Introduction to Technical Analysis, Part II

DISCLAIMER: MUST READ:

DISCLAIMER: MUST READ STAT seminars are for educational and entertainment purposes only STAT does not encourage trading with real money, which is very risky. Any mention of strategies, trades, and contract symbols strictly refer to simulation trading, to the members that choose to participate in our Student Trading Lab We do not dispense financial advice; do not construe any words said as financial advice We do not guarantee anything said to be 100% accurate Always do your own due diligence before making any transaction in the financial markets; consider the consultation of a professional financial advisor If a specific contract is mentioned, be aware the speaker may hold a position and buy and sell that position at any time If you do not acknowledge this disclaimer, we must kindly ask you to leave.

Introduction to Technical Analysis Workshop, Part 2.:

Introduction to Technical Analysis Workshop, Part 2. Hosted by: Speculative Trading & Arbitrage Team (STAT) "I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. ” – Paul Tudor Jones

Objective:

Objective Too many traders are stuck on level 1 thinking with TA: Read chart & find pattern Execute trade & set stop Wait for $$$$ Learning the patterns = the EZ part The market ain’t no kiddie game. You will LOSE if that is all you do! My goal is to get EVERYONE to think beyond level 1.

Review:

Review Two points to reiterate: It does not always work – you must cut your losses if you are making technical trades and the technicals move against your position. Discretionary trading will test your emotions like nothing else! Understand MARKETS first before technical analysis The “theory” behind technical analysis is not searching for esoteric patterns, it’s about diagnosing bullish and bearish sentiment Don’t just memorize patterns. It is not a game of lines and numbers on a chart. The patterns you identify should reflect changes in market conditions, supply & demand… Identifying these patterns explicitly help to reduce cognitive load – a big problem for many beginning traders there is no *extra* strategic value with “by-the-book” patterns (IMHO)

The Unpredictable:

The Unpredictable NEWS & EVENTS fall into two categories: 1) fundamentally unpredictable & 2) tiny, negligible predictability Extremely risky to hold through events. Anticipate the runup or ride the move but DON’T HOLD THROUGH unless you want to gamb0l. Individual stocks are highly-event driven – there’s FAR more idiosyncratic risk than indices, commodities, currencies, t-bills The technical history goes OUT THE WINDOW when there are game-changing events , especially unexpected events Ex. new technologies, new products, “disaster events” (BP or 9/11), mgmt. scandals, securities fraud, buyout rumors, analyst initiation, panic liquidation by beneficial owner, legislation, natural disaster Known events that many *try* to predict but fail (So don’t bother) Earnings, FDA approval, analyst upgrades, buyouts/partnerships You will never beat the people who have an edge at this game because they’re probably cheating

Case Study: Fat Pill Makers:

Case Study: Fat Pill Makers OREX ( Orexigen ), ARNA (Arena), VVUS ( Vivus ) – all small-cap biotech companies with blockbuster drug potential in late stage development (Phase III)… all weight-loss drugs ARNA’s lorcaserin considered ‘safest’, VVUS’ Qnexa considered ‘most effective, OREX’s Contrave considered the WORST! ARNA ran up into FDA advisory panel. Voted against, tanked. VVUS ran into FDA advisory panel. Voted against, tanked. OREX trades flat into FDA panel. Voted FOR , gaps up 120%. VVUS and ARNA investors rage on the internet  Last week, February 1 st – FDA rejects Contrave for PDUFA (prescription drug user fee act) and OREX tanks all the way to $2.50, -70% ! The market was wrong… technical analysis is just a measure of sentiment, not predictive of events People try to guess on fundamental drug data, FAILED

Slide 7:

Rejected by panel Rejected by panel Approved by panel Rejected by FDA (complete letter of response)

Gaps:

Gaps Gap = a break between prices on a chart that occurs when the price of a stock moves up or down with no trading occurring Major gap = Stocks with major news announcements will HALT trading, then the market makers will provide bid/ask prices when it opens again Common gap = small gaps that will occur from pre-market trading. If the SPX is strong, most major stocks will have some type of gap-up. Analyzing movements towards or away f rom the gap can provide significant info: --Whether news was priced in too much/too little --How the day traders are playing the stock --Another significant price level, as many traders are often watching to see if a stock will “fill the gap”

The Open & The Close (and in-between):

