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chap 3

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Chapter 3 – Technical Analysis
Revised: June 26th, 2019 V1.0
How to lose money when trading
Introduction
The idea of these articles is not to make you the ultimate trading machine. Only a few are and will
ever be. The idea and intention here are to help you avoid the most common mistakes that either
make you lose some or all your savings. In worst case trading may put you in debt. Becoming a
winner is very much like evolution in nature - you learn from your mistakes. The stock market is full
of predators just waiting for newbies they can feed on. Stocks may be subject to “pump and dump”
where news is pushed to press the stock up while major players sell, or the other way around.
Another common way is for professional traders to fire up a rally in illiquid stocks and let small
traders lose as they get in too late and get out even later. These events are known as “the penny
stock runs” as they mainly happen in penny stocks with very low daily trading. These runs are often
initiated by stock forums spamming where the initiators of the run pump rumors or otherwise create
attention to the stock just after buying shares. However, the main reason so many investors lose
money while trading is due to lack of knowledge and access to information.
I will bit by bit introduce technical analysis in this text as I believe this is a tool any trader should
know. Technical Analysis (TA) will help improve your timing and ultimately help you make better
overall trading decisions. In the end, it all comes down to decisions, and in the stock market, there is
very little room for error unless you have proper stop-loss strategies.
Yours,
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Table of Contents
Chapter 3 - Technical Analysis ................................................................................................................. 4
Understanding how technical analysis is different from fundamental analysis ................................. 4
Technical Analysis - Volume, the one indicator you really need to learn ........................................... 5
Why you should measure volume as liquidity (price * volume) ..................................................... 5
The example of the differences....................................................................................................... 6
Technical Analysis - Accumulated Volume - support and resistance ................................................ 10
When accumulated volume fools you ........................................................................................... 12
Trading on accumulated volume - mind the gap .......................................................................... 12
The stupid gamble ......................................................................................................................... 14
Technical Analysis - Relative Strength Index (RSI) ............................................................................. 15
RSI in different market conditions................................................................................................. 16
The Facebook example .................................................................................................................. 17
Technical Analysis - Pivot Points ....................................................................................................... 19
Finding the good pivot points........................................................................................................ 19
The Apple Case .............................................................................................................................. 20
Other use of pivot points............................................................................................................... 20
What is the lesson about Pivot Points? ......................................................................................... 21
Technical Analysis - Trading with moving average ............................................................................ 22
Moving average - then intent ........................................................................................................ 22
Moving average - the understanding ............................................................................................ 23
Volatility will affect the use of moving average as a trading tool. ................................................ 24
Time is the name of the game ....................................................................................................... 25
Moving average - digging into the nuances .................................................................................. 27
The Moving Average Hausse index ............................................................................................... 29
Moving average - The Death Cross................................................................................................ 29
Moving average - The Golden Star (By J.Stromberg) .................................................................... 30
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Chapter 3 - Technical Analysis
In this chapter, some of the main indicators used in technical analysis will be described both in function
and how it can be used while trading. Personally, I like the word “indicators” as it so clearly states that
nothing is really given. Over the years I read many posts or articles using technical analysis as guaranty
for forthcoming change. Posts like “golden cross to push Apple above USD 150”, “The high increase in
volume will push the stock above USD 20”. But nothing is really given, the moving average may flip
back to sell after a few days and the volume may top out causing a vacuum and heavy fall. Any and all
signals will just give you an indication, but with enough indications, you will achieve a level of
probability that eventually will help you in your trading.
Understanding how technical analysis is different from fundamental analysis
The main difference between technical analysis and fundamental analysis is the focus on historical
numbers. Where fundamental analysis considers elements like the intangible value of a brand, market
position, potential sales, last year’s financials etc., technical analysis looks purely at the price data. In
most cases we connect technical analysis with chart analysis of stock prices (open, high, low, closed)
and volume. However, technical analysis was used in Japan in the middle ages trying to forecast silver
and rise prices. The first real recordings of “professional” use date back to the 18th century and Japan.
The Japanese influence is best recognized by the candle charts developed by Munehisa Homma (17241803) that was a Japanese rice trader from Sakata (Japan). The modern technical analysis as we know
it, is credited Charles Dow (1851-1902). The strong defenders of technical analysis like to believe that
any and all knowledge about a stock is reflected in the price. Based on this assumption you can foresee
fundamental changes as well. For example: if a stock is falling despite record revenues it is because the
“market” knows that the revenues will decline. This, however, is far from the truth. You cannot expect
a stock with very low trading volume to have a price that constantly reflects all market knowledge.
There is no such thing as the “correct” or “fair” price, etc. The price is exactly what the buyer is willing
to pay, and seller is willing to sell for, right there and then. The very best way to use technical analysis
is to remove assumptions.
