What is Technical Analysis?

A trading strategy is a plan. A trading strategy is a roadmap for making money by trading the markets. There is a saying: If you don't know where you are going, you will never get there. A trading strategy tells us how to get to where we want to go. Some strategies are better than others; none are perfect.

Trading is a four legged stool

four elements of a trading strategy You wouldn't try to plop down on a stool with a broken leg would you? You would'nt try to sit on a stool that had only two legs either would you… You should not try to trade with fewer than four legs of your trading stool firmly in place either lest you soon land on your butt. Don't let that happen.

What I mean by this is that there are (at least) four key elements to any successful trading strategy. I'm not saying there can't be more elements, only that there cannot be fewer. These are the four key elements:

  1. Instrument selection
  2. timing
  3. money mangement
  4. psychology

The XLTrader™ add-ins available only for members of our XLTrader-Talk Google group, that are discussed on this website only help the trader with one element of his or her trading strategy. Can you guess which one? Thats right… item 2 … timing. Nobody makes money in the markets with only timing no matter how good they become at it. (And it is a skill at which anyone can learn and improve at). Any successful trader knows that market timing is only one element of a successful strading strategy. And here's a little secret…

Timing is the Least Important Element of a Trading Strategy

encyclopedia of trading strategiesNovice traders find it hard to believe that timing is the least important element of a successful trading strategy. But its true. Infact in their (really good) book Encyclopedia of Trading Strategies Jeffrey Owen Katz and Donna L. McCormick show that even with a random entry (meaning a flip of a coin), while its not recommended, a trader can make money provided the other elements of the stool (our trading stategy) are firmly in place.

My aim in this brief introduction is merely to alert newcomers to technical analysis and market timing that what they are learning is only one element needed to succeed in the market. It can be said that timing is a “necessary but not sufficient” element of an overall trading strategy. We need to choose wisely, then manage our money and the trade but most importantly manage our mind. Trading is 90% mental; trading is 10% mechanical.

Instrument selection

This seems pretty obvious but before you can trade you need to choose something to trade. There are many options to choose from. In equities you have mutual funds, exchange traded funds, stocks, 401k and 403b funds etc. You can trade bonds and bond funds. You can trade currencies (many experienced traders love trading currencies). There there are options, futures and commodites contracts which you will learn about as time progresses.

For each of these “instruments” there are a myriad of differnent ways to go about choosing what to buy. Sometimes these selection methods have clever names like: “Fallen Angels” or “Dogs of the Dow” or “CANSLIM” or a whole host of others.

Focus. Don't try to be an expert in too many things. Know what ever it is you are trading. This is why farmers should trade commodites like corn and soybeans and high-tech people might concentrate on Nasdaq stocks. The main point is this: the first element of any successful trade is choosing your market wisely.

Timing

This is where technical analysis comes in. This entire website is geared towards telling you about methods that have worked well in the past and will in all likelyhood continue to work well long after we're both gone.

Money Management

Though its not talked about nearly enough (seems everyone is focused on timing) Money Management is the key to successful trading. What exactly is money mangement you ask? Three things really:

  1. Position sizing
  2. Stop loss protection
  3. Exit stratgey

Position sizing has to do with how much. Because trading is a game of chance (there is a chance we will lose money) we should not wager everthing on one trade. Gamblers do that. We're in this to make money not excitement so we want to wager the optimal amount on each trade.

Ralph Vince wrote a book called: Portfolio Management Formulas which tells you how to calculate how much to wager on any trade given the metrics (win/loss, percent win etc.) of your trading system. Those calculations are for finding the “optimalf” or fixed fraction of your total trading stake that is necessary to grow your account the fastest. It will also tell you what “risk of ruin” is. Traders need to know.

Stoploss is like a circut breaker. Think of a GFCI outlet in your house. Before you get electrocuted it breaks. When we are wrong with our analysis, we need a circuit breaker for the trade. Thats what a stop loss is. There are many different strategies for setting a stoploss. You have to find the one that works best for your system

We have timing systems to get us into the trade… and we need an exit strategy to get us out. Again, there many different option to consider but which one we choose will effect the overall profitablitly of our system. There is an old trader addage: Let you winners run and cut your losers

Psychology

For most of us this is the hardest part of trading… controlling our emotions. They cause the Buy and Hold investor to sell out just as the market is bottoming. They cause the mechanical system trader to go on “manual overide”. They cause discresionary traders to not follow their rules. Invariably, when we do those things, we get into trouble.

“I have met the enemy and we are it…”

Pogo

There are several good trading psychologist: Mark Douglas, Brett Steenbarger etc. that can give us good advice on how to approach the mental game. Get your mind straight before you try to trade.