The Open & The Close (and in-between) The Open and The Close – most important intraday hours Participants of all timeframes will trade The Open, thus the first half hour usually has the most volume and volatility The Close is when position traders (often representing mutual and hedge funds) return to the market to build longer timeframe positions, thus the last hour typically shows more sustained directional moves Reasons why mid-day (7:30-11:00am PST) trading kinda sucks: Position traders waiting until close = lower volume trading Day traders eating lunch = lower volume trading Passive market-making strategies designed to shake out over-exposed traders = many false breakout signals The computers ( algo’s , HFT’s) become a larger % of the total order flow during mid-day hours b/c of reasons #1 and #2. They trade the spread, NOT the trend. False breakout signals, insignificant price levels, lower volume, lower volatility, more ambiguity = more risk in trading mid-day

Technical Indicators:

Technical Indicators Technical indicator: a series of data points that are derived by applying a formula to the price data of a security Types of indicators: Momentum oscillators: RSI, stochastic, CCI, MACD Directional oscillators: OBV, Chaikin Money Flow, Accum / Dist Moving averages: simple, exponential, volume Bollinger bands (moving average + standard deviation) Simple measuring: average true range, average daily range These indicators can generate mechanical BUY and SELL signals – can be back tested to determine edge Challenge of indicators: balance of sensitivity and consistency. Sensitivity – decreasing the # of periods to generate earlier signals and a greater number of signals Consistency – increasing the # of periods to reduce false signals (whipsaw) Remember risk-reward: 1) win % 2) avg winner 3) avg loser 4) # of opportunities

Technical Indicator Calculations:

Technical Indicator Calculations

Technical Indicator Examples:

Technical Indicator Examples Moving Averages – simple & exponential Bollinger Bands Average True Range Ichimoku Clouds

Slide 13:

They are many technical indicators, these are just the mainstream indicators. Play around with them if you want but you do NOT need to use them or know all of them. More indicators =/= superior trading system MACD (Moving Avg Convergence-Divergence) RSI (Relative Strength Index) Accumulation-Distribution Line

Scout the market with TA:

Scout the market with TA Although most TA books concentrate on patterns for entry/exit & prediction, not enough time is spent on the simple yet fundamental skill of identifying trends, pullbacks & rallies, volatility (range), and the idiosyncratic characteristics of a stock Think of about this: What do you NOT want to trade? Choppy, ambiguous trends if you’re a trend trader Being the last guy in and getting screwed if you’re a momentum trader Illiquid stocks… stocks with zero movement… ugly charts… Stocks that screw you – they offer you seemingly favorable entries but continually punish you with pattern breakdown Scouting the market for stocks that conform to your preferences & filtering out the bad ones = another way to reduce risk Relates to stock selection… which is its own topic… and trading style, based on personal strengths and weaknesses Develop ideas & directional biases

TA for Risk Management:

TA for Risk Management A good technically-based exit strategy must be “efficient” – a balance between getting clear indications & minimizing risk Price levels should be significant – in the sense that, if hit, the subsequent price movement indicates a shift in market behavior and therefore a rejection of the trading hypothesis Using TA to determine entry/exit criterion could be described as “buy at support, sell at resistance” (or vice versa) If you buy at a price level of significance, then once that area gets penetrated, you can cut your losses on the strong possibility that market strength has, at least temporarily, disappeared If you buy at an insignificant or “random” price level and it gets penetrated, you may be receiving insufficient information on market conditions (noise), yet cut the trade for a loss anyway. In the other words, if you find yourself exiting long for a loss when the market is still strong – your exit plans are inefficient

More on Support & Resistance:

More on Support & Resistance Support and resistance is fluid -- as variables change, time passes & trends continue, old price levels will lose their “signaling value” (significance) to new price levels Think in units of timeframe and volatility At the present moment, a market index trades at $X The further away we look from $X in terms of timeframe and volatility, the less significant the price levels will be Take an extreme example: Bob has a multi-year outlook for the S&P 500 and wants to buy 2014 SPX futures… 3 yrs ahead. There are simply TOO MANY FUNDAMENTALLY UNPREDICTABLE EVENTS in between now and 2014. Another example: Bob has a price target of $2000 on the SPX, 700 points away from current 1300 price. TOO MUCH CAN HAPPEN in between $1300 and $2000. Nobody does this (admittedly an extreme example but trying to make a point)

Slide 17:

1173 price level was key support in November. We have since moved 100+ pts higher. Traders will move their stops higher to protect gains and dip buyers from 1173 may already exited their positions. Novice technicians will anchor to old price levels when they are no longer pertinent. The fact is, it would take a 140 pt move to get back to 1173. There could be a big game changing event in between. This is not a game of lines and numbers, where the 1173 price level has eternal support. The level will likely have to be tested again to see if there is significance.

