Below is a copy of my article in the current (May 2006) issue of Stocks, Futures and Options Magazine (www.sfomag.com) This article describes how I analyze individual stocks and reading it will help you get more value from my posts on this site.
By Brian Shannon
We have all heard the market cliché “the trend is your friend” and for good reason. Making big money in the markets is accomplished by entering a position at the onset of a new trend and then having the patience to hold the position long enough to allow the profit to accumulate into a large winner. Participation in a long term trend is the dream of every investor; to have a huge winner that we had conviction in and held well beyond the point where most participants would have been shaken out of the stock on a short term pullback is what allows successful investors to reap large gains. It may be a three year hold where investors find their most satisfying winners, but that timeframe does not fit with all participants in the markets. There are those of us whose mindset leads us to believe that long term capital gains should be recognized after just a few days and three years seems like a lifetime. Short term trading can lead to outsized trading returns, but only as long as losers are managed properly and the gainers are larger than the losers a truth fro any timeframe.
In order to attain larger winners than losers, the easiest way to get the odds in your favor is to trade with the primary trend, regardless of whether you are an investor or a trader. Think of the most basic definition of an uptrend, which is stock price making “higher highs and higher lows”. In an uptrend, the sum of the rallies will always be greater than the sum of the declines; otherwise the trend would not be intact. The opposite is true for a downtrend; the sum of the declines will always be greater than the sum of the rallies, which obviously makes the short side more profitable in a down trending stock. The simple math of trends is the biggest argument for why it makes sense to participate in moves that are aligned with the direction of the primary trend, rather than trying to pick tops and bottoms. Even if you can accurately predict turning points in a market, your reward will not be as great as it would be if you were participating in the trend.
Not only is it difficult to predict turning points with any consistency, but the way that markets correct is another factor that stacks the odds against those who attempt to profit by trading against the trend. There are two ways that markets can correct after a move in either direction. The first type of correction is one that occurs by price; an up trending market will experience a pullback in price or a down trending stock will experience a short term rally before the primary trend re-exerts its dominance. The other way a market corrects is through time, meaning that instead of a counter trend move, the market will trade sideways as the buyers and sellers battle it out for control. A correction through time is typically marked by low volatility in a tight range which can leave the person who is anticipating a reversal to become frustrated. Because there are often numerous trends prevalent in a given market, the surest way to stack the odds in your favor is to utilize multiple timeframe analysis for trend alignment before risking your capital.
In theory, trend trading is simple, buy low and sell high for longs and sell high and buy back low for short positions. In reality, many traders find trend trading frustrating because they are not focusing on the right trend. A little over one hundred years ago, Charles H. Dow wrote a series of editorials in the Wall Street Journal in which he laid out his views of how the stock market works; collectively these writings are referred to as “The Dow Theory”. The work of Dow is still referred to today and it is the underlying premise of technical analysis. One of the foundations of the Dow Theory is the identification of three types of price trends; the primary trend, the secondary trend and minor trends. The Primary movements were compared to oceanic tides, they are the main trend of the market whose duration can last from a few months to several years. Primary trends cannot be manipulated as the forces of supply and demand are too large for any one participant to successfully influence the collective reasoning of the crowd. Secondary movements were referred to as waves and they are known as reactionary moves, these trends typically last from 2 weeks to 3 months. The secondary movements are often created by a large participant (mutual fund, hedge fund, etc.) exiting all or a significant part of their position, once that supply (in and uptrend) is absorbed by the market, the buyers regain control and the stock continues higher in the primary trend. Short term trends were viewed as insignificant ripples which last less than 2 weeks and were given little significance because they represent fluctuations in the secondary trend. The short term ripples in the market can be difficult to predict because they are often emotionally driven events, however skilled day traders thrive on this type of emotional short term movement.
Because there are three trends in a market, one of the most important elements to successful mastery of trend trading is to determine which trend to focus on. Deciding which timeframe to engage the market on is largely determined by individual factors such as; time available to commit to the markets, your capital base, experience level, risk tolerance and even your level of patience. Investors are naturally attracted to the Primary movement, while the Secondary moves are going to be the focus of a more intermediate term participant (swing traders) and the minor trends will be the obvious choice of day traders. Even as simple as that concept may seem, it becomes more complicated because technical analysis is about timing and time cannot be looked at one dimensionally if you are to truly have the odds in your favor.
In order to make timing decisions that will allow you to determine a low risk area to get involved and still have large profit potential, it is essential to make your analysis on multiple timeframes. We will now explore three different timeframes that investors, swing traders and day traders should look at. To make this analysis real we will use an example of a current setup in the market as if we were going to enter an investment or a swing trade. Because of the short term nature of a day trade we will outline the timeframes to consider but will not study an actual trade setup (see table 1).
