Stock Trading Essentials

Using Technical Analysis
 

 

There are two main schools of thought when it comes to analyzing stocks.  One school of thought uses fundamental analysis to analyze companies and attempt to value how much a company is worth and, hence, the price the stock should sell for.  The other school of thought is called Technical Analysis, which uses tools such as chart patterns and trend analysis to project future trends in stock prices. 

 

Fundamental Analysis

Uses economic data, historical financial information found in financial statements, financial projections, to determine intrinsic or fair value of a company.

 

Technical Analysis

Highly depends on current market psychology and investor sentiment in choosing a stock.

 

If you’re like many new investors, you’re probably wondering who uses technical analysis and who uses fundamental analysis?  In general, fundamental analysis is applied by long-term investors, while technical analysis is mostly applied by short- and mid-term traders.  The below chart breaks down some differences between fundamental and technical analysis:

 


 

Why technical analysis?

There is a theory that the stock market is “efficient”; this would mean all investors in the stock market behave in a “rational” manner.  The problem with the efficient market hypothesis (EMH) is that it doesn’t factor in important drivers such as human emotions.  Those who rely on technical analysis believe less in an efficient market and more in market psychology as a driver of stock prices.    

Market psychology uses human psychology to measure the sentiment of the stock market, and to project future market prices.  These are believed to be identifiable as they recur in the form of price patterns that can determine the trend and direction of the market. 

 

Herding

An important concept under market psychology involves market herding.  The concept of market herding assumes that many market participants don’t do their own research, but, rather, they follow what others are doing.  This creates a herd mentality wherein investors follow investments made by others, instead of thinking independently.  Herding goes against the efficient market hypothesis.

 

Three Principals of Technical Analysis

There are three main principles of technical analysis:

  1. Market action discounts everything
    The price of an asset discounts all known news, whether it be fundamental (company’s financial results), political, economic, psychological, and otherwise.
     
  2. Prices move in trends
    Technical analysts believe prices move in short-, medium-, and long-term trends.  In other words, a stock price is more likely to continue a past trend than move erratically.  Most technical trading strategies are based on this assumption.
     
  3. History repeats itself
    Price movements can be attributed to market psychology and market participants react in a consistent manner to market stimuli over time.  These price patterns become repetitive over time and across asset classes.

Technical analysis uses market psychology and concepts like herding to explain market sentiment.  Trading relies heavily on human behavior and market psychology, which rely on the view that humans react in similar ways to similar situations.  This human behavior and tendency to react in similar ways leads to predictable behaviors.  These behaviors are seen in the market through market patterns, which is why traders use patterns to project or predict future price action.  

Some important tools technical analysts use to measure and predict trends include charts, patterns, and trends.

 

Three types of charts

There are three main charts that technical analysts use.  
 

 

While each of the charts above can be important, the line chart and candlestick chart are the most widely used by traders.  The line chart is easy to understand, as it simply shows the changes in prices (often times closing prices).  Since traders care about both price changes (the opening and closing price of a stock) and the price movement of a stock during a specific timeframe, candlestick charts are often used.  Candlestick charts help traders visualize price changes over periods and, since they are a bit more complex, we will discuss candlestick charts below.

 

Candlestick Charts

 

 

The above graphic shows how candlestick charts work.  On the left side you can see the price movements of a stock during a trading day.  It shows the opening price, the high, low, and closing price.  The candlestick is a powerful tool because it is a way to visualize all four of these points in one small visual.  On the right side you can see the green candlestick.  The bottom tail depicts the low for the day, the start of the lower body shows the open for the day, the top of the body shows the close, and the top tail shows the high for the day.  The color of the candlestick is important as it depicts a positive or negative day.  The colors used here are green (up day) and red (down day).

 

 

As you can see, the green candlestick shows a stock that closed at a higher price than it opened.  The red candlestick closed at a lower price than it opened.   Candlesticks are a great way to visualize the range a stock moves during a specific time period. 

To better understand how candlesticks can work with time periods, we can view the below graphic.

 

 

As you can see, a candlestick can be visualized as anything from intraday and daily, to weekly and monthly.  The candlestick chart time scale you choose may depend on how short or long you hold positions before you sell or your trading style.  Between candlestick charts, line charts, and bar charts, you may be wondering which type you should choose.  In general, it comes down to personal preference.  Traders will sometimes look at both line charts and candlestick charts, or line charts and bar charts.  Since bar and candlestick charts show the same general data, you can use whichever chart you prefer.

 

Chart Patterns

Technical analysts use chart patterns to target potential trades.  They can help traders pinpoint potential entry and exit points as well as whether the stock may reverse (reversal pattern) or continue (continuation pattern) its price movement.
There are two main chart patterns.  Each of these patterns can be either bullish or bearish.

  • Reversals
    o    Bullish Reversals
    o    Bearish Reversals
     
  • Continuation Pattern
    o    Bearish Continuation
    o    Bullish Continuation

Bullish vs. Bearish Reversal

The below graphic shows a bullish double bottom pattern vs. a bearish double top pattern.

The bottom graphic shows a bullish reversal pattern.  This would be a potential bullish trade that could lead to profit.  The top graphic shows a bearish reversal pattern.  This may be signal a price you may not want to buy considering it has potential to lose value.