If you know little about technical analysis it will open a whole new world for you. I like to believe that
technical analysis is the best tool you can get for timing and optimizing your trades. However, using
technical analysis in combination with fundamental analysis will give you an even stronger tool.
These two directions are not in competition with each other and especially when considering longer
investment periods. Understanding all the aspects, the different variables and indicators will take
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time and with an ever-faster pace of the technological development around the world, trading bots
and algorithms will do most of the work for you. In fact, there is no need for you to draw your own
trend lines or calculate the proper relative strength index (RSI). But do yourself the favor of
understanding the main principles. Do not choose MACD as your indicator because someone says it is
the best, or blindly trust the volume. Knowledge will be your best friend when it comes to making
good decisions. In the following part I will do my best to give you some understanding of the
technical indicators and how they can and should be used.
Technical Analysis - Volume, the one indicator you really need to learn
Cash flows, and it flows in the path of less resistance. Amount of cash flowing in or out of a stock can
be seen in the volume and the price. The number of stocks traded represent the volume. Volume can
be defined as a number in different time perspectives like per minute, per hour or day. It can be
smoothed, accumulated or both and if wanted drawn in a chart. Nevertheless, the amount of trades is
an indicator of the interest in the stock. Like fashion, interest can change any game. In most cases, high
interest equals high price, but there will always be the exceptions. In the following chapter you may
be confused about mixed use of the word’s liquidity and volume. The difference is explained below,
but throughout this chapter and I will refer to volume as volume * price.
Why you should measure volume as liquidity (price * volume)
* Liquidity is here seen as the smoothed blue graph at the bottom
A stock with huge trading volume is, therefore, a “popular” stock. Usually, the popularity can be
defined as “day traders’ favorite” or “popular amongst funds and larger investors”. Like in the world
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of music some are popular years after years, while some just become a fling and are gone with the
wind. Many new traders who are getting into the world of technical analysis forget that volume is not
the same as liquidity (when speaking about trading). Volume is simply the number of shares traded,
while liquidity is the amount of money spent in trading. Liquidity is therefore defined as volume * price.
To give a better understanding of why this distinction is important, let me give you an example. Imagine
you want to trade a stock where the volume follows price (which is good). The stock is on an upturn,
and from the chart, you can see that the volume historically has been much higher. As I have
mentioned before there is always a limit of accessible liquidity. The previous tops and bottoms give
you an indication of the maximum and minimum liquidity levels. As the previous volume tops have
been higher you assume there is more trading liquidity available. But liquidity is money. You should
base your assumptions on price * volume. Because 100.000 shares @ USD 1 is not the same as 100.000
shares @ USD 5. In fact, in the latter there is 5x more money involved. By using liquidity instead of
volume, you get comparable situation. Liquidity flows and it is limited. At some point there is simply
not much more money to put in to fueling the upturn, and what happens then?
The example of the differences
Most chart providers like to print volume as raw bars as shown in the picture above. Each bar
represents the daily traded volume. As mentioned earlier volume should follow the price. If price goes
up the volume should go up and vice versa. Volume tops also give an indication of possible turning
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points as there is not likely that more liquidity will flow into the stock on short term. There are simply
not more buyers. By looking at the picture above you can assume that point 1, 2 and 3 represent
volume tops. You can also see something that looks like a pattern. For point 1 the volume seems to
follow the price. Point 2 do not have the same pattern. Question is do point 3 represent a selling point?
In order to better understand what is happening and see the relation between volume and price we
will use some statistical principles. The first thing we do is trying to get trends (statistical directions),
and we do this by smoothing the volume. We do this by grouping a certain amount of days and look at
the average change. The second thing we do is trying to measure the same parameters. To do this we
multiply the volume with the price for the given day and get the daily liquidity (price * volume).
Here we see the same chart, but this time with smoothed liquidity. Now it is much easier to see
patterns. From the chart above the following can be stated:
For A and B the liquidity is following the price
For C and D the volume remain high even after the tops and the stock keep climbing
E is topping out on volume
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Just by looking at the chart and using the main rules for volume/liquidity it is clear that buying at
current level around USD 5.6 involve an extreme short-term risk. There are many other indicators to
look at that will help you draw a conclusion, but this is the easiest indicator of them all to learn and
follow. If a stock has a repetitive pattern (liquidity / price) betting against the pattern is a sure way to
lose your money.
The main rule is that volume should follow price. Behavior will then be more predictable. The changes,
and the buying and selling opportunities, are however, often found in divergence. When volume and
price go different ways. A huge increase in volume on in a falling stock often represent a re-bounce
opportunity. A sudden fall of volume in a fast-rising stock, is often a sign of a selling opportunity. The
divergence itself is often used to verify other indicators or formations. Several indicators are made
from the volume such as momentum indicators. Small proverbs often prove to be good advices; Follow
the flow and the huge money are made downstream.
