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Thursday, November 29, 2007

Know your Tool, when using Technical Analysis...

When it comes to investing and trading, there are multiple tools that people use. Oscillators. Stochastics. Seasonals. Commercial vs. Small Speculator Net Positions. RSI. Momentum.

The trick, is to know your tool. In other words, know the theory behind the tool, and use different tools that have different background theories to them, and that measure different things. Below I have listed how I view different tools. Others may have differing opinions. For example, they may feel that momentum tools and timing tools are really similar shades of the same thing. But the important point to keep in mind, is that different tools have different theories and measure different things when it comes to the markets. So you need to diversify your tools, and make sure that there is agreement among them when entering a market. Don't use two tools from the same category. They are really just measuring the same thing. Look to use different tools, from different categories.

Oscillators: These include tools that measure price strength and action in relation to previous days action. Tools such as RSI (Relative Strength Index), and the Commodity Channel Index, or the Williams %R. An oscillator is very good when it comes to measuring price and time together. The oscillators fatal flaw is that it does not account for the strength of the trend of the market. What is occurring within the markets 'bigger picture'. It generally only tends to account for information within the last 30 days. Some only count information that has occurred in the last 10 days. Thus many bad sell signals can be given in a bull market, and vice versa. It is best to take oscillators signals that agree with the major trend (since trends tend to continue) or when a host of tool with non-oscillator theories are in agreement with more than one type of oscillator.

Timing: This would include any tool that measures when it is a good time to enter the market. Seasonal indicators would fit into this slot, as well as some pure cyclical tools. Timing tools are very similar to oscillators, except their weakness is that they pay no attention to price. A timing tool simply tells you when it may be a good time to enter the market. But all true entrances into the market should be based on two things. Time, as well as price.

Accumulation: Ok, so it's pretty obvious that the Accumulation / Distribution Tool would fit into this category. But what does Accumulation / Distribution measure? Volume and Price. But why? It's a determination to see (generally when divergence occurs, but other signals can be given) as to when the net buyers or sellers may be gaining control of a certain time period. When one understands the 'why' of a Accumulation tool, their power becomes clear. Another tool that should be put into this category is that of COT Data with Commodity Futures, or any Insider tools when considering the stock market. As well as any tools based off of Open Interest and Volume. Their signals can happen up to two weeks before a move so they are not good at entrance timing. The advantage however, is that such an early clue is usually extremely accurate that something is about to happen, and to use other tools at your disposal.

Trend and Momentum: This would obviously include the "Momentum Indcator", but it would also include tools such as the MACD, in addition to the ADX trend strength tool. Moving averages, trend lines and tools based off support and resistance would fall into this category. The old motto fits in here "The Trend is your friend, never fight the trend". Always look to be a buyer in a bull market, and take buy signals, but not necessarily sell signals. The same would be true in a bear market. Look to be a seller in a bear market, and take all of the sell signals, since trends tend to continue and it is unbelievably difficult to pick market tops and bottoms.

Now do we see why it is a bad idea to use two tools such as RSI and Williams %R together? They are really differing shades of the same thing. It'd be much better to look for agreement between a Seasonal Date, Accumulation / Distribution, ADX, and RSI.

So know your tool. And always look for agreement between tools that measure different things.

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