 

Bullish vs. Bearish Continuation

The below graphic shows a bullish falling wedge and a bearish rising wedge.

 

 

The bullish and bearish wedges are continuation patterns.  The top graphic (bullish falling wedge) shows a bullish pattern which could lead to a gain if purchased.  The bottom graphic (bearish rising wedge) shows a bearish pattern which could lead to a loss if purchased.

 

There are a variety of different patterns used by market technicians.  Some other patterns include (but are not limited to):

  • Triangles
  • Pennants
  • Flags
  • Wedges
  • Double top & bottom
  • Head and shoulders

 

To learn more about the above chart patterns, read through our technical analysis category. 

 

Trend Analysis

There are three distinct trends seen in technical analysis.

 

 

The above trends show the direction of prices given the trend.  The uptrend line show a rising stock price, the downtrend line shows a falling stock price, and the sideways trend shows neutral price movement for a stock over a given timeframe.  When it comes to trends, there are three different timeframe classifications.

  • Minor trend (<2 or 3 weeks)
  • Secondary Trend (3 weeks – several months)
  • Major trend (>1 year)

 

The above graphic shows the three different trends. 

  1. The top chart shows a minor trend (a few weeks).
  2. The middle chart shows a secondary trend (a few months).
  3. The bottom chart shows a minor trend (1 year). 

Another important trend for traders is support and resistance.

 

 

Above you can see a graphic depicting support and resistance.  A trader would buy after a breakout of resistance.  The trader holds the investment when it’s close to support and sells after a breakdown under the support line.  Another important tool for trend analysis is the trend line and channel line.
 

 

You can see above an example of the trend line (bottom) and the channel line (top).  Like the support and resistance lines, the trendline and channel line can help traders decide where to buy and sell a stock.

 

 

If the stock breaks through the channel or the trend line, this could lead to the purchase or sale of the stock.  Above you can see the breakout so the trader buys the stock.  However, be careful of a throwover, which you can see above did not actually lead to a breakout.

 

 

Another important trend is called Fibonacci Retracement.  This is a tool applied by traders to project the retracement of a stock price.  There are common retracements seen in stock prices and they often fall into the 33%, 50% and 66% levels.  Meaning that a stock may retrace down or up by one of these percentages.  Traders will use these retracement levels to plan their entry and exit points. 

If you look at the white line above, you will see the retracement is drawn after it hits the 200 price point. The subsequent white line, tan line, and red line, show the potential retracement levels.  These are the levels you may use for support lines.  While the Fibonacci Retracement above shows a negative retracement, Fibonacci can also be used for positive retracement.  With a positive retracement, you would use the lines as resistance lines instead of support lines.

 

Other Technical Indicators

While we touched on some tools utilized by traders above, there are a handful of other technical indicators applied by traders.  These tools range from trading volume and moving averages, to oscillators.

Volume

The volume is the amount of shares traded over a given period, which is crucial information for the selling/buying of stocks.  Volume analysis is the technique of assessing the health of a trend based on volume activity.  The volume indicator is the most popular indicator used by market technicians.

Below shows a stock’s price movement (candlestick chart) and the volume of the stock.

 

 

The blue bars at the bottom of the above chart represent the volume.  Comparing the volume of trades to certain movements is an important aspect of trading and technical analysis since some predictive patterns and trends may rely on volume.

 

Volume indications

A rise in volume indicates that

  • Market participants are interested in seeing the price go higher in an uptrend and are willing to buy higher in order to participate in upcoming market action.
  • Market participants are interested in seeing prices go lower in a downtrend and are willing to sell lower in order to participate in the upcoming market action.

A decline in volume indicates

  • Market participants are losing interest in seeing the price go higher in an uptrend and are more willing to buy lower.
  • Market participants are losing interest in seeing the price go lower in a downtrend and are more willing to sell higher.

Volume is a very important factor for most trades.  Another popular technical tool is called the moving average.

 

Moving Averages

Moving averages (MA) are widely used indicators used to identify trends, execute trades, and act as support and resistance.  MA is the price of a stock averaged out over time, giving a smoother line than the individual prices that are more volatile due to short-term “noise”.  Long-term traders often look at the 50-, 100- and 200- day simple moving average (SMA).  Short-term traders prefer the 5- and 20-day MA as these represent a week and a month.

3 types of moving averages

  1. Simple moving average (SMA):  The SMA is by far the most common moving average.  It simply takes the closing stock price and averages it out over a period of time. 
  2. Weighted moving average (WMA):  The WMA puts more weight on the most recent data.
  3. Exponential moving average (EMA):  The EMA places greater weighting on the most recent data but it also considers the data set.  This is widely used by more experienced traders.
     

 

The above chart shows the price movement of a stock over a ten-year period.  As you can see, the red line is the 12-month MA, the blue line is the 24-month MA, and the grey line is the 60-month MA.  You may notice that the stock has times when it is trading much higher than the moving averages and times when it’s trading lower than the moving averages.  The moving averages can also act as a form of support and resistance for stock prices. 

Oscillators
An oscillator is a secondary indicator that varies over time within a band.  Oscillators are used to discover short periods of overbought or oversold conditions. 

