With stock technical analysis, it will take time to learn how to effectively learn to use this strategy to make money in the stock market, but can be done well.
Types of Traders
Most traders fall into a few camps. One camp is fundamental analysis and developing a thesis around the economy, company fundamentals or demographics. They use this information to help them identify whether the company is undervalued or overvalued. This type of trader/investor usually has a longer time frame. Another camp is technical analysis and looking at the price of a stock to determine when to buy or sell. This type of trader tends to be more active and shorter term in nature. Then there is another totally different type of trader focused on arbitrage. This type of trader is looking for opportunities to try to capture an anomaly that shows up in different securities. This is not an exhausted list of types of traders but should capture a large portion of them. All of these different types of strategies work. You just have to make sure they work for your trading style.
Stock Technical Analysis Basics
For the purposes of this article we are going to focus on stock technical analysis. Technical analysis is generally classified as looking at chart patterns, Fibonacci levels, or support and resistance levels.
All of these types of analysis have one thing in common. All of these strategies work off of the past price of the security. If you look deeper every one of these types of analysis is built on, Supply and Demand. Supply and demand is the amount of stock bought or sold at any given time.
To most fundamentalist, stock technical analysis is voodoo. They believe there is no way for technicians to consistently make money because you can’t predict future prices based on past prices. I will tend to agree. There is no way the past price will predict the future price. Now that I have angered all of the technicians, let me explain my theory. The actual price has nothing to do with technical analysis. Supply and demand is the only thing that matters. Let me re-peat, stock technical analysis is not just looking at the price but being able to identify where supply or demand will change the price. This may sound easy but there is more to it than meets the eye. Not only do you have to identify price levels but you have to have a good understanding of the psychology behind the traders that makes them act the way they do. That is why technical analysis is as much an art as it is a science
Stock technical analysis is not easy. So it is easy to understand why people think it is voodoo. The traders who try technical analysis find out very quickly it does not always translate into profits, so they assume it does not work. The few who take the time to study and work through stock technical analysis will find the art side of the analysis comes through experience. Fundamental analysts are basically doing the same thing by using supply and demand of the actual widgets the company sells to try to determine what the price of the security should be in the future. They are analyzing supply and demand just in a different way.
Why is it so hard to identify supply and demand? I am going to use an example to explain problems with being able to forecast supply and demand levels. For all the chess fanatics, here is a way to explain the issue. The market has traders/investors that have different levels of ability to play chess (trade). Using the Elo rating system, I would label the majority of players/traders as novice (below 1200) players. Then you have a few players that actually qualify somewhere between Class A and D level (2000 to 1200). There are only a limited number of players at a level of candidate master to FIDE Master (2400 to 2000). Then you have a couple of shining stars that achieve a level of Grandmaster or better. Your job is to play chess with all of these players at the same time. Assuming you are in the upper Classes you see a move based on your strategy that should work, when all of the sudden a novice chess player makes a “dumb” move that they should not have made and it stalled your strategy. If everybody were experts in trading then they would all be looking at each strategy and understand the next move to “logically” make but not all players/traders are experts. In chess and in trading the experts should be able to make adjustments and beat the lower Class players/traders but that does not mean your strategy will always play out the way you thought.
For fun click the link to check your Elo chess rating: http://www.chessmaniac.com/ELORating/ELO_Chess_Rating.shtml
The point to this explanation is to show you an example of why it is so hard to accurately identify where supply and demand levels are on a chart. It is important to understand every stock and/or index has its own players/traders and they may act differently than the players/traders in another stock and/or index.
Now that I have convinced you that stock technical analysis is a daunting task. Let’s break it down into ten rules to help you learn how to identify areas of supply and demand. For clarification, support and resistance are interchangeable with demand and supply.
Top Ten Rules of Supply and Demand
- The more times a level is held the better it is as a support (demand) or resistant (supply) level.
- You must account for throw overs, sharp quick moves that violate the demand or supply level.
- No analysis is expected to be perfect.
- Supply or demand will eventually get exhausted. Learn how to identify this and you can make a lot of money.
- Most of the time major markets will dictate the supply or demand appetite. It is not very profitable to try to go against the markets unless you are a long-term position trader.
- Emotions play a big part in supply and demand and emotions are very seldom logical.
- Organized supply or demand (trend) is easier to trade than sporadic supply and demand.
- Identifying supply and demand take patience and work.
- Once you have identified the levels of supply and demand, do not second guess yourself.
- Volume can help you better understand supply and demand.
Stock technical analysis can be very profitable if you work and study supply and demand. Most traders gravitate to this type of analysis because it is very visual and easy to get access to charts. The issue with most novice traders is they have not taken the time required to become an expert in identifying supply and demand and it ends up costing them a lot of money.
Anything in life worth pursuing takes time and work. If you want to trade using stock technical analysis you have to take time to learn this type of trading strategy before you will be consistently successful.