Over the last 20 years I’ve been very fortunate to talk to a lot of traders, some of them are just learning and others that have been trading for quite some time.
A few have become proficient and profitable traders over a decade or more and some of these have gone on to write books, hold seminars, and even produce material for other traders to follow and learn from.
There is one thing that all of these successful traders have in common, and that is a relentless and dedicated study of markets, their movement and behaviours, the management of risk etc…
Personally, I love technical analysis and the study of charts as these are at the forefront of any successful trading. Psychology, money management, market selection are all secondary and irrelevant if you cannot determine which way any market is likely to head in the next campaign. I’m not suggesting for one minute any of these fore mentioned market attributes are not important, but if you cannot tell where the market is going next then how is psychology going to help you?
This important factor leads the new trader to look for the Holy Grail, that one tool or technical strategy that the bigger traders must know about and keep secret from the rest of us…
Let me assure you after 20 years of active participation in the markets that there is no one secret tool or strategy that will make any trader remarkably rich. Having said that there are some fabulous tools that I use on a daily basis to help me determine the trend and direction that the market is likely to take next.
Notice that I said tools (plural), because I do believe with some conviction and with the benefit of hindsight that multiple signals at the one point prove to be better indicators of a successful opportunity.
In today’s article we will look at one particular aspect of charting that has given me important visual clues, revealing a potential turning point which maybe a new opportunity or a threat to an existing position.
In this example we will use the S&P 500, the top 500 stocks in the world’s largest economy because this chart should be readily accessible by any trader. We will start looking at the movement from August 2014.
Markets have a tendency to produce large range days which are followed by small range days then followed by large range days and so on…
May I suggest that you read the previous paragraph several times because this single factor alone could help you eliminate a lot of losing trades and indicate a lot of potential opportunities right in front of you. I know it certainly was that way for me and has still been a fabulous clue in combination with my Gann tools and Fibonacci strategies that I like to use.
Let’s now look at a practical example of what the paragraph really means.
At point A on the chart we look at August 7, 2014, which is a low point and from this day the market starts to run higher. It does so for several weeks until August 26, which is point B on the chart, and this is where our reference to size is on clear display. Notice that around point B the bars of the day’s trading are much smaller in size which to me indicate a lack of momentum to push the market higher – which in turn could indicate the buyers have run out of steam.
This is my early warning clue to now look for a confirmation of a counter trend or a movement down as profit-taking starts to take advantage of the rally since August 7. Point C on the chart shows a determined effort to push the market higher but there is just no resolve or momentum to continue to higher prices.
I am now on red alert for a pull back or a slide in prices that will impact on the profit I will make from my Long position earlier in the month.
Notice how the false breaks are prevalent in this market as they are in most of liquid markets. A false break can be determined when a market tries to go higher than a previous high but fails to close above the previous high then goes lower almost immediately afterwards. Points C and D are classic examples of a false break.
At this point it is clear to educated and professional traders that this market is now much more likely to have a major pull back and sellers will start in earnest to clear long positions and start short positions to take advantage of the fall.
At point E on the chart we see very large bars at the bottom of the movement which is an indication of a lot of trading going on where institutional and professional traders consider the market is at an important low and now likely to rally to higher prices.
A strong rise does follow and the market continues to climb up to point F when we see a repeat wherein the bars start to reduce in size as the momentum starts to lose steam.
To emphasize the importance of that previous paragraph let me repeat here with a slight change of emphasis in brackets:
Markets have a tendency to produce large range days (at lows) which are followed by small range days (at tops) then followed by large range days and so on…
Now that we know and understand the significance of the size of the bars have a look again at points F and G on the chart and you should see without any conjecture or doubt that the buyers are diminished or even exhausted and this is my warning clue that the market is due for a retracement or pullback.
Now look closely at point H on the chart and again you will see that the bars have got much wider in range or size indicating that there is a lot of activity going on at the bottom which is traditionally educated or institutional traders buying up cheap stock.
Another repeat of the size cycle is clearly evident here between point H and point I where the market shows very small bars indicating lack of momentum and a potential decline which does indeed follow.
On the S&P around point J you can see a sideways movement dictated by large bars at the bottom indicating volume buying which is preventing the market from falling lower. Whilst it may be difficult to trade sideways movements the fact that large bars are at the bottom is sure sign of buying at this support level.
The lows at point J lead traders to buy into this rally with a stop loss protective order just under the lows and eventually a strong rally appears until again, this cycle of size at point K shows the bars reducing in size or momentum. Another sure sign that this market is showing exhaustion and a decline or fall in prices should be expected in the not too distant future.
What we have covered here in this article should be considered as the ultimate essence of trading by technical analysis. The reading of the chart in a clear and uncluttered environment will reveal many important clues that any trader of any stature or experience will be able to legally take advantage of.
Once you have understood the elements or the basis of chart reading then you may continue on to add your favourite tools, techniques, strategies or indicators to firm up or identify entry points, exits and stop loss protection placement.
Remember, every house and every building must have solid foundations or it is almost certain to eventually crumble into dust.
I hope this article has been of some benefit to you and I’m sure if you take the concepts from this article and applied to the market or markets in which you are actively engaged you may just see these subtle but extremely important signals helping you to become a better trader.