As you can expect there is much more to volume that what I have mentioned so far. For instance, you
cannot read volume in low liquid stocks the way you read it for major companies. Certain events will
affect volume, like news and overall market conditions. The volume will also to some degree be
seasonal. Yet the main principles will help you in your trading. Most newbies or un-experienced traders
and investors lose their money going in on a high note. The train is already at max speed and
momentum is about to fade out. The professional traders do not try to be first in and last out, they
reduce the risk by making sure the momentum is established and jump of before it maxes out. Many
of you reading this will, or already have lost money trying to jump on the penny stock ride. However,
come to mind what was said earlier on. Easy come, easy go.
Lesson:
Why would you buy a stock at very high volume/liquidity if history shows that it usually falls back
afterward?
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Some main rules about volume:
Volume should follow price. If the price is going up, the volume should be going up. This will
make the stock more predictable and ultimately tradeable.
Volume price going in different directions is called divergence and usually indicates a change.
This can be the start/end of a trend or end of a signal/formation, etc. Divergence can be
considered as a trading option. You just have to understand what change it is and act on it.
Low volume increases all kinds of risk.
Volume is presented in many ways. Either just as volume or as liquidity (vol * price). Liquidity
is more “readable” and statistically correct.
Volume is not unlimited, but it can dry up completely.
Volume is the main verifier of all signals and formations.
Side note:
A friend of mine loves trading low-liquid stocks simply because these stocks often have high spread. It
is a game of patience, but doable. The spread, in this case,
is defined as the distance between the sell offer and the
buy offer. It is very common in some stocks to have 3-10%
spread. If you manage to buy on the low and sell on the
high you can cash in some profit. You will just have to
understand the pattern of the stock. Is it opening high and closing low? Meaning you can buy at close
and sell on opening the next day?
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Technical Analysis - Accumulated Volume - support and resistance
Volume is perhaps the best indicator of all and should follow the price; if the volume goes up, the price
goes up. If this does not happen there is divergence and divergence mean trading spots you want to
look for. However, volume, sorted and accumulated, also allows defining support and resistance levels.
These levels are important as they define good buying and selling spots. It also may explain why the
stock sometimes struggle to breach a certain level. One way to lose money is trade a stock that is about
to hit a resistance level or sell a stock that just hit support level.
In the picture above, which is a snapshot of the Red Robin Gourmet Burgers (RRGB) chart after trading
29 May 2019, you can see the accumulated volume as grey bars on the right axis. The bars indicate
how much of the stocks been traded on each price during the chart period. The theory is very simple:
people buying at a given level will use this guide as a decision point. Imagine you bought RRGB @ USD
29.90. The current price is USD 30.40. You are still @ profit and would consider USD 29.90 as another
chance to buy cheap and since you’re human you will be reluctant to sell. That makes USD 29.90 a
support level. The strength of the level depends on how many shares were sold and bought on that
price (accumulated). Visually this is seen as longer or shorter bars or the right axis. On the other hand,
if the stock turns up there is a lot of people who bought @ USD 32.00. These are impatiently waiting
for stock to get back so they can dump their shares without losses. That is why USD 32.00 becomes a
resistance level. It is very important to understand that liquidity and volatility of the share have a huge
influence.
Over time the importance of previous events is reduced. This also applies to accumulated volume. This
simply means that recent volume is of more importance than previous volumes. The logic is that with
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time more and more people are getting out of their previous positions and therefore the resistance
and support no longer have the same validity. In a technical analysis tool like ours, this can be
accounted for by using “weighted accumulated volume”. When using weighted accumulated volume,
you emphasize recent volume more and emphasize less on past volume. As a trader, you cannot
remember all the small tweaks and twists, but you should understand the logic of how things work as
the same rule applies for all indicators in general. Over time you will see that support and resistance
form accumulated volume works very well and should be a part of any trading strategy. There are a
few unwritten rules like the stock always will try 2 times to break a good resistance, so you never buy
on the first attempt. If not breaking on the second attempt it most likely will not manage to do it in the
very short term. From the picture below we can see how FB tried to break through USD 152 twice
without making it and caused a double top formation which triggered a sell signal.
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When accumulated volume fools you
Now you think you have it. Just look for the grey bars. Long bars mean good support or resistance. Put
your buy or sell above or below depending on the formations of the accumulates support bars.