  • An oscillator is most useful when its value has reached an extreme reading near the upper or lower end of its boundaries.
  • A divergence between the oscillators and the price action when the oscillator is in an extreme position is usually an important indicator.
  • Crossing the zero line can be an important trading signal in the direction of the price trend.
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Examples of oscillators:

  • Relative Strength Index (RSI)
  • Moving Average Convergence Divergence (MACD)
  • Stochastics
  • Bollinger Bands

Technical Checklist

To help you manage some of the important factors of technical analysis, the below checklist can be used.  Note that this is not an all-inclusive checklist, but a recommended checklist. 

Technical Checklist

  1. What is the direction of the main/sector indices?
  2. What are the weekly and monthly continuation charts showing?
  3. Are the major, intermediate, and minor trends up, down, or sideways?
  4. Where are the important support and resistance levels?
  5. Where are the important trend lines or channels?
  6. Is volume confirming the price action?
  7. Where are the 33%, 50% and 66% retracements?
  8. Are there any price gaps and what type are they?
  9. Are there any major reversal/continuation patterns visible?
  10. What are the price objectives from those patterns?
  11. Which way are the moving averages pointing?
  12. Are the oscillators overbought or oversold?
  13. Are any divergences apparent on the oscillators?
  14. Are there any cycle tops or bottoms due?
  15. Is the market showing right or left translation?

After you’ve arrived at a bullish or bearish conclusion, ask yourself the following questions.

  1. Which way will the market trend over the next 1-3 months?
  2. Am I going to buy or sell this market?
  3. How many shares will I trade?
  4. How much am I prepared to risk if I’m wrong?
  5. What is my profit objective?
  6. Where will I enter the market?
  7. What type of order will I use?
  8. Where will I place my protective stop?

Remember that the above list is not all-inclusive but a recommended set of points to check before making your trades.

 

Conclusion

While there is a lot to learn about technical analysis, it’s something that nearly everyone can grasp.  Learning the patterns and trends as well as the different tools that you have at your disposal, can help you become a more confident trader, and potentially a more profitable trader as well. 

 

While we didn’t touch on risk management in this article, it’s as important (likely more important) than all of the patterns and trends and charts we’ve mentioned here.  Creating a trade plan and managing risk efficiently is something that all traders should do as they buy and sell positions. 

 

It is HIGHLY recommended to watch our “Choosing your Risk Management Strategy” video by clicking here: https://www.youtube.com/watch?v=K_2Um6SXLso

 

Thanks for reading this intro to technical analysis and good luck with your trading and investment endeavor.

 

 

Pattern analysis is a popular tool used by traders to project the future movement of stock prices.  The process of identifying chart patterns can be considered subjective in nature and many consider it to be more art than science.  That being said, pattern recognition is a highly useful skill that all traders should learn. 

 

This article focuses on the popular patterns used to identify bullish and bearish trends.  The bullish and bearish patterns in the article are all associated with continuation patterns and can help identify if a stock may continue in the direction the stock previously moved.

 

Bullish Continuations

 

 

 

 

 

 

 

There are five main bullish continuation patterns seen above.  As you can see, the prices begin with appreciation, then have a consolidation phase, then a breakout phase.  Below you can see more about the five bullish continuations above.

 

 

 

Opposite its symmetrical triangle counterpart, an expanding triangle is a bullish continuation pattern wherein prices expand by reaching higher highs and lower lows over time.  This price movement can be viewed as the market becoming “more volatile” with its price range expanding prior to a breakout occurring.  This bullish expanding triangle breaks out at the topside.

 

 

 

The symmetrical triangle above is a bullish continuation pattern wherein the slope of the triangle is equal or nearly equal.  The slopes converge at a point and the above symmetrical triangle is a continuation pattern since it begins with an uptrend and ends with an uptrend.

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The above pattern shows a bullish ascending triangle. The ascending triangle includes a flat line on the top connecting the peaks and a line with a slope connecting the troughs.  

 

 

The bullish flag pattern includes a steep uptrend (known as the flagpole) followed by a slight downtrend channel.  The flag pattern above ends with an uptrend in price confirming the bullish pattern.

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Similar to the bullish flag, the bullish pennant starts with a flagpole (steep uptrend in price).  The difference between the bullish flag and bullish pennant is that the bullish pennant has two converging lines while the bullish flag includes parallel lines creating a channel.

 

 

The cup and handle begins with an uptrend in price followed by a longer consolidation phase.  The consolidation phase is then followed by an uptrend and then a shorter consolidation phase followed by another breakout.

 

Bearish Continuations

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There are five main bearish continuation patterns seen above.  As you can see, the prices begin with a decline in prices, then a sideways phase, then a breakdown phase.  Below you can see more about the four bearish continuations above.

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Opposite its symmetrical triangle counterpart, an expanding triangle is a bearish continuation pattern wherein prices expand by reaching higher highs and lower lows over time.  This price movement can be viewed as the market becoming “more volatile” with its price range expanding prior to a breakdown occurring.  This bearish expanding triangle breaks to the downside.

 

 

 

The symmetrical triangle above is a bearish continuation pattern wherein the slope of the triangle is equal or nearly equal.  The slopes converge at a point and the above symmetrical triangle is a continuation pattern since it begins with an downtrend and ends with an downtrend.

