Technical Analysis

I've mentioned in several of my options strategies that I use technical analysis to time my entries and exits. In this section, I want to outline some of the key tools I use.

I should point out that with many of the strategies I use, the analysis isn't as critical, however it can help improve profitability and reliability of my trades by getting me in and out sooner.

What is technical analysis? A full and completely technical answer would probably take up pages. The simple answer is that it is based on the assumption that patterns can be recognized in price movments of stocks and that those price movements are ultimately driven by the collective psychology of traders trading that stock. There are those who believe that technical analysis is a waste of time because the price movment is a completely random occurance.

Let me just say that I use technical analysis to determine what is LIKELY to happen. The biggest hurdle I had to get over when learning to use technical analysis effectively was to learn that any tool I use isn't a guarantee of behavior. Knowing that things like news and even trader sentiment can change everything, I've had to learn to use analysis tools to simply define trigger points for action... either to enter or exit a trade.

Most of my analysis is done by analyzing price behavior using stock charts, preferably using an interactive charting tool. The two key things I look at are where the stock is relative to the moving average and key support and resistance levels. I will use candlestick chart patterns as a confirming indicator.

I have referenced in some of my options strategies entering trades off support and resistance. That may include simple horizontal support or resistance or trendline support... or something more fancy like fibonacci retracements.

I also use some technical studies to help confirm what I may be seeing. In particular, I will use the stochastic indicator, which can show oversold & overbought conditions. I also like to use the MACD, which is another oscillating indicator that can help show convergences and divergences of moving averages in different time frames.

With all of that background, here are ways I use those technical analysis tools to time entries and exits.

Bounce off support or resistance

Knowing that support and resistance come in different forms, there are actually three variations of this approach.

Horizontal support & resistance bounce


Bullish SupportOn a horizontal support bounce, I'm looking for an established pattern of bouncing off the support level.
Depending on the strategy, even short term moves can be traded for a profit.
Notice on this chart that after bouncing a couple of times, a new support level is established (temporarily).



The bearish resistance bounce is pretty much the opposite. Earlier on in Bearish Resistancethis pattern, the moves are pretty strong. As the pattern develops, the moves become less pronounced and offer less opportunity to profit on the trade. However, you never know when the big one will come along.



Up trending or down trending bounces

Bullish BounceThe ideal entry for a bullish bounce is usually the first indication that a higher low has been established.


Note that this is not a perfect entry as you never know for sure if a higher low has been confirmed until several candles.

If I'm in a bullish trade, I'll use a break of the trend line as an exit indicator.




Trading a bearish bounce would be done in a similar way. Bearish bounceThe ideal entry for a bearish bounce is at the first indication of a lower low.

As with the bullish bounce, it is often difficult to be exact on where this point is.

If I'm in a bearish trade, I'll use a break of this trend line as an exit indicator.

Fibonacci bounces

Fibonacci retracements are one of the coolest technical analysis tools for determining support and resistance. I'm not going to spend a lot of time here since the entries and exits will be very similar to horizontal support and resistance levels covered above. What I really like about fibonacci retracements is that they allow me to project POTENTIAL support and resistance levels. I highlighted the word potential because they are not guaranteed, but more often than not show an uncanny tendency to hold up.

Breakout through resistance or support


One interesting thing about the horizontal resistance and support levels is that they will only last a limited time before either breaking the support or resistance level to completely change trends or using that support or Support Breakresistance to start a strong trend.
An interesting variation of trading the support resistance bounce is to trade the break of support or resistance.

It is sometimes difficult to catch the break of support or resistance, but a really nice alternative is to catch the bounce when support becomes resistance or visa versa.

A brief comment on the VIX

While not a technical analysis tool in the strict sense, the VIX is an indicator I pay attention to and can offer confirmation on something I may be seeing in the broader market. How I use the VIX has varied in different markets. Prior to its breakouts over historic highs back in the fall of 2008, I could count on it to show me extreme levels where market turns may develop.

These days, the VIX has shown itself to either be trending up or trending down. I actually apply some technical analysis on the VIX itself. I find significance in breaking out over past highs or past lows, or breaking through established up trending lines or down trending lines.

Summary

One of the common themes on the chart patterns I showed above is that no trend lasts forever. Support will be support until it no longer acts as support. When that happens, what does that signify? To me, it means the trend may be changing, therefore I have to change. If I'm in a bullish trade that the charts tell me may be changing to a bearish trend, I need to take that as a cue to take my profits. If I've been considering a bearish entry, but I see a break of horizontal resistance or a down trending resistance line, I need to either forget the trade or find a bullish one.

If by now, you have the impression I am a master chart technician, you are mistaken. There are many who could be considered 'experts' in the area of technical analysis and I often defer to their perspectives when I am looking for either confirmation or clarification of my uncertainty.

Here are a couple of places I like to go to see technical analysis applied.

Dave Johnson's Chart Signals
Dave Johnson is an instructor with Investools and has a vast amount of experience over many years. He shares his insights freely on his Chart Signals blog.
Tim Knight's Slope of Hope
Tim Knight is the original founder of Prophet.net and creator of the Prophet Charts charting tool. Tim is a bit of a contrarian and somewhat of a perma bear so it is nice to have an opposing perspective.



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