For most folks, some very basic technical analysis skills can greatly enhance long-term performance.
In this article I focus on “position trading” which applies to trades that you mean to keep for quarters to years.
These simple signals will help you manage your positions over the long-term without over trading, which is one of the greatest sins of investing.
Cheating by using a simple weekly measure of Relative Strength Index or RSI might be all that you need 90% of the time.
I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”
Paul Tudor Jones
Paul Tudor Jones is one of the best stock market traders and investors of all-time. We should pay attention.
The essence of his quote is telling you two things:
Don’t overtrade.
Look for extremes.
As a position trader, which means I’m looking for my trades to last quarters to years, I certainly do not want to overtrade.
And, as you’ll hear me say over and over, avoid the “middle of the market.” That is, don’t trade unless there is a compelling reason to do so.
Manage Risk First
Our goal as investors is to manage risk FIRST. Using basic technical indicators is tremendously helpful with that.
Technical analysis is the final leg in our investment process.
Secular Trends
Government & Central Bank Policy
Industry & Company Fundamentals
Technical Analysis Of Price Trends
Technical analysis guides us when to buy or sell, add or trim, sell covered calls or cash-secured puts. Every successful money manager uses technical analysis to some extent – even the guy in Omaha.
Scale In So You Can Scale Out Later
You want to scale in so that you don’t have to be perfect. Scaling in also makes scaling out easier later. A few bullet points:
Make sure your scale in prices are double digit percentages apart.
There is no point scaling in if your 2nd and 3rd purchases do not materially change your cost basis if the price is falling.
If a price is rising and you do not have a full allocation, we will use shorter-term technical indicators to find where to “buy the dips.”
In a bear market look to buy around bottom fishing.
In a bull market we are looking to “buy the dips” at the top of our updated buy zones.
Starting positions should be around a 1/2% of your total investment value for stocks.
Starting positions should be around 2% of your total investment value for Core ETFs.
Starting positions should be around 1% of your total investment value for Tactical ETFs.
I can not stress enough how important it is to scale in slowly. Do not try to be perfect. Have a plan and then execute it over time.
You And Technical Analysis
A lot of people look at technical analysis or charting as some sort of Voodoo magical gambling system. For most people that is what it is. But, not because it is not useful or fails regularly, it’s because they don’t use it right.
Too many people overtrade looking for quick gains. Unless you have an edge on the super computers running high frequency trading systems, and hedge funds that plant information on the internet to support their next trade, and the many professionals trading, well, then you should not day-trade or swing-trade.
With position trading, looking for longer term trades based on secular trends, government and central bank policy and fundamentals, simple technical analysis helps a lot. Add a some quantitative (based on math not pretty lines on charts) based indicators and you can use technical analysis very well.
Because prices regularly rise or fall for reasons that we do not understand or agree with, we look for rationalization of those price moves. That rationalization can be right quite often, but prices still move against us.
Why is that?
It’s because of the way money moves.
Big money moves in near troughs and out near peaks. Are they just better at trading? To some extent yes. They have the advantage of insider information that is barely legal. There is no doubt about that.
However, they also have to move big piles of money. And, since the capital gains rate is 20%+, they don’t mess with the little trades in the middle of the market. They generally only sell at two times:
When they believe the risk of loss in the next year or two is greater than the tax they would pay.
If they believe an investment just isn’t cracked up to be what they thought it would be, i.e. change of thesis.
That leaves the middle of the market to the madness of crowds.
Swing-trader and day-trader wannabes fall prey to the age old problem of trying get rich quick. So, they learn a little technical analysis and try to play with the big guys, the super computing high frequency traders, hedge funds and professionals.
4 out of 5 day-traders and swing-traders do not make money. That is a fact that the IRS provides year after year after year.
Most people should settle for being position traders who scale in slow and wide (double digit % price differences before adding to a position) and then holding for an extended period of time.
People who buy stocks should generally opt to hold for years to let good businesses do good things. Eventually, the market notices.
People who buy ETFs can trade a little more often as rotations offer an opportunity or two per year. But that is mainly asset allocation maintenance.
Technical analysis can help you find those periodic opportunities to adjust your asset allocation in deliberate, slow-handed and effective way.