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The above pattern is a bearish descending triangle. The pattern includes a flat line on the bottom connecting the troughs and a line with a slope connecting the peaks.  This pattern begins with a downtrend and continues with a downtrend after some consolidation.

 

 

The bearish flag pattern includes a steep downtrend (flagpole) followed by a slight uptrend channel.  The flag pattern above ends with an downtrend in price confirming the bearish pattern.

 

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Similar to the bearish flag, the bearish pennant starts with a flagpole (steep downtrend in price).  The difference between the bearish flag and bearish pennant is that the bearish pennant has two converging lines while the bearish flag includes parallel lines creating a channel.   

We highly suggest watching our video regarding risk management here: https://www.youtube.com/watch?v=K_2Um6SXLso

 

Chart patterns have established definition and criteria, and these patterns can help project trends in stock prices; keep in mind there are no patterns that tell you with 100% certainty the future trend of a stock price. The process of identifying chart patterns based on these criteria can be subjective in nature, which is why charting is often seen as more of an art than a science.

 

The two most popular chart patterns are reversals and continuations. A reversals signals that a prior trend will reverse (breakout) upon completion of the pattern, while a continuation pattern signals that the trend will continue once the pattern is complete. These patterns can be found across any timeframe.

 

This article will be discussing bullish and bearish reversal patterns.

 

Bullish Reversals

 

 

There are five main bullish reversal patterns seen above.  You may notice that bullish reversal patterns begin with a bearish price movement that reverses to an increase in the stock price.  This is because the bearish trend of the stock price is reversing, leading to an uptrend in the stock. 

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The double bottom (and the triple bottom) are patterns wherein the price of a stock will hit a bottom two (or three) times before leading to a breakout.  The double and triple bottom patterns have a neckline that can be drawn from the highest point after the first bottom (and second bottom for triple bottoms). 

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An inverted head and shoulder resembles an upsidedown head with two shoulders (see below head and shoulders to better see the image of a head with two shoulders).  An inverted head and shoulders pattern has the head as the lowest point and two shoulders with a neckline.  The height from the neckline to the head is used to create a bullilsh price target.  The distance from the head to the neckline is used as the upward price target.

 

 

A falling wedge (also known as a bullish wedge) shows a pattern wherein the distance between the highs and lows are declining, leading to a wedge-like pattern.  As the distance between the highs and lows is compacting in a downward pattern, it leads to a consolidation in the price action.  Eventually, if the stock breaks the downtrend line (the line on top in the above graphic) the stock can breakout, which is why this is a bullish reversal (the stock is reversing from a bearish pattern to a bullish pattern).

 

 

The rounding bottom is a somewhat rare pattern that begins with a bearish trending price.  The price enters a prolonged consolidation phase (the bottom) which eventually turns into a bullish trend.  The consolidation phase of the rounding bottom can last for weeks or months before the bullish trend begins.

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Bearish Reversals

 

 

Similar to the bullish reversals, there are five main bearish reversal patterns seen above.  Bearish reversals start with a bullish price movement reverses into a decreasing stock price.  This is because the bullish trend of the stock is reversing, leading to a downtrend in the stock.

 

 

The double top (and the triple top) are patterns wherein the price of a stock will hit a high two (or three) times before leading to a breakdown.  The double and triple top patterns have a neckline that can be drawn from the lowest point after the first top (and second top for triple tops).  

 

 

The head and shoulders pattern resembles an head (peak) with two shoulders.  The head is the highest point with the bottom of the two shoulders being the neckline..  The height from the neckline to the head is used to create a bearish price target.  The distance from the head to the neckline is used as the downward price target.

 

 

A rising wedge (also known as a bearish wedge) shows a pattern wherein the distance between the highs and lows are declining in an upward pattern, leading to a wedge-like pattern.  As the distance between the highs and lows is compacting, it leads to a consolidation in the price.  Eventually, if the stock breaks the downtrend line (the line on the bottom in the above graphic) the stock can breakdown, which is why this is a bullish reversal (the stock is reversing from a bullish pattern to a bearish pattern).

 

 

The rounding top is a somewhat rare pattern that begins with a bullish trending price.  The price enters a prolonged consolidation phase (the top) which eventually turns into a bearish trend.  The consolidation phase of the rounding bottom can last for weeks or months before the bullish trend begins.

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We highly suggest watching our video regarding risk management here: https://www.youtube.com/watch?v=K_2Um6SXLso

 

One of the three basic premises of technical analysis is that prices move in trends.  One reason prices likely move in trends is due to the tendency of people to follow others (also known as herding).  Herding happens regularly but it is particularly common during times of uncertainty and volatility.  As a result, this behavioral pattern is reflected frequently in identified price patterns and can therefore be anticipated or projected.

 

Since the price patterns reflected in the market can be projected, technical analysis uses these patterns to trade.  An example of this may be as market sentiment shifts from optimism to fear, a certain pattern might emerge before traders and investors start selling and send the stock price lower.

 

There are three trend directions and three trend classifications.

 

Trend Directions

 

 

Above you can see the three different trend directions.  The uptrend is an ascending trend, the downtrend is a descending trend, and sideways trends are horizontal without ascending or descending in any one direction.

 

Three Classifications

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There are three classifications of trends that can move in any of the three trend directions mentioned above. 