However, it is a bit more complicated than that. You can have large transactions recorded due to
fundamental issues like new stock issuance, bids, etc. This is still valid as support/resistance but do not
have the same strength despite the huge accumulated volume. This was the case of SnapChat (SNAP)
where stocks were issued to investors with great discount and put out for trade @ market price. This
led most investors to take immediate profit and the stock plunged. To reduce your risk, you can
consider a group of bars as resistance level like shown here as these are several trading days.
Professionals like to refer to a support level ($29.30-$29.90) and not a support price ($29.90). This
follow another important rule in technical analysis; The validation of signals.
Trading on accumulated volume - mind the gap
Lack of no trading at a certain level (no accumulated volume - resistance or support) gives room for
very rapid movements. In fact, these are one of my favorite trading opportunities. I often post these
opportunities or threats on Twitter or other social media platform and in most cases I act on these
myself. Below is a sample of a tweet I wrote regarding no support for the SNAP stock, it was super for
a short, and the stock really took a heavy fall and made me and my wallet a lot happier.
You cannot call every move correctly, but why would you buy knowing there is no good support below
the current level? The only reason I see is that you either know something nobody else does, or you
don’t measure your risks, either way, that is how you lose money.
In the picture you can see the
drawn rectangle marking out
the area of no support from
accumulated volume
Accumulated volume could
be used as an indicator alone
but combine it with volume
and other indicators and it
becomes
powerful.
even
The
more
magic
of
numbers, like 1, 10, 100 also play a role, and if you study enough charts you will see that accumulated
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volume is often peaking around these numbers. If a resistance is met at already high volume there is
very little chance for resistance to be broken, while if it is met on low, but rising volume there is a very
good chance it will. The reason and logic are that there is a higher interest than resistance, or in other
words, more buyers than sellers (and they just keep coming -rising volume).
Let us get back to the SNAP chart (Feb 22th, 2017). Currently, the price stands at not support and above
is a ton of resistance. Your logic may say that it has fallen so much that it must be a good buy case right
now, but the fact is that technically this stock is doomed for an even deeper and quicker fall on its way
to USD 5. From a trading perspective, it is far more lucrative to short than anything else. There is always
a chance of some fundamental news disrupting the picture, an offer, a deal for something and often
these are thrown out by the management itself in attempt to do some damage, control or try to
influence the share price. No better example in the world for this trick than Elon Musk’s behavior @
Tesla. But as a careful trader with a good strategy, you would avoid the trade in Snap @ 18.70 because
it was too risky.
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The stupid gamble
Below is just another example of a situation where you should not gamble. There is no support below
$5.40, while there is a lot of resistance above current price. The best choice in this case would be to
put a short with close stop loss. Trying the opposite. Buying. Is the perfect way to lose money.
The lesson from all this is, that accumulated volume offers you a very good chance to time your buy
and sell better. It also gives you an indication of what to expect. With more accumulated volume above
the price (resistance) a move upwards will be slower, the same a lot of accumulated volume under the
current price a downwards (resistance) movement will be slower.
Now you can add this knowledge to your strategy. For example, to never buy shares with lack of e.g
5% support under your buying level. This small advice will save you a lot of money if followed.
Personally, I use accumulated volume as part of defining the stop-loss and timing my trades.
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Technical Analysis - Relative Strength Index (RSI)
If you ever wanted a signal that easy to understand and that can help you perform better. The Relative
Strength Index (RSI) is the one you've been looking for.
The relative strength index (RSI) is a momentum indicator that measures the days of upturns and
downturns during a specific period, e.g. 14 or 21 days. The idea is very simple, and the indicator was
originally developed by J. Welles Wilder, who published in his book "New Concepts in Technical Trading
Systems" for the first time in 1978. If a stock is moving up or down too many days in a row the chances
of an opposite reaction increase.
However, when is a stock really oversold or overbought?
To solve this question J. Welles Wilder, who was a mechanical engineer, turned to mathematics and
created the RSI formula, which gives a score between 0-100. He later assigned values under 30 as
“oversold” and above 70 as “overbought”. This is normally marked as red for the price line of
overbought and green for the price line of oversold.
Boeing Company being overbought on RSI 14 at end of September
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The perfect solution?
Now you probably think that you found the secret formula for profitable trading. However, it is not
that simple, and again you will lose money if you just jump straight to the idea. There are a few catches
you need to understand before taking full advantage of the RSI-tool.
RSI in different market conditions
It makes sense that people are less negative in an upturn market. The sentiment is positive, and beliefs
are strong. Everything is possible if you are in a good mood and usually, this reflects in the stock market
as well. Very often stocks and even the whole market itself can go long and hard in overbought (RSI
higher than 70).
