By Sam Evans, Co-Founder & CEO
Finding your style and grove in trading and investing can be tricky. While markets can only go up, down, or sideways, there are plenty of other things to distract us from this simple dynamic. Economic news, earnings, options, and Reddit boards are just a few. In the search for that ‘secret sauce’, it usually doesn’t take many new traders and investors long to discover the potential “holy grail” of technical indicators.
Please take note that I used the word “potential” in that last sentence. There is no such thing as a quick and easy path to riches in the markets. Too often people make a fortune in the blink of an eye on pure luck, only to lose it just as quickly. Sometimes losing even more. Real and lasting speculation takes time, effort, and skill just like any other endeavor. Understand that and you are already on the right path forward. Now back to those technical indicators.
If you are new to the world of charting then I will make this quick. Price charts show us the trading history of any asset over any given period of time. Technical analysts attempt to use this chart information to make decisions on when to buy and sell stocks, commodities, or any other tradable asset. There are many clues on price charts that help us to spot a potential opportunity to enter or exit.
At StockAbility™ we focus on the most robust studies of all: Price and Trend. In our humble opinion, you cant get a better understanding of the market than using price action itself. Yet many find themselves seduced by technical indicators and the riches they potentially offer. A technical indicator is a mathematical study that can be overlaid on the price chart to offer further information. This could be a measure of say trends strength, momentum, or when something is potentially too expansive or too cheap.
The indicators then give signals of when to get in and out of the market, based on their calculations and data. Some of the more popular indicators are Moving Averages, MACD, Stochastics, and Bollinger Bands. Each of these gives its own breakdown of price and opportunity.
The first time I saw them I was amazed and excited by the potential I could see. It seemed to me that I finally had a tool to help me time the market and hit my goals. My excitement soon turned to disappointment as I realized it was not quite that easy. You see all indicators are a function of price and require the price to provide them data. Therefore price will always move before the indicator can do its thing and thus the indicators lag and get us late to signal. Now sometimes this can still work out for us but more often than not, we get false signals and frustration. This becomes especially damaging when traders become too reliant on the indicator signals and use them blindly.
It is not all doom and gloom though! Many indicators can be powerful decision support tools if combined effectively with a robust price action trading system based on price primarily. Personally, I love using Moving Averages and Stochastics in my analysis. But please note, I do not use them to make a decision to enter or exit a trade but rather to build my case when finding a trading or investing setup. There is a distinct difference here.
Let’s take a look at a smarter approach to using an indicator with a quick study of Bollinger Bands. These are a great tool which simply measures the average price of a given security, over a set period of time. Then when the average has been determined, the bands establish a potential range of how far the price could move in either direction. The result: we can see when something is becoming overbought or oversold. This in turn can often lead to a reversal in the price. An overbought signal suggests a selling opportunity and an oversold signal suggests a buying opportunity. Look at the example below to see how this lines up:
A piercing of the upper or lower band is the buy or sell signal we are looking for, with the average price being the green line in the middle. Notice how when Disney (DIS) was overbought, it soon went lower? Conversely, when the stock was oversold, it rallied shortly after. Simple signals like these are what typically draw in the amateur analyst and convince them that they have found their secret sauce. Unfortunately it does not always work out so well. Assets can stay overbought or oversold for a long time too, as we can see here:
Imagine being on the wrong side of this, selling over and over again as the market just keeps going up? This is why risk control and rules are so vital. Plus we need to factor in other dynamics such as trend, into this equation. It is not quite as simple as just using the Bollinger Bands and nothing else. At StockAbility™, we will combine something like a Bollinger Band with a more concrete form of analysis, such as a Support or Resistance Zone, like this:
Notice how when the price was hitting the Bollinger Bands in this example, we are more importantly testing price Support and Resistance Zones too? We call this confluence and will always look for multiple reasons to take a trade. The primary signal however will come from a price level. The technical indicator signal being just a supporting act to cement the trade idea. In fact, there are many times when the price alone is more than enough to see a trade. The indicator becomes just another way to build the case and probability.
In my next article, we’ll take our study of Bollinger Bands a step further with more practical ways to use them the right way.
Be well and trade well,
– Sam Evans