because he was on the wrong side of the market when
the bubble burst but because he didn't manage risk when he was on the
wrong side of the market. (In the major reversal section we discuss
major reversal patterns that can help identify chart patterns that can
reverse a major trend and presage a 100% retracement. Any investor who
has mastered this section would knows to protect himself!)
You can be right a thousand times, become very wealthy and then get
wiped out completely if you manage your risk poorly just once.
One last time: That is why it
is more important to control risk than to maximize profits!
ON A MORE PERSONAL NOTE
TA can be overwhelming. How do you know what to look for? How do
you organize your thinking in a market of 9,000 stocks (and more)
trading billions of shares per day? How do you learn your way
We want to approach TA the same way you might teach someone
his or her way around a city. Just having a map is great, but it's not
really a substitute for walking the streets of Paris or New York.
When I (Adam Oliensis) was 19 I visited my sister who had moved
to Manhattan. The most fun I had was putting on my running shoes and
jogging - first through the East Village, then uptown through
Chelsea and into midtown Manhattan. I jogged up 6th Avenue at lunch
hour in the midst of the hustling crowds and traffic and skyscrapers
and into Central Park. I ran by the lake and the ball fields then
suddenly found myself standing between Tavern on the Green and the
Sheep Meadows. I walked into the field and sat down for a while
viewing the city: I saw 5th Avenue to the east, Midtown to the south,
and the sun now angling down toward evening in the west. I felt as if
I knew the city intimately and was no longer a stranger. You can't get
that feeling from just a
That's how we would like for you to learn about TA in this course.
In addition to sharing theories and practices of TA (the map of the
city) with you, we'd also like to share our hands-on experience using
TA. (We've eaten at all the Chinese restaurants in the neighborhood,
so we know which ones are good and which ones not so good.) We want
you to learn the neighborhoods in a way that will save you from
wasting your time (eating at the crummy restaurants) and help you to
develop more than a general understanding. We want you to develop a
useful understanding of what tends to work and what doesn't. This
knowledge is what we intend to share with this online course.
Okay, now that you know something about TA and how it can empower
you in the markets, let's get to it!
Adam Oliensis & Dan Hassey