So what conclusion can be made from this? The first conclusion is that overbought is not simply
overbought. In fact, you will be better off if you say that overbought is when the assigned value is
higher than 80 with an upward trend and oversold is when the assigned value is less than 30. It is the
total opposite in a negative trend. Then RSI above 70 really is “oversold”. The reason for this is very
logical and simple. If a stock is already in a falling trend there is a general overweight of negativism and
it takes less to trigger further fall. And if you are feeling negative first, well, then it takes a long time
for you to be positive, so stocks in a falling trend can stay oversold longer than normal.
Snap being oversold for almost 2 months!
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To make it even worse. There is a huge individual difference from stock to stock. General volatile stocks
(like penny stocks) statistically stay oversold and overbought longer than e.g. solid stocks like Apple.
Again, it all comes down to strategy and you need to define it yourself. If trading by RSI is in your
strategy it should be clearly defined like:
“I will buy stocks in an upwards trend and use oversold RSI as entrance point”.
Now what you will need to do is scan market for all stocks in a rising trend with RSI lower than 30. This
can be done at e.g. Stockinvest.us. You will then have a list of candidates matching your request.
However, still, half of the job is done. You need to take into consideration the individual patterns for
each stock. The best way to do this is just by looking at the chart. How did the stock behave in the past
when being oversold? Does it usually react up quickly or can it be oversold for a long period? What is
the most common reaction? Just 2-4% reaction up or 20%? There is no point in being a day trader
buying a stock on oversold RSI if it usually uses a very long time to gain even 5%. In general, RSI is
better as long-term signal than a short-term indicator.
The Facebook example
In the sample above FB was oversold a few days ago. The same situation happened back in September.
At that point the stock gained from USD 160 to USD 168 or approx. 5%. It has now already taken out
about the same gain and being in a falling trend this is still no “buy case”. Analyzing history in your
trading is essential, but you should be aware that patterns changes, so always take this into
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consideration. It may very well be that FB now will gain 40%, but statistically, the chances are higher
that it will continue to fall.
Your question should always be: Where do you put your gamble? Should I go for a safer bet?
What is the lesson about RSI?
1. RSI can be measured in a different time frame. The most common is 14 and 21, whereas 14 is
short term and 21 long term.
2. RSI is in general more predictable as long-term signal.
3. The RSI-effect depends on the trend direction.
4. The RSI-effect differs from stock to stock. Volatility matters.
5. In general RSI above 70 is considered overbought, while below 30 is considered oversold.
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Technical Analysis - Pivot Points
Pivot Points refer to points of significant change. As a trader you had several pivotal moments in your
trading history. It may be the day you learned that what goes up, also goes down. The one trade that
was so green and you were high above the sky, but still got sold with loss several months later. It may
be the day you realized that no lunch is for free and that beating the market requires work. You need
to stay ahead of the game. These moments stand out to you as moments of change. They teach you
not to be so greedy, to take profit, to simply stop trading or focus on funds instead. These points are
your pivotal points. The same kind points can be made in a chart.
In technical analysis Pivot Points are the points that signal a significant change. This does not
necessarily mean that price direction changes from going up to going down, it may very well be major
shifts in volume, RSI or other technical indicators. In our system we refer pivot points as short-term
tops and bottoms. These are defined using zigzag patterns and signal possible good buy and sell
opportunities.
You can use pivot points as your only trading strategy. The downside to this is the loss occurring before
and after pivot points are identified. There simply has to be a bottom, before a bottom can be
identified. The typical signal delay is 2-time units. For some stocks these 2 time units can be 1%, while
in other stocks it can be 10%. If we look statistically it usually means that about 33-66% of the possible
profit is lost as you get in or out too late. The reason for 33-66% range is due to a repetitive pattern
For example, in a strong rising trend you have 3 days of executive gains and then 1 day
of loss. In a less rising trend it may be 3 days up and 2 days down. This same rule applies in many cases
and can be seen in typical re-bounce stocks (stocks that fall very hard), that instantly react and regain
of the fall.
Finding the good pivot points
If life was easy, you could buy and sell on pivot point signals and still make a good profit. But that is
also just another way of losing your money. There is no point in buying on pivot bottom if the average
gain between pivot bottom and top is 1%. Especially as we know you will lose some gain in both the
beginning and end of trade due to signal delay.
You will need a substantial amount of cash to make a profit on 0.33-0.66% considering you must pay
trading fees and have a certain degree of risk involved. And risk is something to consider. If you go for
stocks that usually have a very high gap between pivot bottoms and tops the risk is equally high.
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The secret is to be patient and make sure you identify stocks that have as predictable pattern as
possible. Usually predictable simply means that its pattern is repetitive, and you can see it by looking
at the chart.