About the only time I swing trade is when there is a catalyst sitting behind an emerging technical set-up.
That is, the technicals are starting to indicate some bigger move or pivot might be coming AND I have a reason to make the trade based on fundamentals. That is, a catalyst is coming, usually a potential earnings beat or potential M&A activity.
Overbought And Oversold
The pivots that Jones talks about are indicated by various technical signals.
Using some very simple signals, we can often get very good ballpark estimates of the overbought and oversold conditions that precede turns in an assets price. Respecting these signals can save you a lot of money and make you a lot more.
Overbought means that too many people have bought an asset for new buyers to have any meaningful impact on pushing the price higher.
Oversold means that most people interested in potentially selling have done so which alleviates the risk of further declines (presuming the asset has value in the first place).
You might think that the value of a business would drive price in the short-term. But that’s not the case.
With big investors, who control 80-90% of the money in the markets, doing the vast majority of their trading near the extremes, and the wannabes trading the middle of the market, prices move a lot more than we think they should.
Wild price swings are driven by the madness of crowds, which are often influenced by the trading narrative of the day or week.
The Market Is… (Kirk Spano)
The Power Of Narrative On Price Volatility
We are primarily “position traders.” That is, we are looking for investments that can carry us through an entire sub-cycle of a bull market or an entire cyclical bull market. Trades generally last 6 months to several years.
Markets are “fractal.” That is, cycles within cycles.
A long bull market, which typically last 3 to 7 years, will be punctuated by corrections down and then a continuation up. The bull market typically ends when there is no more liquidity or FOMO to push prices up. The smart money sells here.
A long bear market, which will typically last 1-2 years, will be punctuated by rallies (corrections up) and then continued price drops. The last phase of the bear market ends with capitulation, that is, most investors throwing in the towel. The smart money buys here.
In the middle of the market, the trader’s narrative of the day or week, will drive prices. Be very aware that traders narratives have only gotten stronger with the advent of the internet.
The days of rumors and innuendo of riches to be made in markets on stock tips from shoeshine boys and taxi drives is long gone.
So, how do we use volatility to our advantage? How do we get over our fears and doubts?
I suggest basic technical analysis to help manage your investing decisions, AFTER, you’ve done all the other work in the 4-step process.
A simple systemization, using basic technical analysis, of your trading approach completes your management of investments in your asset allocation.
“The true investor welcomes volatility… a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”
Warren Buffett (again)
Essential Technical Analysis Book
Everyone should read this book as it will give you the broad understanding of the things I talk about periodically, including indicators and oscillators not mentioned above:
JACK D. SCHWAGER is the CEO of Wizard Trading, a commodity trading advisory firm that has been managing client funds since 1990. He is the author of The Complete Guide to the Futures Markets, Market Wizards, The New Market Wizards, Fundamental Analysis, and Technical Analysis.
One of the most important concepts applies to all analysis. Use the right time frame for measuring the market.
Every indicator can measure various time frames: hours, days, weeks, months.
Short time frames, like daily and hourly measurements, are for swing and day traders.
The weekly time frame is excellent for pinpointing good times to buy or sell, trim or add, and especially sell options. Weekly time frames are important for stocks and industry or theme based ETFs.
The monthly time frame is for locating major market and sector tops and bottoms, for example, with the S&P 500 (SPY), Invesco QQQ (QQQ) and 11 S&P 500 sectors.
Also, look at the relevant time frame for the stock, ETF or major market you are evaluating.
In 2023, we are have 3 very relevant time frames to look at:
since the 2014-16 choppy sideways bear market.
since the 2018 “short vol” and Repo market corrections.
since 2020 the peak and trough on both sides of Covid Crash.
So, short story (in this 4000 word guide), look at a big enough chart, before zeroing in on the past few years.
Technical Analysis Shortcuts
I think you can use just a handful of technical indicators to help you. I’ll start with some definitions and then give a few examples.
I will start with money flow oscillators, which are very good at helping us “follow the big money.”
Divergences
Extremely important: When an indicator is moving the opposite direction of price, or, another similar indicator. When this happens, something has to change. Understanding and finding divergences can be great warning signals. Learn to look for divergences.
