Have you ever wanted to make your own trading system? If so there are certain "rules" that you should follow when doing so. Here at http://stocktradersbulletin.com we will take a closer look at trading systems, how to make them and how to do proper testing of them. We will also take a look at various trading systems and see if they live up to expectations. Later we will also go in more detail about specific technical indicators. If you have any requests or suggestions let us know by contacting us. But first let us take a look at the fundamental parts of building a trading system.
Building a trading system
There
is much to be said about technical analysis, what indicators to use and
how to use them. In this article we will look at some indicators and
how they can be combined to form a system that we can base our buy and
sell actions upon. Indicators
can be divided into several categories like momentum, volume or trend
as the most commonly used ones. The indicators we will focus on and use
here are all from one of these categories.
If we take a look at www.stocktradersbulletin.com the analysis carried out there are usually based upon three (four) charts/indicators,
Before we take this any further we will now look at these charts/indicators individually.
Price
The
price chart can be displayed in many ways with candlesticks and line
chart probably being the most common ways. To complicate it further we
can choose to plot the data logarithmic or linear. What you choose
comes down to personal preferences but I would recommend using a
logarithmic candlestick way of displaying the bars. The price chart
basically tells us how the stock price is moving whether rising,
falling or moving sideways. Candlesticks are also a nice way of
displaying the data as you can recognize chart patterns. But we will
not cover that in this article.
Price chart using candlesticks.
Volume
There
are many volume indicators available for us to use but here we will
look at the actual volume i.e. how many stocks have been traded
throughout a day. Generally we speak of volume as a positive signal
when the stock price is rising and volume is increasing, and a negative
signal when the stock price is falling while volume is increasing. We
can often see an increase in volume
when the stock price is reaching support and resistance levels. We also
often see a slowdown in volume as a price trend is coming to an end. If
a stock has been in a nice upward moving trend with a general
increasing volume and then all of a sudden the volume starts to decline
this usually signals that the trend is coming to an end.
From this chart we clearly see that the volume is generally increasing
while the stock price is falling. This is a negative signal and further
fall in price can be expected.
ADX
Directional
Movement indicator is a trend indicator developed by Wells Wilder. The
indicator is usually plotted as three components
Basically what this indicator tells us is if a stock is trending or trading (moving sideways). The
ADX line (blue line in the chart below) gives us the value of the
indicator and as a general rule of thumb says that a reading of 25 and
above indicates that the stock is trending, while a value lower than
25 indicates that the stock is trading. If you have a look at the chart
you also see two more lines. The green line +DI and red line –DI tells
us if the trend is negative or positive. When +DI is above –DI and ADX
is showing values above 25 the stock is in a positive trend. When –DI
is above +DI and ADX are showing values above 25 the stock is in a
negative trend.
RSI
Relative Strength Index is a momentum indicator developed by Wells Wilder.
This
indicator is what we call an oscillator where the values oscillate
between 0 and 100 but usually between 15 and 85. RSI measures the
stocks own strength based upon previous
readings. It is most common to let RSI be based upon the last 14 day’s
readings. As RSI is an oscillator we can use it as a measure to see if
the stock is oversold or overbought. This means that if the stock has
experienced a selling pressure lately RSI values falls leaving the
stock to enter the oversold area. Oversold levels are usually defined
as RSI values lower than 30 while overbought is usually defined as RSI
values over 70. Some might also say that when the value crosses the 50
level upwards this is a good signal indicating strengthening in the
stock.
Putting it all together
It is when we combine the information we get from the different indicators we really get the most out of technical analysis.
Divergence
When
we recognize divergence between different indicators or indicators and
price it is usually a strong signal that we should pay attention to.
From the set of indicators we have in our setup here the most common
divergence to look for is between price movement and RSI. If we see a
falling trend in price but a rising trend for RSI values over the same
time interval we have detected a divergence. A divergence like this
could signal that the falling price trend is coming to an end and the
stock price could start rising again. If the price trend is upward
while the RSI trend is falling this usually signals a coming fall in
price.
Here we see a divergence between price trend and
RSI trend. As expected it turned out that the falling
price trend was coming to an end and a rise in stock
price occured.
Trend or Trading
When
you use oscillators like RSI you should also use an indicator telling
you if the stock price is trading (moving sideways) or trending. Here
we use ADX as our “Trend or Trading” telling indicator. When ADX tells
us the stock is trading the actual RSI value becomes more reliable and
valid. Oscillator indicators like RSI perform better when a stock is in
a trading range. When we use RSI, its value is 20 and ADX tells us the
stock is in a trading range we have much more confidence to say that
the stock is now oversold and we could get a rise in price soon. If on
the
other hand a stock is in a strong upward trend and RSI value is 80,
this do not necessarily mean that the stock is overbought. When a stock
is trending the RSI values become “exaggerated” in the direction of the
trend. As you can see from this it is very important to combine
indicators and not just analyze a stock based upon one indicator.
Trendlines, support and resistance
As
in this article you have probably heard the words trendline, support,
resistance and trend channel when someone talks about technical
analysis. Basically this is not more than lines drawn at the charts.
These lines are used as aid in predicting where future movement for
indicators and price will be. There are many ways in drawing these
lines but we will not focus on that in this article. The easiest way is
just to go ahead and try for your self. The more you do it the better
you get at it. Here you see an examples of how you could draw some
trendlines (green and brown lines), trend channels (red lines) and
support- (green line) and resistance- (brown) lines.
A few words on money management
Money
management is a large subject in its self but before we do any trading
we need to have at least some idée about money management. Money
management is like trading with a security guard telling you when to
get out of the shop when they close. If you do not get out in time you
can be in great trouble. The most important thing you need to remember
when it comes to money management is STOP LOSS. Before you even buy a
stock decide what your stop loss level is i.e. when to sell the stock.
This will define your risk level and can vary from person to person.
But never risk more money than you can afford to loose.
There
are many ways of how and where to set your stop loss limit depending
upon personality and money available. Trend lines, support and
resistance levels are all good methods of where to set your stop loss.
Indicators can also be of great help. Experiment and find your way of
doing it but do not skip it – Stop loss is very important.
Final note
What is described in this article is just one way of using technical analysis.
I
strongly suggest that you play around yourself and find a set of
indicators that you feel comfortable with. Just remember a few points
when you do so
Select a set of 3 – 5 indicators for your setup
Use
indicators that tells the “story” differently from each other i.e.
choose 1 – 2 indicators from the different indicator categories
Learn
those indicators inn and out, the more you know your setup the better
understanding you have for how to make money from it
Make
your setup personal, one person’s setup might not be the correct one
for another person as this varies due to risk, personal behavior etc.
For many more analysis of actual stocks please go to www.stocktradersbulletin.com
Disclaimer
The author of this article hereby disclaim all responsibility of any profit or loss people might have based upon this article.
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