The Apple Case
In this Apple chart, pivot points are marked with red or green circles. A quick check indicates a trading
range of roughly around 3-7%. Last top was identified just around $153.8, so a bottom should be
somewhere around $142-$149. The interesting thing is that this indicates a bottom above the previous
bottom ($142.19) and therefore, it is a small signal for a possible shift. Looking at the volume fall within
the same period (end of the chart) gives strength to this indication. The main rules are that in a falling
trend the bottoms should always be lower, and in a rising trend, the tops should always be higher. Any
deviation from these signals means possible changes and weaken any signal whatsoever. In this case
(Apple) the signal from pivot top (red circle end of chart @ USD 153.80) is still valid and there is a
higher chance for the stock to fall ($142-149 range), than to surge.
Other use of pivot points
Pivot points are also one of the main identifiers of formations and patterns like double tops, head and
shoulders, rectangle formations with more. In our chart, we use smoothed volume so there is a slight
delay, but good pivot points are followed up by volume changes. In theory, this makes sense: news hit
the market and there is a “pivotal” change in the stock. Or that the stock reaches the level where the
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traders go from positive to negative and you get a small sell-off (lots of stocks changing hands or the
opposite, meaning there suddenly is a complete dry up).
So how to trade on pivot points? First, you would need to set your criteria using your trading strategy.
If you have decided to go for high risk, trading on pivot points in Apple will not make you rich. If fast
money is your case, you will look for stocks with high volatility. After identifying such stocks, you will
look for the ones that have a certain degree of predictability. Your next step is to evaluate the time of
your buy and set your stop loss. I would recommend the stop loss to be set no lower than the pivot
bottom. If the stock falls lower, - the signal is invalid.
What is the lesson about Pivot Points?
1. Pivot Points can be used for trading.
2. Look for repetitive patterns. This reduces the overall risk.
3. Good Pivot Points are followed by a change in volume.
4. In falling trends, pivot bottoms should continue to be lower. Any change to this is an indicator
for a possible shift. The same logic applies to rising trends.
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Technical Analysis - Trading with moving average
As an investor, you always seek to understand what other traders think and how they will act. The
moving average is one of the best technical indicators to answer this question. This makes moving
averages one of the most common methods of trading and the basic indicator in most automatic
trading platforms. One of the very big advantages of moving averages is how easy it is to understand
and use. This makes it easy to include into any trading strategy you may have, as it simply is; buy if
moving average is under price line and sell if it goes above. However, despite being easy to use and
understand there are few things you need to know if you want to utilize it to the full potential of
moving average. Use moving average blindly and you will find yourself popping in and out of shares
without really making much money, and in worst case, your popping in and out will make you lose
even more.
Moving average - then intent
The first use of moving average is honored R.H. Hooker (1901) and published as “instantaneous
averages” in Journal of the Royal Statistical Society, by G.U Yule in 1909 (Journal of the Royal Statistical
Society, 72, 721-730) and in book form by W.I King in 1912 (Elements of Statistical Method). But the
fact is that moving averages had been used in decades. Moving averages belong to the grouping, Time
Series Analysis, (TSA) and can be applied to anything that holds a defined series of data.
Technically moving average is a way of smoothing out the price based on history. The reason for this
is because we seek a way to predict the future and we use history to do so. By smoothing the price,
we reduce noise. You may consider noise as a distraction like for instance news that gets a strong
impact on the stock when released. More than 1 person has lost his/her money while jumping on an
intraday rocket just to slam to the ground the following day because the news has no real impact on
the share value. In fact, un-serious brokers, companies, and traders may often use “news” as part of
their pump and dump tactic or damage control. No one is better at this than Elon Musk. He pushed
comments and news just before bad quarterly results and was fined USD 20 million (in late 2018) for
news made up, while high on a joint, about south Arabic investors offering premium prices. And his
joint stunt did the work it was supposed to do.
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The reason we want to reduce noise is based on the same principle and psychological factor as we turn
the head if a police car drives by with sirens on. Noise attracts our attention and we lose focus. Moving
averages can be considered as dynamical trends trying to say something about the general direction.
Noise is smoothed out and the length of the smoothing defines if it is a short term or long-term signal.
If the price is under the moving average, there is a general sell signal and when above there is a buy
signal. It is very popular to use the abbreviation MV for moving average, where the following number
describes the days of smoothing (e.g. MV35 means moving average smoothed over 35 days).
Moving average - the understanding
When we apply moving average in the trading, we buy shares if the price goes above the moving
average and sell if it goes below. Here we see the price as an indicator of behavior. Price going up or
down indicates the level of investor optimism. Still, we want to reduce the noise, like news, erratic
behavior to get a more correct view of the general direction of the stock and what the most current
action indicates. To do this we make a benchmark (moving average) and use this as a baseline. If the
price is going up above the moving average this is indicating that the investors are getting more positive
and this will likely push the price higher in the short term. If the price goes below the moving average
it indicates a negative change. Moving average crossing price line can be considered as a switch or
early warning, and this is the knowledge you trade on.
