In momentum trading, a trader watches for signs that a stock is about to "pop," that is, undertake a significant unidirectional price movement on high volume for a sufficient period of time that enables a profit. By virtue of watching the momentum line, the momentum trader has already engaged in technical analysis by examining stock charts for signs of the breakout. But the technical indicators used in momentum trading are only the tip of the iceberg; they are only a small sampling of the wide range of chart and graph patterns available to the technical trader.
Reviewing Different Types of Traders
Before we focus on technical trading, let's review the major styles of equity trading:
- Scalping: The scalper is an individual who makes dozens or hundreds of trades per day, trying to "scalp" a small profit from each trade by exploiting the bid-ask spread. (See also: Introduction to Types of Trading: Scalpers)
- Momentum Trading: Momentum traders look to find stocks that are moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit. (See also: Introduction to Types of Trading: Momentum Traders.)
- Technical Trading: Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.
- Fundamental Trading: Fundamentalists trade companies based on fundamental analysis, which examines things like corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions. (See also: Introduction to Types of Trading: Fundamental Traders.)
- Swing Trading: Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit. (See also: Introduction to Types of Trading: Swing Traders.)
Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice. Entire textbooks are devoted to each style, although many titles such as "Day Trade Online" or "How to Get Started in Electronic Day Trading" are unclear about what type of trading they espouse.
Exploring Technical Trading
Technical trading is a broader style, and is not even necessarily limited to trading; it can indicate a much broader philosophy or approach to investing. In general, a technician is somebody who looks back in history using the recognizable patterns of past trading data to try to predict what might happen to stocks in the future. This is the same general method practiced by economists and meteorologists: looking to the past for insight into the future. However, we all know how poor their forecasts can be. We can only hope as technicians that we will be able to do more than a little bit better.
The challenge of technical analysis is that there are literally hundreds of technical indicators available—enough to make even the most advanced statistician's or mathematician's eyes bug out. And there is no single indicator that can be considered universally best, as each particular indicator, or group of indicators, may be applicable only to specific circumstances. Some technical indicators may be useful for certain industries, others only for stocks of a certain classification (for example, stocks within a certain range of liquidity or market capitalization). Because of the unique patterns that highly traded stocks might exhibit throughout history, some indicators may be relevant only to certain individual stocks.
Technical indicators, like momentum indicators, are not to be used as a silver bullet for when to buy or sell. They are poor predictors of exact timing, but they are good at indicating which stocks are candidates for further analysis with such detailed data as the Level 2 screen. As such, technical analysis can be viewed as a starting point—the historical patterns do not necessarily translate into an exact picture of future performance.
Instead of trying to provide an exhaustive study of all of the indicators available to the technical trader, we go over the most common groupings, attempting to provide a general introduction to each. Do click on the links to additional resources. Also, this discussion is limited to indicators applicable to individual stocks—there are many indicators that might be useful to predict an index or industry group, but that's not what we're concerned about here.
Common Groups of Technical Indicators:
- Relative Strength Index (RSI): This measures a stock's recent performance in relation to its historical strength by comparing the number and magnitude of recent and historical up and down closes. If the RSI rises above 80, it may be indicating an overbought condition, which is a sell signal. Below 20, it may be indicating an oversold stock, indicating a buy signal. (See also: Getting to Know Oscillators: RSI.)
- Trading Ranges: A series of high, low and closing prices are plotted on a graph for a certain period of time, and support and resistance lines are drawn across the bottom and top of the range. A breakout occurs when the price sustains a movement, even for a period or two, above or below the range.
- Pattern Analysis: This may be the form of technical analysis that is easiest to understand. The same price charts discussed above are analyzed for specific patterns that have historically appeared in the same stock or for common patterns that have been seen in many stocks over time. The most commonly observed patterns are head-and-shoulders patterns, triangle-up or triangle-down patterns, rounded tops or rounded bottoms, cup-and-handle formation and so on.
- Trend Analysis: Highly complex and mathematical, trend analysis looks at short and long-term trends and tries to identify crossovers, where prices cross over their long-term averages. The long-term averages are referred to as moving averages, where a price range is smoothed for a period of time by averaging a series of data points and plotting the smoothed line against the actual price line of the stock. The moving average convergence divergence (MACD) is used to identify crossovers, divergence and convergence, and overbought and oversold conditions.
- Gap Analysis: A gap occurs when the opening price of a stock is significantly higher or lower than its closing price the previous day, possibly because of company news released overnight or some other factor. The gap trader is concerned with the performance of the stock above or below its open, which may indicate further movement in either direction. In this sense, the trader's decisions may be closer in style to that of the momentum trader than the technical analyst.
The Bottom Line
There are many, perhaps even hundreds, of excellent books available on technical trading. In addition to exploring introductory day trading texts for chapters on technical analysis, I heartily recommend the following books, all of which have been universally accepted as being the very best:
- "Technical Analysis of the Financial Markets," by John Murphy. This is a comprehensive guide to trading methods and applications.
- "Technical Analysis of Stock Trends," by Robert Edwards and John Magee.
- "Encyclopedia of Chart Patterns," by Thomas Bulkowski.