A divergence occurs when an asset’s price is moving opposite to a specific technical indicator or is moving in a different direction from other relevant data. The divergence indicator warns traders and technical analysts of changes in a price trend, oftentimes that it is weakening or changing direction.
Divergence can be either positive, signifying the possibility of a move that is higher in the asset’s price, or it can be negative, signifying the possibility of a move that is lower in the asset’s price.
Oscillators are popular and widely used because they are leading indicators that can signal a possible trend change that is yet to start. This type of indicator oscillates between two limits, above and below a midpoint and its value helps to gauge the strength and momentum of a trend. Oscillators also typically signal if a market is overbought or oversold (meaning price is unjustifiably high or unjustifiably low), which could point to a reversal of the trend. This could be used to determine when to close open positions.
Oscillators work best in ranging markets because in trending markets they can show overbought or oversold conditions too soon. Common things to look for are a midpoint cross, approaching maximum or minimum value and regular or hidden divergence. Oscillators are usually plotted with a line or histogram. There are many oscillators such as the Relative Strength Index – RSI,Money Flow Index – MFI, Chaiking Money Flow – CMF and other useful tools.
“The Relative Strength Index [RSI] is a well versed momentum based oscillator which is used to measure the speed (velocity) as well as the change (magnitude) of directional price movements. Essentially the RSI, when graphed, provides a visual mean to monitor both the current, as well as historical, strength and weakness of a particular market.
The strength or weakness is based on closing prices over the duration of a specified trading period creating a reliable metric of price and momentum changes. Given the popularity of cash settled instruments (stock indexes) and leveraged financial products (the entire field of derivatives); RSI has proven to be a viable indicator of price movements.”
Over 70 is overbought, below 30 is oversold. Look for touching tops and bottoms twice, i.e. double tops and double bottoms.
“The Money Flow Index indicator [MFI] is a tool used in technical analysis for measuring buying and selling pressure. This is done through analyzing both price and volume.
Like RSI, the MFI’s calculation generates a value that is then plotted as a line that moves within a range of 0-100, making it an oscillator. When the MFI rises, this indicates an increase in buying pressure. When it falls, this indicates an increase in selling pressure.
The Money Flow Index can generate several signals, most notably: overbought and oversold conditions, divergences, and failure swings.”
Over 80 is overbought, below 20 is oversold. Look for touching tops and bottoms twice, i.e. double tops and double bottoms.
“Chaikin Money Flow [CMF] is a technical analysis indicator used to measure Money Flow Volume over a set period of time. Money Flow Volume (a concept also created by Marc Chaikin) is a metric used to measure the buying and selling pressure of a security for single period. CMF then sums Money Flow Volume over a user determined look-back period. Any look-back period can be used however the most popular settings would be 20 or 21 days.
Chaikin Money Flow’s Value fluctuates between 1 and -1. CMF can be used as a way to further quantify changes in buying and selling pressure and can help to anticipate future changes and therefore trading opportunities.”
“MACD is an extremely popular indicator used in technical analysis. MACD can be used to identify aspects of a security’s overall trend. Most notably these aspects are momentum, as well as trend direction and duration.
What makes MACD so informative is that it is actually the combination of two different types of indicators.
First, MACD employs two Moving Averages of varying lengths (which are lagging indicators) to identify trend direction and duration. Then, MACD takes the difference in values between those two Moving Averages (MACD Line) and an EMA of those Moving Averages (Signal Line) and plots that difference between the two lines as a histogram which oscillates above and below a center Zero Line. The histogram is used as a good indication of a security’s momentum.”
VRVP – Visible Range Volume Profile
One of my favorites, makes sure to watch video in the TradingView link.
Volume Profile is an advanced charting study that displays trading activity over a specified time period at specified price levels. The study (accounting for user defined parameters such as number of rows and time period) plots a histogram on the chart meant to reveal dominant and/or significant price levels based on volume. Essentially, Volume Profile takes the total volume traded at a specific price level during the specified time period and divides the total volume into either buy volume or sell volume and then makes that information easily visible to the trader.
Looking at RSI vs MFI vs CMF
The core difference between RSI and both MFI & CMF is a volume component. MFI and Chaikin both include a volume component while RSI does not. I use VRVP because more volume signals pricing extremes. Stronger and weaker volume matter.