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The Facebook example - moving average
Above is an example of the Facebook stock price (FB) between Oct 23rd, 2018 and January 22’nd 2019.
The light blue line is a 7-day moving average and the dark blue line is 35 days moving average. The
large red and green boxes just illustrate the way you trade using a moving average. When short term
average is above price (red box) you sell, and vice versa you buy when short term moving average is
under the price line (green box). In the sample above the logic seem clear and easy to use.
However, there is more to it than just buy and sell as price crosses the MV line. You will quickly learn
that moving average is very reliable for some stocks, and not at all for other stocks. It even depends
on the current market situation and you will have to decide what time (smoothing) factor should be
used. For some stocks, you will need longer or shorter smoothing periods depending on the stock
volatility and it will be highly reflected in your trading horizon. By smoothing period, I refer to days of
moving average, like e.g. MV7, MV35, MV49 etc.… There is no rule saying MV7 and MV35 is the correct
MV’s to be used in all circumstances.
As a thumb rule, you will use longer smoothing for the longer trading horizon you have. Furthermore,
trying to use moving average as a buy strategy on stocks in a falling trend is close to hopeless. To make
moving average work in falling trends you will need stocks with enough volatility (movements) as for
example shown in the FB chart above. The FB stock is in a generally weak falling trend but is moving so
much up and down (volatility) that there are obvious trading opportunities. To avoid digging too deep
into it we can assign 3 very important elements to the moving average strategy.
[ VOLATILITY ] How volatile is the stock you are trading?
[ TIME ]
What time length is used when calculating the moving average?
[ LIQUIDITY ]
How reliable is the moving average?
Since moving average is just an average it also becomes clear that eventually, it will get back to the
price line. The buy or sell signal from MV is not an indefinite situation. In trading perspective, this
means you - in order to optimize the outcome of the signal - need to get out of the buy or sell position
before the moving average goes back to the price line and flip to the opposite signal. The question is
how to tell when optimal exit point is reached.
Volatility will affect the use of moving average as a trading tool.
Volatility is seen as risk and is visualized by how much the stock turns up or down during a defined
period. If the stock fluctuates much during a trading day the stock has high intraday volatility. This can
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be measured looking at the price high and price low during a day. There are many stocks out there that
have intraday fluctuations above 5%. For intraday traders, these are perfect trading stocks and often
traders would refer to doing intraday swing trades. Much of this trading is based on moving average
signals.
The volatility can be measured day to day, weekly, monthly and even yearly. As mentioned, several
times volatility equals risk. Trying to use moving average when trading with penny stocks is almost a
guaranteed way to lose your money. At the same time, you need some volatility to trade efficiently
using moving average. This is where liquidity comes to our aid: the main rule is that good liquidity
usually equals less risk. There is a huge difference in risk when trading in the Facebook stock or doing
trading on a minor biotech company.
The second rule is:
Liquidity (volume * price) will tell you information about the risk. The higher the liquidity
the more reliable the moving average is.
Time is the name of the game
Time is extremely important. This is where the money is made and lost. Time is indeed relative, and
you need to think about time as a concept. To this concept, you will add the proper moving average
that fits your trading strategy, the stock(s) in question and the volatility of the stock(s). Time as a
concept is the result of 2 factors: your trading horizon and the behavior of the price. To give some
examples:
if you are a short-term trader using MV100 is not your interest.
if the stock is just steadily going in one direction (behavior) you will have to use a longer moving
average than you normally would.
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Source: https://www.ablebits.com/office-addins-blog/2015/09/25/moving-average-excel/
In the picture above you can see how a simple moving average is calculated. In this example, 3
executive days are added together and divided by 3. The abbreviation would be MV3. For the common
stock trader, the most used MV’s are; M7, MV35, MV100, and MV200.
There are some different formulas made to calculate the moving average. The most common is just
simple moving average, but you can also use weighted moving average and several other methods.
The use and the introduction of machine learning (ML) have made it easier to identify a good moving
average for the individual stock, because stocks behave differently and what fits one stock may not
necessarily fit another stock.
Most charting programs offer some sort of ways to select moving average or use the best average
based on statistics. There is nothing wrong in using several moving averages at the same time and if
you keep a nice spread, they will give initial signals you can play with.
Some key notes:
Do not use moving average as a buy signal if the stock is within a falling trend.
Do not use moving average as buy signal if fundamental news has been dropped (this will
disturb the moving average unless you smooth it long enough.)
Playing the moving average strategy without understanding that you have to beat a zero-sum
game is like taking the zip line without a safety belt.
