We are going to round off our introductory technical analysis series, in the last three articles, by putting together what we’ve learnt so far. It’s fine having all this new knowledge, but how do you use it in the real world? Technical analysis is a multi-talented tool that can be used for many things in your trading – not just direct price analysis. So this week, we are going to look at how you can use technical analysis to design, build and implement a trading strategy. In our final two articles, we will see how you can apply technical analysis in your risk and trade management and how you can use it to improve your results!
Strategy, design & implementation:
What are your options?
At a higher level, if you’re going to integrate technical analysis into your trading, I believe you’ve got three main choices: 1. Trade purely technically. 2. Use technical analysis to aid your fundamental analysis. 3. Use it to trade and develop systematic models.
One of the biggest factors to influence what you are going to trade, will be the liquidity of the market. Technical analysis, as a stand alone trading tool, works very well when the markets are liquid i.e. high turnover. So this makes markets such as FX, Indices and some of the larger commodities and equities an attractive proposition to deploy technical analysis in. If the markets are less liquid e.g Lean Hogs or an AIM stock etc, then I like to use technical analysis as a timing tool for entry and exit and risk management and rely more on fundamental, behaviour and sentiment tools as the driving factor behind my trading strategy.
Another often overlooked factor is your own personal circumstance and objectives. Technical analysis is brilliant for creating trading opportunities and strategies around your lifestyle. You can speed up or slow down your trading as much as you like by utilising the many ‘time frames’ available to trade. Or you can even get rid of time altogether and concentrate on pure price movement using charts such as Renko, Kagi and Line Break.
The immense pace at which technology has developed over the last decade, and tools have become available in the market place, also throws out another option – systematic trading. This is easier than you think and has many advantages. If you have an ‘edge’ in your trading strategy, then systemising it using technical analysis, can take away a lot of the psychological defects and possible failings that can affect a potential winning idea!
What is a strategy?
Before you go off and start trading anything, using technical analysis or not, you need a plan and you need a strategy! So, what is a strategy? It’s a set of trading rules that are constructed around an idea or uncertainty that you are trying to benefit from. Your strategy can be fundamental, technical or based on behaviors in the markets etc. It answers the Who, What, Why, Where, How, When’s….
You need to firstly:
- Create a robust diagnosis of the situation and the problem to be solved.
- Offer a simple solution to the problem.
- Create a clear action plan / framework for its execution and implementation.
For example: You have a mental model of how you think copper will trade intraday based on some market stock/warehouse flow information you have, so you define it in minute detail.
Basic strategy design process:
- Idea generation/pre-defined strategy
- Fundamental analysis
- Technical Analysis
- Reality Check – Q. does all your analysis all add up?
- Head Check – Q. are you mentally prepared to trade?
- Risk and Portfolio construction
E.G. Idea: Oil is going up (for whatever reason, be it fundamental, technical etc.)
- What: Buy Shell, Sell EasyJet
- Why: Good for oil producers, bad for airlines.
- How: Time it using technical analysis for entry and exit points.
(The above example is known as a ‘Pairs’ trade which is common in stocks)
Strategy: Using purely the technicals:
- Technical tools: MACD / Parabolic SAR/ CCI: use standard market settings.
- When MACD and Parabolic SAR flip in the same direction and;
- CCI is also in the same alignment as the MACD and Parabolic SAR using the following rules: CCI > 100 = long trade and CCI < 100 = short trade
- Put all 3 together for trade entry.
- Check longer term trend in chart timescale above: trade in that direction for added confidence.
- Stops: at relevant support / resistance for trade order.
- In trade management: Trail 5 / 10 points above close of daily high / low.
- Trade objective: risk reward 2:1
What a typical set up might look like using the S&P500 (Charts: TradingView)
An essential rule : MultiCollinearity
This rule states that you should not add indicators together based on the same underlying inputs because essentially they will all be giving the same answer.
E.G. RSI + Momentum = bad, as all calculated on the close.
E.G. RSI + Stochastic = good, as RSI on close and Stochastics on True Range.
When putting indicators together you should also do this in conjunction with other forms of analysis: charts, patterns, volume, open interest, volatility etc.
Strategy: Based on a fundamental idea:
Trading Plan (Basic – in reality will be more detailed): You know that Lean Hogs buying historically fizzles out by late summer and the market continually sees large drops in price around July through August.
- You use the CFTC Commitment of Traders report (COT) to monitor fundamental trading activity and your knowledge of historical seasonality to prepare yourself for the trade.
- You will use technical analysis on the daily chart to time your entry, manage and set your stop levels and ascertain an exit point using Fibonacci analysis.
This approach will therefore take out some of the emotion of the trade.
Example using Lean Hogs seasonality fundamentals, aided using technical analysis (Charts: TradingView)
Systematic trading systems:
Technical analysis lends itself very well to creating systematic systems in different time frames and different markets. One of the reasons so many people fail at trading is that they can’t trade systematically and psychology and human emotion time and time again interferes and ruins a great idea. Again, when building any system you’ll need to answer the who, what, why, where, when, how. You can do this by back testing your theory to see if your initial idea has legs, then put it into live practice.
There are many software tools that allow you to build up the basics of a strategy very quickly and very simply using just technical analysis. Depending on your IT talent, you could even build your own system. At THE STOP HUNTER we run a very successful technical analysis systematic trading fund, based purely on Renko and Line Break charts.
Further reading and learning:
If you are interested in learning more about how you can maximise technical analysis, build and develop your own strategies or learn technical analysis trading techniques and approaches please contact us at THE STOP HUNTER. We offer bespoke training and learning solutions, as well as classroom based learning. Stephen Hoad (Trader & CEO of THE STOP HUNTER) is one of the UK’s leading technical analysts, specialising in Japanese charting methods and systematic trading systems. He is also a lecturer for the Society of Technical Analysts (STA) in the UK.
Technical analysis, if deployed and used in the right way, can be a very powerful trading tool on its own or used in conjunction with a more fundamental approach, to design and implement a strategy. However, it is not a magic bullet and needs to be understood and used correctly if you are to maximise its potential in your trading.
Next time: Technical Analysis (Part 24): Putting it all together: Risk & Trade Management