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1.    Minor trend – Short-term trend that lasts around 3 weeks or less.

2.    Secondary trend – Mid-term trend that may last anywhere from several weeks to several months.

3.    Major trend – Long-term trend that may last more than 1 year.

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To summarize thus far, there are three trend directions (uptrend, downtrend, sideways) as well as three trend categories (major, secondary, minor).  Now that we understand these directions and categories, we can use additional concepts to help use determine price targets and strategies given potential trends.

 

Support & Resistance

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Support and resistance lines help traders establish areas of buying and selling pressure.  For example, on the left side you can see an uptrend with resistance at the peaks and support at the troughs.  One way traders utilize these support and resistance lines is by buying at breakouts above resistance and selling at breakdowns below support.

 

The below graphic shows how a trader may approach a stock.  Some traders try to “anticipate price moves, and may buy when a stock is close to resistance levels and sell when it’s close to support levels.  However, an approach with a better probability of success is buying at breakouts and selling at breakdowns. Below shows how a trader would purchase this stock after breaking through resistance.

 

Because buying around resistance and sellling around support is “anticipaing” the price movement of a stock, it is has a lower probability of being successful.  By buying after a breakout, there is a higher probability of success.  As you can see the trader holds around support instead of anticipating the stock breaking support.  Only if the stock has a breakdown below support will they sell at their stoploss.

 

Another observation to note is that the original resistance level (left half of graphic) becomes a support level once the stock breaks out (right half of graphic).  This is because the prices at the new support level may have buying interest since the stock was able to breakout of the previous resistance levels.

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Trend Line & Channel

 

 

Traders also utilize the trend line and channel line.  Above you can see that the trend line and channel line are drawn across the peaks and troughs of the uptrending price.  A trend line is first drawn then the channel line is a parallel line drawn in the same direction of the trend line.  If the above graphic were in a downtrend, the trend line would be on top with the channel line on the bottom.

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The above graphic shows where a trader should buy and sell given a stock moving in an uptrend channel.  The green area shows where a trader would buy after a breakout of the channel.  The throwover in red is a market condition where prices briefly or temporarily break beyond the existing trend line as a result of a sudden surge in either market demand or sell down. This situation usually normalizes as the market eventually realizes that it may have overreacted to a certain catalyst.  A throwover can fool traders so be mindful of a true breakout before buying.

 

Retracement

 

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Fibonacci Retracement is another way to decide which levels to trade a stock.  This is a tool used by many traders and it includes three common retracement levels.  A trader may be mindful of each of the three levels and make decisions with Fibonacci Retracement in mind. 

 

Above you can see the three common retracement levels are 33%, 50%, and 66%.  In the above example, a trader would use the three levels.  For example, if the stock bounces off the 33% minimum retracement, a trader may see this as an entry point to purchase the stock.  If it falls past the 33% retracement to the 50% then bounces, a trader may purchase at that level, and so on…

 

What would you do?

 

Let’s test your knowledge with the below example. 

Given this chart, what would you do?

 

 

One way to approach this is to first draw your support and resistance lines.

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What should you do if the stock price breaks the support line?

 

 

First, since the stock broke the support line you can sell at your predetermined stop loss. You can then change your support line to your resistance line. 

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After waiting for a new breakout of resistance, what would you do in this situation?

 

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While it may look like the stock broke resistance, it didn’t close above resistance (the price traded above it during the trading day only) and wasn’t considered to be a true breakout.  Be careful of false breakouts like this; below you can see this actually resulted in the “kiss of death” and the stock plunged lower. 

 

 

Trends are a key component when it comes to technical analysis.  Using trends can help traders determine support levels, resistance levels, and channels.  Fibonacci Retracement is also a helpful tool to use and can help determine price targets for entry and exit points.  Using all of these tools in combination with the categories of trends and the direction of trends can help you become a better trader.

 

We highly suggest watching our video regarding risk management here: https://www.youtube.com/watch?v=K_2Um6SXLso

 

Technical analysis is comprised of different concepts; two important concepts traders heavily rely on include pattern and trend analysis.  Another important concept traders utilize are technical indicators, which are often used in conjunction with pattern and trend analysis to help firm up a trader’s views on specific stocks.

 

Some important indicators used by traders include:

  • Moving averages
  • MACD
  • Parabolic SAR
  • RSI
  • Stochastic Oscillator
  • Money Flow Index
  • Bollinger Bands

Each of these indicators can be further classified as trend indicators, momentum indicators, volume indicators, and volatility indicators. 

 

Technical Indicators (Trend)

 

Moving Averages

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A moving average (MA) is commonly used with time series data to smooth out short-term fluctuations and highlight longer-term trends or cycles.

 

There are different types of moving averages including simple, weighted, exponential, and cumulative MA’s. 

 

Statistically, the moving average is optimal for recovering the underlying trend of the time series when the fluctuations about the trend are normally distributed.

 

The chart above shows long-term moving averages:

 

Red – 12 months

Blue – 24 months

Green – 60 months

 

Many traders use shorter-term moving averages such as:

 

50-day moving average

100-day moving average

200-day moving average

 

Moving averages can help traders decide entry and exit points.  
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Above you can see two signals used by traders. The Golden Cross on the left is a bullish signal.  This occurs when the 50-day MA crosses the 200-day MA in an upward trend.  The Death Cross is a bearish signal.  This occurs when the 50-day MA crosses the 200-day MA in a downward trend.   These can either signal an entry point or an exit point of a position. 

