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Which technical indicators will work for you?

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"Which indicators will work for me?"

Traders have various levels of expertise, different experiences, risk levels and general market exposure and therefore different investment goals.

This is why traders will have different criteria in their checklists and why something may work for one but not another.

Part of understanding which indicators will work for you is understanding why you would be willing to either buy or sell a stock. You can do this by creating your own technical checklist.

Setting up a system

This system will comprise of the following elements: a technical checklist for each buy or sell decision; a fundamental checklist for each buy or sell decision; and a set of rules.

Setting up a technical checklist can help you decide whether it is a good or bad time to buy/sell the stock (and to ultimately answer the question: "Which indicators will work for me"). The checklist(s) should be able to mark the change in the trend you are trading as well as the direction. For example: when trading a minor swing, the checklist will move from downtrend, to sideways to uptrend. Some point during this progression will be the traders entry point. The entry point should have the "perfect score" on your technical buy checklist. The exit point will be covered by your technical sell checklist, a perfect score here means sell.

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The intention of the fundamental checklist is to help decide whether or not the company is worth investing in. Does this company have the base fundamental characteristics to justify the current or future stock price? This checklist is a combination of earnings reports/expectation, news, revenues, politics, etc. A high score here is bullish while a low score means bearish fundamentals. The rules are to keep you on track. Don't break your rules since the only person you hurt is yourself. Rules can also be statements which define your goals like "ride the profits and cut the loses" or "take out emotion". Several of these nifty rules and statements will also be provided in the example checklists however, each trader should really define their own.

We will only be covering the technical checklist in this newsletter .

Defining what trend you plan to trade

If you have not decided yet what trend you plan to trade let's consider some key points.

It is important to note that not all technical indicators work well in all time frames. This is also why most technical indicators allow the ability to adjust certain parameters. These differences in time frames will result in different indicator and parameter choices. This is why what works for me may not work for you.

Quick note on trend

Overview

There are three types/categories of trends.

1. The uptrend which is defined as a price movement with successively higher peaks (highs) and higher troughs (lows).
2. The downtrend which has successively lower peaks and troughs.
3. The sideways trend which peaks and troughs don't successively rise or fall.

Each trend has (typically) three parts/stages. The primary (major) trend is a long term trend lasting from a year to several years. The secondary trend (or mid-term trend) lasts three weeks to three months and represents corrections of one third to two thirds of the previous movement - most often fifty percent of the movement. The minor trend (or short-term trends) lasts less than three weeks and represent fluctuations in the secondary trend.

Test your trading system on paper first! If you don't understand why you are buying or selling a stock, don't do it. Until you are confident in your decisions don't worry about what you are missing out on while paper-trading. A little bit of practice and patience will save you a bundle here. Be confident in your "why should I buy it checklist" and "when should I sell it checklist."

Important additional reading: Dow Theory, trendlines, breakout signals.

The technical checklist

A technical checklist is a list of technical indicator conditions which must be met to make a buy or sell decision. Here are two important reasons to have a technical or fundamental checklist.

A technical checklist helps you to time your buy and sell decisions. Technical analysis, for the most part, is based on trend analysis. Whether through overbought/oversold, momentum, or other technical conditions, they primarily mark trend direction and changes in the direction of the trend. Technical signals do not offer any real forecasting ability. The ability to mark trend and changes in trend is an important key to improving your investment decisions.

A technical checklist helps you structure your goals and define the minimum trading requirements that must be met to define a buy and sell condition. It will also give you the ability to fix and modify your decision requirements.

 

A side note: A technical checklist should be balanced with a fundamental checklist. The intention of the technical checklist is to help decide whether it is a good or bad time to buy the stock (ie: direction of trend) or if it is time to sell the stock you have (trend reversal). The intention of the fundamental checklist is to help decide whether or not the company is worth investing in. Does this company have the base fundamental characteristics to justify the current or future stock price? A complete trading system should have a technical and fundamental checklist to decide to buy and a technical and fundamental checklist to decide to sell.

Fitting technical indicators to your timeframe

Different parameter settings will make the difference between an effective technical system and one that produces signals outside your preferred timeframe.

Parameters should be based on your trading time frame. A short-term trader needs a more sensitive indicator, using smaller numbers; while a long-term trader can use a larger number of trading days in their formula.

To figure out which parameter fits, here are some tips:

1. Are you a short-term trader? Using smaller numbers for your parameter will make the indicator more sensitive to recent price moves and trigger signals more often. However, the older data is ignored (it is more difficult to apply the longer term trend lines). So if you trade a longer term and use a small parameter, you can be whipsawed. It is also more difficult to draw accurate trend lines since the indicator is more volatile (moves quickly up and down).
2. Are you a long-term trader? Using larger numbers for your time frame ensures that older prices movements are still accounted for. Signals are generated less often and sudden price movements are averaged out. The larger your parameter, the less sensitive the indicator to short term swings.

The concept behind larger parameter numbers versus smaller parameter numbers is extremely important in our next step, so I will go over some example parameter settings before we choose some indicators.

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