If you read much of my work, you will begin to see that applying technical tools takes work; it takes a lot of time and experience to know how to apply them correctly, even if we are using relatively simple tools with a statistical edge. (Beware: most technical tools and most technical analysis do not work as advertised, meaning that there is no verifiable statistical edge in most technical tools!) I realize that this level of depth may create barriers, and, really, there are tools that even casual market participants can use to control their risk and, hopefully, increase their returns. I want to write a short series of posts that might be subtitled “easy things you can do with technical analysis.” Here are a few ideas to start with today:
- Learn to think in probabilities. In some types of analysis, it’s easy to forget that any conclusion is only valid within the range of statistical probability. For instance, if we do valuation work, we might think that is the value, and just wait for price to converge. Technical tools make us face the reality in the market, and that is that markets are not very predictable, and are only predictable within a range of probabilities.
- Learn to cut your losses. It’s impossible to say what is the “most important” thing in trading or investing, but this certainly is a candidate. Many methodologies do not have any way of telling you when you’re wrong. For instance, if price is under your valuation and it goes down, the logical course of action is to buy more. At some point, declining prices carry a message, and technical tools can force us to respect that message.
- Understand how a market has been trending. This can be as easy as squinting at a price chart and see if it “goes up, down, or is pretty flat”. You don’t need moving averages or indicators to do this–simple visual inspection is enough. However (and this is a huge “however”), do not assume that a market that has been trending in the past will continue to trend in the future. That requires a few more steps.
- Understand when the rubber band might be stretched a bit too far. Markets tend to move in waves: directional movements will alternate with pullbacks or flat periods. Sometimes, a market goes a bit too far, too fast and can be set to snap back. Buying a market (or shorting) when it is overextended is chasing, and can open the trader up to some stunning losses. There are simple technical tools that will highlight when markets are perhaps a bit overextended, and can tell us to wait for more favorable conditions.
- Enforce discipline. Markets are random, but you cannot be random. The only way to get consistent results out of difficult and competitive markets is to always act with consistency and discipline. Technical methodologies encourage us to face market conditions and to immediately evaluate the results of our actions. There is no better way to drive toward consistent behavior.
These may not seem like earth-shattering ideas, but think back to some of your losses and mistakes over the years–I’m willing to bet that many of them (most? nearly all?) could have been avoided or lessened with some attention to each of these points. Over the next few days we’ll dig a little deeper into each of these ideas, and I’ll give you some tools that you can actually begin to apply in your own trading and investing.