 

Moving Average Convergence Divergence (MACD)

 

 

MACD is an indicator using the change in a stock's underlying price trend. The theory suggests that when a price is trending, it is expected that speculative forces "test" the trend. While the primary function is to identify turning points in a trend, the level at which the signals occur determines the strength of the reading.

 

When the MACD line falls below the signal line, it leads to a bearish signal (A).  When the MACD line passes above the signal line it shows a bullish signal (B).  The histogram helps visualize the relationship between the MACD line and signal line.

 

Parabolic Stop and Reverse (SAR)

 

 

Parabolic SAR is used as a trailing stop loss based on prices tending to stay within a parabolic curve during a strong trend.  The concept draws on the idea that time is the enemy (similar to option theory's concept of time decay), and unless a security can continue to generate more profits over time, it should be liquidated.

 

The indicator generally works well in trending markets, but provides "whipsaws" during non-trending, sideways phases; A parabola below the price is generally bullish (see “A” above), while a parabola above is generally bearish (see “b” above).

 

Technical Indicators (Momentum)

 

Relative Strength Index (RSI)

 

 

RSI is a measure of the stock's recent trading strength.  When the price moves up very rapidly, at some point it is considered overbought. Likewise, when the price falls very rapidly, at some point it is considered oversold.

 

Tops and bottoms are indicated when RSI goes above 70 or drops below 30 (yellow dashed lines). Traditionally, RSI readings greater than the 70 level are considered to be in overbought territory, and RSI readings lower than the 30 level are considered to be in oversold territory. In between the 30 and 70 level is considered neutral, with the 50 level a sign of no trend.

 

Uptrends generally traded between RSI 40 and 80, while downtrends usually traded between RSI 60 and 20.

 

Stochastics Oscillator
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The stochastics oscillator is a momentum indicator that uses support and resistance levels. The term stochastic refers to the location of a current price in relation to its price range over a period of time.

 

This method attempts to predict price turning points by comparing the closing price of a security to its price range.  The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning.  The signal to act is when you have divergence-convergence, in an extreme area.

 

Technical Indicators (Volume)

 

Money Flow Index

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The Money Flow Index uses both price information and volume information.  Like Stochastics, the Money Flow Index is an oscillator and a figure above 80 is considered overbought while a figure below 20 is considered oversold.  Also similar to Stochastics, traders look for divergences between stock prices and the indicator which could be a signal.

 

Technical Indicators (Volatility)

 

Bollinger Bands

 

 

Bollinger Bands use the simple moving average along standard deviation to create a “band” which nearly 90% of stock prices trade within.  The use of bollinger bands is partly reliant on the squeezing together and moving apart of the bands.  A squeeze occurs when the upper band and lower band move closer together.  A squeeze means lower volatility and can be a signal of future higher volatility for a stock.  The moving apart of the bands shows higher volatility and can be a signal of lower volatiliy in the future.

 

Technical indicators are powerful tools used by traders.  While technical indicators can be highly useful, they are used in conjunction with other aspects of trading; such as pattern and trend analysis.  These indicators can help solidify a thesis for a trader, but are not often used solely to determine entry and exit points of trades. 

 

We highly suggest watching our video regarding risk management here: https://www.youtube.com/watch?v=K_2Um6SXLso

 

What attracts you to the idea of trading stocks?  Is it the potential gains you can earn?  Or, is it the challenge of technical analysis that comes with trading?  Whatever the reason, there’s a good chance you’re focused on learning and mastering the art of technical analysis and pattern recognition.  This is the buy side of trading and it involves the methodology you use to find trading opportunities.  The buy side is the appealing side of trading.  Using your technical skills and pattern recognition to find the perfect stock trading at the perfect price with the perfect potential to pop.  
But, what if we told you the tantalizing buy side of trading is actually NOT the most important part of trading? 

 

You may not like to hear it, but the fact is stocks don’t always act how you think they will.  No matter how amazing the chart looks, there’s always a chance the price of the stock declines and squeezes you out; even if it leads to a pop in the stock price after you sell. 

 

So, if the buy side isn’t the most important aspect of trading, what is? 

 

The answer: it’s the money management and risk management side of trading.

 

What is risk management and money management?

Risk management and money management are perhaps the only factors you have control over when trading.  Afterall, you don’t have control over the future price movement of a stock.  What you can control is the risk you take.  Some different ways you can manage risk is through your allocation maximum, risk per trade, risk/reward ratio, etc. 

Managing risk should be planned ahead of time by creating a personalized trade plan.

 

Create a trade plan

Every trader is different.  The way you trade will be dependent on your risk tolerance, your personality, the amount you have available to invest, etc.  Because every trader is different, it’s important to create a trade plan that you will stick to.  A trade plan should include everything from your portfolio allocation maximum, and risk per trade, to your preferred risk/reward ratio.
Your trade plan should include two categories of rules.  The first category relates to your total portfolio balance.  The second category applies to specific trades.   