A thought exercise:

A thought exercise Buy Yahoo (YHOO) at close for $20, price target at 30, stop at $17 Every day you have an option to get out (or add, but let’s keep it simple) Day 2: Option to exit at $21-$22 (intraday range), you stay in Day 3: Option to exit at $20.90-21.33, you stay in Day 10: Option to exit at $18-19, you stay in Day 20: Option to exit at $17.50-19, you stay in Day 100: Option to exit at $26-29.50, you stay in Day 200: Option to exit at $20… exit stock… for zero profit That’s 200 days in a position – 3 different earnings quarters, likely multiple analyst upgrade/downgrades, lots of news… These big news events can smash significant price levels just by gapping over/under them on huge volume. It will push the reset button on your technical levels. Market sentiment has likely shifted multiple times while you stick with your rigid, stale trading plan. There could have been many technical patterns in between days 100 and 200 to indicate buyer exhaustion or a short-term top in the stock

Finding Significant Price Levels:

Finding Significant Price Levels Rules of thumb on where the most significant price levels are: Round number levels -- 5.00, 10.00, 20.00, 100.00; .25/.50/.75 "Many years ago I began to profit from the simplest of type of Pivot Points trades. Frequently I had observed that when a stock sold at 50, 100, 200 and even 300. a fast and straight movement almost invariably occurred after such points were passed. “ – Jesse Livermore 52-week high and low Intraday high and low (HOD, LOD – high of day, low of day) Prior close – known as the green / red point Gaps Popular moving averages – 50 day, 200 day simple MA Bases – channels, consolidation, flat trading ranges Scales to the higher timeframes (e.g. resistance level on 5-min/1 day chart is also resistance on daily/3-month chart) Ranges – 30-min opening range, 60-min afternoon consolidation Price levels with multiple factors = more likely to be significant THINK: Where would everyone else place their stop loss?

Slide 20:

From John Lee (weeklyTA) of chartsgonewild.com

Multiple Timeframes:

Multiple Timeframes Finding patterns that align on multiple timeframes(reversal or continuation pattern that scale onto the 5-min, 15-min, daily & weekly chart) will put the probability in your favor Example: stock has resistance at 10.00 that is evident on 5-minute, 15-min, and daily chart. The best risk-reward trading setups will offer a considerable margin of error. Taking a piece from a move that may be the start of a significant long-term trend = higher margin of error – in other words, you can screw up and still make money Taking a piece from a move with no indication of higher-timeframe alignment = lower margin of error, requires superior timing and execution to make an ideal profit Fractal – “pattern within a pattern”

Slide 22:

We cannot handpick our exit price, we can only watch our position and exit when risk-reward becomes skewed towards risk (exit criteria can be anything – news, fundamentals, pattern breakdown, % stop, tape reading)… wherever that may be You are a short-term trader who places 2-3 day swing trades. What do you think would be the trade that provides you with a greater margin of error? A) a long trade that could be a segment within a 10-point longer-term uptrend B) a short trade that could be a segment within a 5-point intermediate-term downtrend 10 point move 5 point move Daily chart 5-min intraday chart

Multiple Timeframe Usage:

Multiple Timeframe Usage Taken from Brian Shannon’s AlphaTrends.net (the expert on the subject) 9.50 resistance on weekly (Sept 2009) 9.50 res on daily (Nov 2010) 9.50 res on 10-min intraday (Jan 11 th ) CELL – Brightpoint Inc

Slide 24:

Stock driven up by earnings report but significant technical lvl breakout + 2-year highs + strong market made for favorable risk-reward day trade  $2 intraday gains possible

Waiting for confirmation:

Waiting for confirmation Waiting for confirmation vs. anticipating the move By the time you confirm something, it’s usually too late Confirmation is not a property inherent in any stock, it is just a matter of perception – nothing is EVER confirmed in the market!

Misc.:

Misc. Who uses technical analysis? Who doesn’t use it (and specifically doesn’t believe it works)? What are some popular strategies? CANSLIM – 50% growth investor, 50% chartist Mean reversion -- overextension plays i.e. 50% tanks and parabolics Momentum – “follow the leader” Basket trading – build a relationship with 15-30 stocks Mechanical – rule-based trading on custom indicators (involves historical backtesting, pattern search, quantitative/statistical analysis) Fund manager style – idea-based trading (based on fundamentals, macro, etc) using TA to find best prices & manage risk News & events – trading before or after major dates (not during) Don’t do this: swing tradethe market (S&P 500)