Of course, no measures are perfect and the stock market likes to play tricks on people. However, the chart above is a logic based shortcut and usually a very good guidepost to start with.
The most important divergence to look for is when an overbought or oversold oscillator changes direction as that almost always indicates a change in price direction, i.e. end of a rally or end of a decline.
Once again, I remind you about time frames. The longer your measurement time frame, i.e. daily, weekly, monthly, the longer the next price change direction will last – with interruptions of course, due to the fractal nature of markets, that is, cycles within cycles.
My Oscillator Chart Settings
The oscillator settings you see most places are based on daily charts. It’s part of the brainwashing to get people to overtrade. The weekly setting is best for most stocks and ETFs. Monthly gives a long-term view of major bear and bull market cycles.
Oscillator Settings
RSI
MFI
CMF
MACD
Daily for narrowing down short-term entries.
11d
11d
20d
12/26/9d
Weekly for finding spots to buy the dips or sell options.
8w
8w
13w
4/13/8w
Monthly for identifying major market tops and bottoms.
3m
3m
12m
3/12/6m
Daily Notes:
My settings are slightly faster on RSI and MFI than standard 14 days to give us a little more notice than other traders.
CMF is on short side of 20 day or 21 day norm.
MACD is standard.
Weekly Notes:
I’m looking for weekly signals into quarterly money flows. So, I use 8 weeks on RSI and MFI because 2 months is about the length of most option selling trades. I use 13 weeks on Chaikin Money Flow to understand institutional money flows that move a bit slower and show up on quarterly 13F forms.
MACD is based on a month into a quarter with the signal line being midpoint. There’s probably a slightly better tweak, but this seems to work fairly well.
Monthly Notes:
I’m looking for big market tops and bottom here.
We will only see extremes several times per decade.
MACD is based on a quarter into a year with with the signal line being the midpoint. There’s probably a slightly better tweak, but this seems to work fairly well.
Technical Analysis Examples
Monthly (QQQ) – look at the big picture first. See I went back to 2008 financial crisis collapse that triggered the beginning of the QE to pick my relevant long-term time frame.
Notice the divergence between RSI/MFI and CMF. Also, the flattish MACD.
My interpretation is that if we continue to see QQQ rally, that will be met with a significant decline. Otherwise, we are in line to see RSI, MFI, MACD and price all decline soon. Remember, monthly chart. Soon is 1-6 months.
Weekly (QQQ) – your most usable chart for buying dips and selling options. I shortened the time frame to the long consolidation period that ended in 2016 and led to an extended bull market that was marked by 2 substantial corrections.
Now look at CMF heading up. That means although it was selling off on the monthly, it has turned up on the weekly shorter time frame. RSI and MFI are overbought though.
So, prior longer-term weakness on CMF, but a rally shorter team, with MFI and RSI overbought on shorter term. And, MACD drifted up, but the move is shallow, that is, weak.
What fundamental thing happened to suggest that big money might have left the market? Quantitative tightening near or at the peak of valuations?
Seems like potential for a correction setting up. Are we heading for a continuation of the 3rd substantial correction?
Daily (QQQ) – used for narrowing down to a trade day if not using GTC limit orders.
Notice the daily RSI and MFI having a hard time getting all the way to oversold. Like it’s being met with sellers.
Chaikin hasn’t spiked higher and MACD only a bit higher. Seems weak to me.
Might have some choppiness, but appears to be having a difficult time. That usually means the market needs a positive catalyst to extend higher.
We’ll revisit in a follow up article around New Year’s 2024.
Essential Technical Analysis Book
Everyone should read this book as it will give you the broad understanding of the things I talk about periodically, including indicators and oscillators not mentioned above:
JACK D. SCHWAGER is the CEO of Wizard Trading, a commodity trading advisory firm that has been managing client funds since 1990. He is the author of The Complete Guide to the Futures Markets, Market Wizards, The New Market Wizards, Fundamental Analysis, and Technical Analysis.
Yes, I know I posted this book twice. Buy it. Read it. You’ll make your money back many, many times over.
And, quite seriously, if you are not willing to read a few books on investing, as well as, spend several hours per week managing your portfolio, then you should not be investing your own money. Hire me to do it instead.
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