 

Category 1 – Portfolio Rules

Portfolio rules relate to the overall balance of your portfolio (not specific trades).  For example, if you have P10,000,000 total in your portfolio, these rules relate to that money. 

 

Portfolio Rule 1: Portfolio allocation maximum

The amount of your portfolio you allocate to any one trade is a personal decision.  Some investors will only allocate 5% - 10% of their portfolio into one trade, while other investors may allocate 20% or even more to a trade.  One factor to consider is how many positions you want to hold at any one point in time and how much you want to keep in cash on the sidelines. 

 

For example, if you are someone who may want 5 equal sized positions open at the same time with no cash, you wouldn’t want to allocate more than 20% of your portfolio to any one trade.  You can see why below:

 

P500,000 portfolio

Position 1 – P100,000 = 20% of portfolio
Position 2 – P100,000 = 20% of portfolio
Position 3 – P100,000 = 20% of portfolio
Position 4 – P100,000 = 20% of portfolio
Position 5 – P100,000 = 20% of portfolio

 

As you can see, having five equal positions open at the same time would require a maximum of 20% of your portfolio in each position.  Your portfolio allocation maximum may depend on your risk tolerance.  Some hypothetical risk tolerance examples can be seen below:

 

Portfolio Allocation Maximum

Conservative = 5%

Moderate = 15%

Aggressive = 25%

 

Taking these risk tolerances, you could expect to invest the following with a P500,000 portfolio: 

 

Conservative = 12.5%

  • Position 1 = P62,500
  • Position 2 = P62,500
  • Position 3 = P62,500
  • Position 4 = P62,500
  • Position 5 = P62,500
  • Position 6 = P62,500
  • Position 7 = P62,500
  • Position 8 = P62,500
  • Position 9 = P62,500
  • Position 10 = P62,500

Moderate = 20%

  • Position 1 = P100,000
  • Position 2 = P100,000
  • Position 3 = P100,000
  • Position 4 = P100,000
  • Position 5 = P100,000
  • Position 6 = P100,000
  • Position 7 = P100,000
  • Position 8 = P100,000
  • Position 9 = P100,000
  • Position 10 = P100,000

Aggressive = 25%

  • Position 1 = P125,000
  • Position 2 = P125,000
  • Position 3 = P125,000
  • Position 4 = P125,000

 

Now that you understand the importance of choosing a portfolio allocation maximum, you should next focus on understanding stop losses and position sizing.

Stop loss

 

A stop loss is the predetermined price you set to sell a stock.  By choosing a stop loss you are choosing an exit price.  Stop losses can be used to both limit your downside risk and help you calculate your position size.  To better understand stop losses, take the following chart. 

 

 

The above stock, Lumpia Land, Inc, is currently selling for P11.00.  The red line shows a support line for the stock; the stock hasn’t broken the line and there is a potential for it to bounce at the P10.00 level.  However, there is also a possibility the stock will break the P10.00 support and continue lower.  If this happens, you should have decided a stop loss to limit your loss potential.  The above dashed line shows the P9.80 stop loss.  So, if you buy at P11.00 and the stock falls to P9.80, you will sell the stock and take your losses.

 

Stop losses are extremely important tools for traders and using them can help you manage risk. 

 

* There are no automatic stop losses with BDO Securities.  You will need to manually track your positions and sell them if they reach your predetermined stop loss.

 

Portfolio Rule 2: Position sizing

You may have heard of the 1% rule, the 2% rule, the 5% rule, etc.  Each of these rules are preferences traders have regarding their risk per trade.  For example, if you follow the 1% rule, you would only risk 1% of your portfolio allocation maximum.  If you have a P500,000 portfolio and a 20% portfolio allocation maximum (P100,000), you could calculate your risk per trade for Lumpia Land, Inc:

 

Position Sizing:

  • Portfolio balance = P500,000
  • 20% Portfolio allocation max = P100,000
  • 1% maximum risk per trade = P5,000

 

The position sizing percentage will be determined by your risk tolerance.  Below are some hypothetical examples of position sizing risk tolerances:

 

Position sizing:

Portfolio balance = P500,000

20% allocation max

  • Aggressive Risk (3% per trade) = P15,000
  • Moderate Risk (1% per trade) = P5,000
  • Conservative Risk (0.5% per trade) = P2,500

 

Going back to Lumpia Land, Inc, it’s selling for P11.00 and we’ve decided to add a stop loss at P9.80.  In order to calculate our position sizing (the number of shares to purchase) we can do the following using a 1% maximum risk per trade:

 

Position sizing = (portfolio balance x maximum risk per trade) / (stock price – stop loss)

Position sizing = (P500,000 x 1%) / (P11 – P9.80)

Position sizing = (P5,000) / (P1.2)

Position sizing = 4,166 shares

 

Using our formula to find the position size, we’ve determined that we’re willing to risk buying 4,166 shares of Lumpia Land, Inc.  This will total P45,826 (4,166 shares x P11.00 per share).  If the price of Lumpia Land, Ince falls to P9.80 per share, you will be down P5,000 which is 1% of your allocation maximum (P5,000 / P500,000).  We would also check to make sure the position sizing is in range.  Using a 20% position size we can see that the P45,826 is not more than the 20% predetermined position size (P500,000 x 20% = P100,000).  So the trade meets all the criteria.