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Moving average - digging into the nuances
For the more advanced trader, there are more secrets to be revealed. One is the many ways of
calculating moving averages. What should you use? Simple moving average [SMA] or weighted moving
average [WMA]? Perhaps a more complex method? Using moving average is working with statistics
and please do remember, that all statistics pointed Hillary Clinton to win, while Donald Trump did win.
Can statistics just be read blindly?
The same is with moving average. It may indicate something, but the outcome is totally different. A lot
of this has to do with not considering the many individual variables and being bias. You see and read
the numbers as you want to read and see them. How to avoid this? Well, to some degree it is
impossible unless you use computers and systems, but there are some main rules. The variables we
already discussed a bit, things like time length, volatility, etc. To avoid the bias, you should find a
method of how to select what kind of moving average you should use and rules for the smoothing
length. This does not have to be advanced. It can be based on e.g. liquidity and as simple as “for stocks
with average liquidity less than 1 million per day I will use MV35” or “for stocks with more than 5%
daily volatility I will use a weighted moving average”. Then you track performance and adjust
accordingly.
Below there are two attached images for different moving averages in a period for 3 months for GoPro.
[GPRO]. In those images, you can see 8 different ways of calculating moving averages and the returns
that are given from each method. In the first example we use MV7 (Moving average for 7 days) and in
the other MV35. By first eyesight, it looks like you should always use MV7 (40%+ vs 30%+). However,
never underestimate the difference in risk when you must do 9 trades instead of 2.
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The Moving Average Hausse index
Below is a picture showing other ways of using moving averages. In this specific case we use buy signals
issued from MV35 as a measurement of the market situation. The chart is the results of the MV35
signal from more than 7.000 shares and shown in percent. As the image shows the investors are getting
more and more positive. At some point, you reach a level where too many investors are positive, and
you reach a pivotal point (point of change). It is very common to use the 30/70 rule meaning that if
more than 70% of the investors are positive the chance for a change is so high that the level may pose
a good selling opportunity. In the opposite case; if 30% of the investors are negative it signals a possible
buying opportunity.
Moving average - The Death Cross
If we define moving average as the investors level of optimism and divide this into short term, medium
term and long-term investors we get the option of looking at the differences between the moving
averages. The relationship between short- and long-term moving averages gave birth to the notorious
death cross that has appeared in all major stock market setbacks, starting with the major crash of 1929.
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Source:
https://www.zerohedge.com/news/2016-10-31/gulf-stocks-death-cross-suggests-crude-
slide-has-legs
The death cross appears when a short term moving average passes down under the long-term moving
average. It is an established truth that death cross should be based on MV50 (short) and MV200 (long),
but this is a truth with large modifications. Furthermore, as Jeff Cox in CNBC points out in the article
“Looks like the 'Golden Cross' isn't so golden after all”. (Golden Cross is the opposite of the Death
Cross) Jeff Cox points out; when measuring all established crosses from 1969 to 2012 there is proof
that the signal has any real value.
So how come, it seems to be a perfect signal only some of the times? The answer is the same as the
reason why people keep losing money on stock trading; you follow an idea blindly.
As I pointed out in the previous section you will need to adjust and adapt. Who said 50/200 is the
correct way to measure 50 years? During these years there might be a long period were the market
move sideways making the signal flip in and out without any real changes being made. However, this
do not make the signal less valuable. Moving averages are very good signals if used correctly.
Moving average - The Golden Star (By J.Stromberg)
I have always been a fan of the moving averages as it is truly helpful when timing buy and sells. I always
wanted to optimize the use of the signal, either by finding ways to set proper moving averages based
on the individuality of the
stock or optimizing it by
using
statistics
(back
testing). In 2005 I came up
with the idea to try to
strengthen
the
Golden
Cross signal by adding a
condition to it. After a lot of
back testing and actual
trading, I ended up with my
version of the Golden Cross
- “The Golden Star”. This signal was first released on my private website Getagraph.com. One of the
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conditions I added was the need for the Golden Cross to appear in the price line as illustrated in the
graph below.
This signal has turned to yield far better results than the Golden Cross and if you add other conditions
like liquidity, time and volatility you get a very tradeable signal. Today the signal is only accessible @
StockInvest.us. From more than 8.000 stocks analyzed every day only a few will issue golden star.
Among these 50% will yield very strongly, while some will not perform at all. From those yielding strong
some will go fast, while other will move slowly but steady. Again, it all comes down to the individuality
of the stock.
The chart above illustrates another key point to all signals/indicators. The importance of
volume/liquidity. As the chart clearly show there is a huge increase in volume on the same time as the
signal is established and this strengthen the signal and make it more reliable. In our current version of
the Golden Star volume is not a part of the algorithm, but at some point, it will. This will reduce the
occurrences of the signal, but also make it more reliable.
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