Basic Trade Analysis

I. Overview

This article illustrates my general approach toward generating and analyzing trade ideas. I use the GLD gold ETF daily chart as an example, but this analysis can be applied to any security in any timeframe.

Many investors follow a passive long-term investing style by placing their money in mutual funds or index funds for diversification. Needless to say, these investors suffered some losses last year as stock markets plunged across North America: TSX: -40%, DJIA: -38%, S&P500: -42%.

A basic knowledge of technical analysis gives investors another tool to protect their portfolio from extreme market volatility and to take advantage of investment opportunities. The ideas of technical analysis are not difficult to learn, although their implementation is more of an art than an exact science. It does not require much time, and long-term investors can analyze charts on a daily or even weekly basis depending on their risk tolerance and time horizon. Chart analysis does not have to be expensive either; the basic daily GLD chart below was obtained for free at http://www.stockcharts.com.

In my experience, there are only three basic requirements that are essential to become successful in trading and investing: discipline, discipline, and discipline.

Finally, I am only presenting a part of my trade analysis methodology, not a comprehensive market analysis, and I am certainly not making any stock recommendations. There is a wealth of investment books, blogs, newspapers, and research journals that you can learn from, and it is up to you to apply this knowledge to your own investment portfolio.

II. Technical Analysis

There are many reasons why technical analysis works. Market psychology and the human emotions of fear and greed are the basic elements that drive all markets. The collective opinions and perspectives of market participants are reflected in stock charts, and well-known chart patterns have a tendency to repeat themselves in a self-fulfilling prophecy.

This daily chart of the GLD gold ETF was obtained for free at http://www.stockcharts.com using the default parameters. The following numbered points below correspond to the numbers on the chart above. Although this analysis pertains to a single chart, I usually look at several charts simultaneously, such as the index futures and currency charts, in order to determine relative strength or weakness.

1. Trend

As the saying goes, “The trend is your friend… until the end.” Trading with the trend gives you a higher probability of profitable trades than trading against the trend. In this chart, I look at the price and the 50 day moving average (50dma) and their relation to the 200 day moving average (200dma). Here, both the price and 50dma are above the 200dma, so the stock is in a general uptrend. However, this does not mean that I should buy now. This just means that I only look for potential buy trades and ignore any potential short trades.

I also prefer the moving averages to be pointing up in an uptrend. In this case, both the 50dma and 200dma are flat, suggesting a pause in the uptrend, a neutral outlook, or a possible reversal in the future.

If either the price or the 50dma fall below the 200dma, then I would consider this the end of the uptrend and the possible start of a new downtrend or a neutral sideways trend.

Elliott wave counts can also be useful in identifying trends and counter-trends. In my opinion, we may have just completed the end of a wave C correction, which suggests that a new bull market primary trend could resume shortly.

2. Support and Resistance

Next, I look for areas of support and resistance on the chart. When a support level gets broken, it tends to become a new resistance level. Similarly, a broken resistance becomes a new support level.

The 50dma and 200dma are very important, and I also draw trend lines between major peaks and major troughs in the chart. For intraday trades, I also look at the previous day’s high, low, and close. Fibonacci ratios are other useful levels to watch.

At point #2 on the chart, the price bounced off the 200dma in a double-bottom pattern, which is a bullish signal.

The stock price also recently broke up through the down trendline near point #4, which a bullish signal as well. This previous resistance line becomes a new support line for GLD.

3. Divergence (Trend Reversal)

Momentum indicators normally follow price movements, so the indicator should go up when the price goes up, and go down when the price goes down.

Divergence occurs when there is a conflict in direction between price versus momentum indicators. Positive divergence occurs when the stock price is falling while the momentum indicator is trending upward. This suggests that the downward price move is unsustainable due to the upward momentum, resulting in a bullish signal. Negative divergence is a bearish signal that occurs when the stock price is rising while the momentum indicator is in a downtrend.

The MACD histogram is a good momentum indicator to watch. In fact, in his book “Come into My Trading Room”, Dr. Alexander Elder regards MACD histogram divergence as the strongest signal in technical analysis.