 

 

Category 2 – Individual Trade Rules

The next category of rules involves specific trades.  Unlike the portfolio allocation maximum and position sizing, the individual trade rules don’t factor in the overall portfolio.  Each of these rules are dependent on the specific trade.

 

Individual Trade Rule 1:  Risk/reward ratio

Another important part of trading is the risk reward ratio.  This is represented as a ratio and it shows the risk (loss) you are willing to take in proportion to the potential reward (profit).

For our Lumpia Land, Inc. example, we can assume our same predetermined stop loss of P9.80.

 

 

Looking at the chart we can see there is a potential resistance at P15.50.  We may decide to take profits if Lumpia Land, Inc. reaches P15.00.  The risk to reward ratio can be calculated using the following:
 

Risk to reward ratio

  • Stock price = P11.00
  • Take profits = P15.00
  • Stop loss = P9.80
  • Risk = P1.20
  • Reward = P4.00
  • Risk to reward ratio = 1.2 : 4

 

Having a proper risk reward ratio is an important part of trading and risk management.  If you are willing to accept large risks for small returns, you won’t be very profitable.  


While the risk reward ratio is important, it also coincides with the win/loss ratio.  Having a proper risk/reward AND win/loss ratio are important for each individual trade.

 

Individual Trade Rule 2:  Win/loss Ratio

The win/loss ratio can be explained like a baseball batting average; the number of hits versus strikeouts.  A hit would be considered a profitable trade and a strikeout would be considered an unprofitable trade.  The proportion of profitable trades (wins) versus unprofitable trades (losses) equal the win/loss ratio.

The below chart shows the relationship between the portfolio allocation, win/loss ratio (batting average) and a proper risk/reward ratio.

Assumptions:

  • P500,000 portfolio
  • Average trade size is 20% portfolio allocation (P100,000)
  • Average of ten (10) trades a year
  • Average profit is +15%; loss is -5% per trade
 
20% Portfolio Allocation
Win 40% Lose 60%

 

​Trade ​Trade Amount ​Return​ ​Profit/Loss​
1 100,000 15% 15,000
2  100,000 15% 15,000
3 100,000  15% 15,000 
4  100,000 15% 15,000
5  100,000 -5% -5,000
6  100,000 -5% -5,000
7  100,000 -5% -5,000
8  100,000 -5% -5,000
9  100,000 -5% -5,000
10  100,000 -5% -5,000

Total Profit/Loss on 500,000 portfolio = 30,000

% Return on P500,000 portfolio = 6%

As you can see above, by only winning 40% of your trades you can still be profitable as long as you have a proper risk reward ratio.  The above example shows an upside 15% gain for trades in the green and a 5% loss for trades in the red.  Because the upside potential is more than the loss potential, only winning 40% of trades still results in an +6% return.

 

What happens if we instead of winning 40% of trades we win 50% of trades?  

 

20% Portfolio Allocation 

Win 50% Lose 50%

 

​Trade ​Trade Amount ​Return​ ​Profit/Loss​
1 100,000 15% 15,000
2  100,000 15% 15,000
3 100,000  15% 15,000 
4  100,000 15% 15,000
5  100,000 15% 15,000
6  100,000 -5% -5,000
7  100,000 -5% -5,000
8  100,000 -5% -5,000
9  100,000 -5% -5,000
10  100,000 -5% -5,000

Total Profit/Loss o 500,000 portfolio = $50,000

% Return on 500,000 portfolio = 10%

 

Above you can see that increasing your batting average from 40% wins to 50% (while keeping everything else equal) results in a higher return.  Still, because you’re using a healthy risk reward ratio, you can achieve a 10% return while only risking 20% of your portfolio per trade if you are only profitable on 50% of trades.

 

 

Batting Average % Wins (PHP) Losses (PHP) Nete Amount (PHP)

​Net Return

(%)
30/70 45,000 -35,000 10,000 2%
40/60 60,000 -30,000 30,000 6%
50/50 75,000 -25,000 50,000 10%
60/40 90,000 -20,000 70,000 14%

The above chart shows a comparison of batting averages vs. wins, losses, and returns.

 

Conclusion

Many traders focus on the buy side of trading and neglect the risk management side of trading.  This can be a mistake since the risk management and money management aspect of trading is so important.  When creating a trade plan, it’s a good idea to break down your plan into two categories of rules.  The first category includes portfolio rules and the second category involves rules for specific trades and positions.  Following these predetermined rules can help you manage the risk you take and lead to more consistent profits.

 

Trading can be highly rewarding but it also comes with its challenges.  Managing the risk you take is one of the most important steps on your journey to trading success.

 

Want to learn more?  Read the suggested article below!
Technically Speaking Video

For concerns, you may contact the BDO Securities Hotline at (+632) 8840-7878, Monday to Friday from 8:30 am to 5:00 pm, or email us via bdosec-customercare@bdo.com.ph. BDO Securities is a PSE and PDEx Trading Participant, an SCCP and SIPF Member, and is regulated by the CMIC with website  www.cmic.com.ph, and the SEC with telephone no. (+63916) 383-8633 and (+632) 8818-0921 and email address at msrd_srd@sec.gov.ph.

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