- 5 Rocket Stocks for Gluttonous Turkey Day Gains
- Time to Sell These 5 'Toxic' Stocks
- 5 Earnings Short-Squeeze Plays
- 5 Must-See Charts
- 5 Stocks With Big Insider Buying
Profit From These 3 Trading Mistakes - 83067 views
BALTIMORE (Stockpickr) -- Historically, Wall Street has prided itself on its ability to stay opaque -- and for good reason. But that’s changed a bit in the last few years. The advents of electronic trading and increased media attention in the last couple of decades have made access to quality investment knowledge more attainable than ever for retail traders.
But that doesn’t mean that the trading environment has gotten any easier. Even though Wall Street’s more open than before, misunderstood trading concepts continue to plague would-be traders’ portfolios.
More From Stockpickr
At best, misunderstood trading concepts lead to sloppy, luck-driven trading that leaves profits on the table. At worst, those misapplied tools can completely wipe out a trader’s portfolio.
Today we’ll take a look at three commonly misunderstood technical trading concepts that, when applied to the markets correctly, can help to spot trading setups before they occur, avoid less favorable trades and minimize losses.
1. React, Don’t Predict
For whatever reason, investors are taught to believe that there’s virtue in the ability to make a good prediction. I’ll admit that the power to perfectly pinpoint a market top or bottom or project a price target for a major index such as the S&P 500 is enviable. But as a result, powerful tools such as technical analysis are used all too often as an excuse to make a set-in-stone prediction about where the market’s headed. Unfortunately, that’s a recipe for losses.
The key to successful technical analysis is that it’s reactionary, not predictive.
In other words, a solid technical strategy is beholden to the market’s price action, instead of demanding that the market be beholden to some prediction. That’s not to say that predictions or estimates are a bad thing -- it’s the idea that those predictions aren’t subject to change that’s the key mistake here.
A good example of that is the idea of support. Simply put, support is a price level that acts as a sort of “floor” for shares of a particular stock; it’s a price level under which there’s an abundance of demand for shares, and as a result, shares have difficulty moving below. Because of that “floor” quality of support, it’s thought of as a good low-risk entry point for shares of a stock. That’s not the same as saying it’s a level that share prices cannot fall below -- market conditions are constantly changing, as a result, support levels can (and do) fail.
While predicting that shares of a stock will cease a sell-off at a strong support level may be a likely forecast, it’s hardly a foolproof prediction. After all, the old adage goes that you should “never catch a falling knife.” For a trader looking to pick of shares of that stock at those lower levels, the better technical move is to wait for shares to stop sliding when they hit that support level, then react to that market action by buying shares. That tells the trader an important thing that the mere previous existence of a support level didn’t: it says that support is still holding at that level, and that a pocket of demand for shares still exists at that price. More significant, it suggests that the trader has some downside protection.
Waiting for the market to confirm a market prediction before acting is a technical concept known as confirmation -- and it’s a key element to any successful trader’s strategy. Waiting for the market to react to pre-defined technical trigger levels (like support and resistance) means that you can more easily spot potential trades before they happen – and substantially reduce your risk.
2. Don’t Jump the Gun on Momentum
It’s likely that momentum is the most misunderstood concept in the field of technical analysis -- it’s also one of the most important. Countless traders use momentum indicators such as RSI, stochastics or MACD in their analysis of a stock’s trade potential, but many don’t realize what they’re missing when they read those small subcharts.
Momentum indicators are popular for their ability to determine whether a stock is “overbought” or “oversold” -- but what exactly do those words mean?
Overbought readings (such as RSI above 70) mean that a stock has made significant moves higher in a short time. Oversold means that shares have moved significantly lower in a short time. Exactly how that move and time are defined vary from indicator to indicator, but they all essentially tell the same story.
The idea of buying an overbought stock doesn’t sound very appealing to most traders – so it’s no surprise that they’re an incredibly popular contrarian signal. A common contrarian trade includes buying a stock when it crosses into oversold territory, waiting for the market to correct its exuberance in the other direction. But statistics show that making contrarian bets on momentum is a costly trading strategy. Instead, in the short-term it’s actually more likely for a stock to continue moving deeper into the extremes of a momentum indicator.
At the same time, stocks don’t need to reverse to bleed off momentum -- they just need to stop accelerating. That means that a stock can move from overbought to neutral just by passing time at the same price, leaving traders who made the contrarian play with pointless carrying costs and commission fees.
There certainly is a use for momentum, but it’s best used when momentum is actually signaling a swift reversal (like a failure swing at the extremes). Better yet, consider watching momentum extremes for signs of a potential reversal, then wait for price action to signal your actual trade (though a trendline break or moving average crossover, for instance).
3. Be a Good Loser
Psychologically, the art of being a good loser may be the toughest of the mistake to master. After all, I don’t know of a single trader who enters a trade hoping to lose money. Even so, losses are absolutely 100% inevitable for any active trader -- the only way to completely avoid them is to completely avoid trading or investing all together.
Most successful traders can take losses in stride. As a result, they’re also better prepared to take gains. It all comes down to how closely you’re willing to follow your trading rules and stick to the plan. I always advocate entering any trade with a well-defined exit; that means you should be aware of your technically relevant stop loss price before you submit your broker order. (And remember that those stop loss levels aren’t ironclad predictions -- they can change.)
But when a position moves against you, it can be tempting to break the rules a bit and hold out for a turnaround. Sometimes, it may work. But if you’re using a solid strategy with well thought out stops, skipping out on taking calculated losses will end up wiping out your portfolio. Just as bad, the habit of letting emotional decisions come into play on trades breeds even more bad trading habits.
By being a good loser, you’re better prepared to psychologically handle gains, and you’re better able to objectively evaluate your performance. It takes practice to avoid emotional selling or holding, but it’s something that every trader needs to be cognizant of. Don’t forget the old adage that it’s always better to take a good loss than a bad gain.
Next time, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.