Point #3 on the chart shows a positive divergence due to a rising trendline on the MACD histogram, while the price made a new low at Point #2. This was another bullish signal for GLD.

4. Trend Continuation

Given the signals above, Point #2 was a good buying opportunity for GLD on Apr 19. If you missed it, you can still look for other support and resistance levels to confirm the uptrend or to signal a possible trend reversal.

Point #4 shows a previous resistance line that is now a support line. If this support holds, then GLD should continue on its uptrend; if it breaks, then GLD may head back down again toward the 200dma.

Point #4 also shows a 50dma resistance level. If GLD can break though the 50dma on large volume, then it will likely head upward toward the next resistance level. If not, then GLD may head into a sideways pattern between the 50dma and 200dma range.

In this case, I would place a buy order just above the 50dma in order to participate in the trend continuation, if the price can break through the 50dma.

5. Uncertainty

If GLD can continue its uptrend, the next hurdle (Point #5) is a major psychological resistance level at $100, which corresponds to a gold price of $1,000 per ounce. GLD came very close to the $100 barrier on Jul 15, 2008 and again on Feb 29, 2009, but was unable to surpass it. If GLD can break though this resistance level, then it will achieve an all-time high with no more resistance levels above. Otherwise, GLD could bounce off the $100 resistance again and head back down.

At these points of uncertainty, it is often a good idea to take some profits or cut your losses by closing out some or all of your position. In this case, I would think about selling GLD just below $100 and buying it back after it finally breaks decisively above the $100 resistance.

III. Fundamental Analysis

Fundamental analysis is always important regardless of your trading methods or time horizon. Sharp fundamental analysts can anticipate the direction of a stock’s price before it happens (i.e. before it appears on a chart for technical analysts to analyze). You simply cannot trade in a vacuum and ignore the market and industry context surrounding your investments.

In gold’s case, there are many macroeconomic reasons to own gold: diversification, rising demand, falling supply, as a hedge against rising inflation (after the current deflationary environment), as a hard-asset hedge against financial (i.e. paper) instruments, as a hedge against falling currencies, etc. For similar reasons, China has reportedly been hoarding gold at a fast pace (“China bolsters its gold reserves” – Reuters) which suggests rising gold demand in the future.

In the case of equities, fundamental analysis includes industry analysis, financial statement analysis, ratio analysis, due diligence, etc, and is a wide-ranging subject that is clearly outside the scope of this blog. The CFA Institute and the Schweser CFA study guides present a comprehensive and concentrated amount of material that should be valuable to all investors.

IV. Risk Management and Discipline

Institutions use a variety of risk management tools for analyzing portfolio risk, pricing derivatives, and hedging risk. On the other hand, individual traders and investors can benefit from a few simple rules of thumb such as setting a maximum loss limit of 2% per trade, immediately closing a trade if the market proves that your analysis was wrong, setting stop losses, and diversification by limiting each trade to no more than 5% of your total investment capital. Although trading rules are important, having the discipline to follow them is vital to success in both trading and investing.

Finally, risks are unpredictable and they are everywhere in black swan formation. A flu pandemic, bank failure, or nuclear crisis can easily destroy the trade ideas you derived from technical and fundamental analysis. Having the proper risk management controls in place should protect your investment portfolio over the long term.

V. Conclusion

You can be the best developer / doctor / lawyer / accountant / etc in your field and still lose 40% of your hard-earned money after investing it in a reputable equity mutual fund last year. You could spend 6 months developing an excellent iPhone app that doesn’t sell because it is too complex and doesn’t generate enough popularity among the general public. You can share your awesome ideas with thousands of followers on social networks and not make a dime in online advertising. You can develop insanely great software that never sees the light of day due to economic circumstances beyond your control.

Trading and investing are some of the very few activities where people can make money directly from their ideas. Trade analysis is not difficult, time-consuming, or expensive, but it requires complete discipline when implementing your trading plan.

A basic knowledge of trade analysis techniques, which span the range of technical analysis, fundamental analysis, and risk management, is essential to everyone who earns an income and/or has money to invest. I encourage you to continue learning about these subjects to help improve your investment performance and recover any losses you may have suffered from last year’s disaster.