Technical trading, generally speaking, means trading where entries and exits are based on charts or graphs of price movement over time. The principles can be applied to many areas such as stocks, futures, indices, foreign exchange or whatever has a price that fluctuates over time. Technical analysis can be very basic (as in the relationship of a price to a moving average) or quite complex using a variety of indicators that may include MACD (moving average convergence divergence), stochastics, or maybe relative strength indicators. The number of indicators is vast and they may be used individually or in conjunction with some or many others. So far, I know of no combination that results in perfect trading, and I suspect that none will ever be found. The problem with finding the 'holy grail' of indicators is that they cannot take into account every nuance of human emotion and it is that emotion that often moves the markets in one direction or another.

Technical traders do look to the past in some effort to predict the future. Past levels of support where a price drop stopped may be a floor or support level. A double bottom, for example, is simply a price area to which a stock dropped and then turned back up on a couple of occasions in the past. It is some evidence that the price may hold around that level if a stock price dips there in the future. A double bottom, however, is no guarantee that a descending price will not go below that double bottom support level in the future. In that sense, then, technical analysis may not accurately predict the future.

Why would one want to use technical analysis in his trading if it is imperfect? As I set out in an earlier article on fundamental trading, fundamentals tell us nothing about when to buy or sell a stock. They simply give us information about the apparent financial health of a company, but in the short to medium run, at least, fundamentals may not move the stock price. The internet bubble provided many examples of companies that had no earnings (not a very good fundamental) than ran up wildly in price. So if we can't rely completely on fundamentals as traders, upon what can we rely to determine entries and exits? All too many traders (the largely unsuccessful) rely on their emotions. They enter a position to try to satisfy greed and often exit prematurely or after too large a loss as a result of fear. If we can't use fundamentals to determine entry and exit and emotions are way to dangerous to rely upon in our decision making, we are left with technical analysis.

I consider myself to be primarily a technical trader. I use chart formations and analysis to attempt to find the best time to enter positions and the best time to exit positions. In fact, using technicals, I ordinarily determine my exit strategy before I ever enter a position. In other words, I know my exit before I enter. I do not exit just because a position hits a target. What if it keeps going past the target? If that happens and I got out at the target, I will have missed out on additional profit. Instead, I generally try to use some technical exit -- a line in the sand of sorts -- to take me out of the play. As a simple example, take a stock that is trending upward. The stock price moves up after touching the trend line. Could I consider buying the stock at that point and deciding that a break down through the trend would be my exit? Of course I could and the result would be that I would remain in my position as long as the trend continued up. What if it broke down through the trend the next day? I would sell. What if it stayed above the trend line for 6 months or a year? I would still be holding the stock. Only a break of the line would take me out. I would not be condemned to bad trading by my fear or greed; I would automatically have a disciplined exit that would cut my losses and let my profits run. Isn't that what really leads to successful trading?

Good Trading!
Bill Kraft

September 29, 2007

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