For momentum trading, which is a type of technical trading, a trader watches for signs that a stock is about to pop; that is, to undertake a significant unidirectional price movement on high volume for a sufficient period of time that might bring 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.
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.
Different Types of Trading
Before we focus on technical trading, here's a review of the main types of equity trading:
- Scalping: The scalper is an individual who makes dozens or hundreds of trades per day in an attempt to "scalp" a small profit from each trade by exploiting the bid-ask spread.
- Momentum Trading: Momentum traders seek stocks that are moving significantly in one direction in high volume. These traders attempt to ride the momentum to the desired profit.
- Technical Trading: Technical traders focus on charts and graphs. They watch 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 corporate events such as actual or anticipated earnings reports, stock splits, reorganizations, or acquisitions.
- Swing Trading: Swing traders are fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals typically require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.
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 are motivated to 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 that is not necessarily limited to trading. Generally, a technician uses historical patterns of trading data to predict what might happen to stocks in the future. This is the same method practiced by economists and meteorologists: looking to the past for insight into the future. However, we all know how poor forecasts can be.
The challenge of technical analysis is that there are literally hundreds of technical indicators available, and there is no single indicator that is considered universally better as each particular indicator or group of indicators, that 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 a silver bullet for deciding when to buy or sell. They are poor predictors of precise 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 discuss the most common groupings and provide a general introduction to each. 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.
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, this may indicate an overbought condition, which is a sell signal. Below 20, the RSI may indicate an oversold stock, which is a buy signal.
- Range Trading: 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.
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, the following books are universally accepted as the very best:
- Technical Analysis of the Financial Markets, John Murphy. —This is a comprehensive guide to trading methods and applications.
- Technical Analysis of Stock Trends, Robert Edwards and John Magee.
- Encyclopedia of Chart Patterns, Thomas Bulkowski.