stop is hit.” – Ed Seykota

Just like builders use hammers and saws to build houses, traders use

technical tools to build their own trading systems. You only need a few of

these tools to begin to build your own signals, and in fact, you can have too

many indicators that lead to confusion. The most important thing to keep in

mind is that there is no one-size-fits-all solution. Some technical indicators

work while markets are range bound and others only work during trends.

Many are useless during high volatility and crashes. No indicators work in

all markets or under all conditions.

Trading profitability doesn’t come from a perfect indicator or a magic

system, it comes from creating an edge over other traders and trading that

edge to have more profits than losses over a long period of time. Your win

rate will fluctuate as market conditions shift between uptrends, downtrends,

range bound, and volatility.

Technical indicators that can be used to build your own buy signals:

- Price

- Price versus previous day’s highs and lows

- Moving averages

- MACD

- RSI

- Chart Patterns

- Trends

- Momentum

- Candlesticks

- Price gaps

Price signals can be breakouts of a price range over a set number of days,

buy signals at 52-week highs, or sell short signals at 52-week lows in price.

There are traders that believe price alone is the only indicator you need.

Trading today based on yesterday’s low or high price range is a day trader

strategy. They also may trade the intra-day range of support and resistance,

buying the lows of the day or selling the high of the day short. Day traders

like intra-day volatility to give them opportunity to make money intra-day

on price swings and trends. Some swing traders set stops based on the high

or low of the previous day’s price range.

Moving averages are the average of prices over a specific time frame, and

they can give a trader a better overall view of a trend. They are trend

following indicators and don’t do well in range bound markets. Moving

averages can act as entries, exits, and trailing stops. Trend following

systems can be built based on moving average crossovers to create buy and

sell signals. Single moving averages like the 200 and 250-day used alone in

index ETFs can outperform buy and hold investing in the long term, for

both higher returns and lower drawdowns in capital.

The MACD (Moving Average Convergence/Divergence) is a momentum

indicator that shows the relationship between two moving averages of

prices. The MACD is the difference between a 26-day and 12-day

exponential moving average. A 9-day exponential moving average, called

the "signal" line is plotted on top of the MACD to show buy/sell

opportunities. The MACD is profitable in markets with wide swinging price

ranges. It is not useful in flat or markets with very tight price ranges. I have

found the MACD to be the most useful as a swing trading indicator after

crossovers. The Moving Average Convergence Divergence can work to

show short-term reversals inside the longer term trend for swing traders. It

can be part of a filter for other signals or a signal in itself.

Relative Strength Index (RSI) is a momentum oscillator that measures the

speed and change of price movements. The RSI oscillates between 0 and

100. RSI is considered overbought when above 70 and oversold when

below 30. Signals can also be generated by centerline crossovers over or

under 50. Over 50 is a bullish cross and under 50 is a bearish cross. RSI can

also be used to identify the general trend as greater than 50 is bullish and

less than 50 is bearish. A breakout over 70 and a breakdown under 30 can

also be used as a trend indicator. The Relative Strength Index can show

when price has become overbought or oversold, is due for a potential

reversal, or the danger of something going parabolic as it breaks out.

Chart patterns use trend lines to map out the buying and selling of market

participants looking for trends and potential reversals of trends. Flags,

pennants, triangles, cups and handles, are examples of connecting the lows

or highs in price over a time frame to establish a trend of higher highs,

lower lows, or price ranges. Chart patterns can be bullish, bearish,

continuation, or reversal patterns. Chart patterns are about connecting trend

lines to identify potential breakout points for an entry to capture the next

trend.

Uptrends are defined as a market having higher highs and higher lows in a

specific time frame. Downtrends are defined as a market having lower highs

and lower lows in a specific time frame.

Trends have to be quantified based on your trading time frame. Warren

Buffet trades the longest term trend: he bets on the capitalist system always

driving up the prices on the stocks of the best businesses. A day trader may

only be concerned with the next hour a stock is trading. The simplest way to

make money in the financial markets is to identify the trend, quantify the

trend, and stay on the right side of it in your time frame. There are many

ways to do this.

Moving fast in one direction with no sizeable pullbacks is my definition of

momentum. Momentum can cut both ways leading to fast profit or fast

losses. The best momentum is found at the beginning of a bull market as a

stock breaks out to new all-time highs. The old all time high is likely to

become the new support. The stock could go on to increase 20% in price in

a month or even double that year. Momentum works at all-time highs

because everyone that is holding that stock has a profit and has no pressure

to sell. There is no pressure from stop losses or trailing stops, only profit

taking pressure, which is usually light. Resistance levels for a stock making

all-time highs tend to be whole numbers like $50 or $100 because this is

where many traders set their profit targets. Momentum trading works best

with new concept stocks that are innovative and have little competition.

Candlesticks are a graphic way of depicting the opening price, closing

price, and trading range on a chart that is more visual than bar charts. While

they are not signals by themselves, they are great for confirmation inside

the context of a chart at key levels. A bullish candle off a key support level has more meaning than a bullish candle in the middle of a strong downtrend

that doesn’t converge with other bullish technical indicators.

When you enter a trade you will either exit with:

- A big profit

- A small profit

- Even

- A small loss

- A big loss

- Stop losses

- Price Targets

- Trailing stops

- ATR stops

- Time stops

The point of stop losses is to make it highly unlikely that you will have big

losses. In contract markets like options, your loss is limited to your position

size. In the stock market, large gaps in price at the open can bypass your

stop loss and give you a bigger loss than expected. Your position size is

your first line of defense against big losses, and your stop loss is the

insurance policy that limits your losses as a trade goes against you.

A stop loss has to be placed outside the normal price action at a key price

level that shows you are wrong, and not at the place that makes you exit out

of fear. Your stop loss has to give your trade enough room and time to be

right, not stopping you out before your trade is invalidated. Key places to

set stop losses are a percentage below key support or resistance levels of

price, moving averages, or key technical indicators like MACD crosses or

moving average crossovers.

Price targets should be set at levels where your risk/reward ratio has skewed

against your trade and the odds of a reversal from an extended price level is

greater than the odds of it going in your favor. Price targets can be set at key

round price levels at overbought/oversold oscillator levels like the 70 RSI to

exit longs, the 30 RSI to exit shorts, rallies back to key price support or

resistance levels, or to key moving averages.

A trailing stop is when you allow your stop loss to stay close as your trade

becomes a winner. A short-term moving average is one way to do this. If

your trade reverses back under the 5-day EMA or 10-day SMA you would

stop out. A strong trend could use the 5-day EMA and a trade with a wider

price rang could use the 10-day SMA. I like to use a close below a key

moving average for my trailing stops so price confirms at the close, and I

am not stopped prematurely intra-day due to noise. You should be very

careful with position size based on volatility to be able to hold to the close.

Another trailing stop could be a loss of the previous day’s low for long

positions, or the break above the previous day’s high for short positions.

These can be intra-day or end of day depending on your time frame.

The ATR% stop method can be used for any type of trade because the width

of the stop is determined by the percentage of average true range (ATR).

ATR is a measure of volatility over a specified period of time. Normally a

high ATR indicates a volatile market, while a low ATR indicates a less

volatile market. By using a certain percentage of ATR, you ensure that your stop is dynamic and moves with market conditions. Widen your stop in

more volatile times and lower it in less volatile markets to keep from being

stopped out too soon and to account for noise in price movement.

Time stops set a limit on how long you will wait for a trade to work before

exiting and looking for better opportunities. It is stop loss on your

opportunity cost. A time stop will vary greatly and may be hours for a day

trader or months for a position trader.