Table 1 The investor, swing trader and day trader will look at different timeframes for their analysis of Primary, Secondary and Minor trends.
Whether you are an investor, swing trader or day trader, the first timeframe that should be studied is one that represents the primary trend. The longer, more powerful trends are the ones that you want to be sure not to be fighting as mistakes can be quite costly. The long term timeframe is not about timing, it is about idea generation and for an investor, the timeframe to start with is a weekly chart that encompasses at least two years worth of data. Looking at Figure 1, the weekly chart of Stats Chippac Ltd (STTS) shows the stock has been bottoming out over the last 18 months and the recent increased volume suggests the stock may be ready for a sustained move higher that could see the stock trade near the 10 level. This is the type of chart that should get an investor interested in further study on shorter timeframes (of course having a fundamental reason for being involved, in this case increased earnings and revenues, is always a bonus).
Figure 1– Weekly chart of Stats Chippac Ltd (STTS) which shows potential upside targets.
The primary trend for a swing trader will not be quite a long term as it would be for an investor; this is why their analysis of a long term trend should take place on a daily chart which shows at least 150 days of data. A swing trader would have good reason for being bullish on the daily trend of STTS as the stock is in a strong uptrend which is defined by a strong volume pattern and the stock holding above rising key moving averages (see figure 2). It is also very encouraging to bullish traders that the stock found support at the prior level of resistance near $7.20 on a recent low volume pullback.
Figure 2 Daily chart of Stats Chippac Ltd.
Day traders will find it necessary to bring their analysis of a long term trend to an even shorter period of time and that can be accomplished by studying price action on a sixty minute chart which shows price movement over at least twenty five days. The sixty minute chart of STTS (see figure 3) is telling day traders a similarly bullish message as was seen on the weekly and daily timeframes. The sixty minute timeframe shows that the buyers have once again taken control of the stock by pushing past the short term resistance at $7.30. Notice how this action has also turned the moving averages higher, confirming the short, intermediate and longer term trends of this timeframe are now higher.
Figure 3– Hourly chart of Stats Chippac Ltd.
The units of time studied in these examples are starting points, it is often necessary to look “further to the left” to see older data that may be relevant to the primary trend. The goal of the long term timeframe is to allow the participant to recognize signs of a new trend or a stock that appears to be early on in an established trend and then move to a shorter timeframe for further confirmation of a reason to get involved in an actual trade.
Once the stock has been identified as a viable candidate for a commitment of capital, the next step is to determine key levels of support and resistance which brings our analysis to the secondary timeframe. The presence of a trend was recognized by studying the primary trend and the next step for a trade setup is to determine if there is sufficient potential for reward relative to the perceived risk, essentially this is where we plan our trade. The evaluation of the risk/ reward scenario should take place on an intermediate term timeframe that allows for easier recognition of levels of support and resistance which might not have been visible on the longer term timeframe.
To view the secondary trend, an investor would study the action on the daily timeframe of STTS (figure 2). In figure 2, the investor should notice that the stock recently rallied from 7.00 to 7.60 on heavy volume and then experienced a lower volume pullback to previous resistance at 7.20. At this point, it appears the 7.2 level is where there should be good support for the stock, but the investor may want to set a stop under the rising 20 day MA which is now at approximately 7.10, this would give the investor a theoretical risk of approximately $0.40. Setting the stop under the 20 day moving average instead under the support at 7.20 exposes the trade to more risk, but it also reduces the chance of getting stopped out of the position prematurely. Coming up with an upward price objective could not be done on the daily timeframe because of the limited price action above 7.00, so the investor would have to revert back to the weekly timeframe (figure 1) to come up with an initial target near 8.20, which is the high for the stock in 2004. Because the stock had limited trading history at the 8.20 level it is unlikely that the resistance would be very strong, thus making a target closer to 10.00 more feasible. Even the 10.00 level could prove to be conservative as there is further potential for the stock to rally up towards 12.00 which was a support level broken in late 2003. Whether the stock eventually rallies up towards ten or twelve, the risk of getting involved with a stop of just $.40 makes this a very attractive long side candidate.
After identifying STTS as a good potential swing trade candidate on a daily timeframe, the intermediate term trader would then drill down the analysis of support and resistance by looking at the hourly timeframe (figure 3). The way a swing trader should interpret the action seen on the hourly chart is that the stock is in an ideal area for purchase as the buyers have just regained control of the trend on this timeframe. By clearing the short term resistance at 7.30, the buyers are back in control of the intermediate term trend and the stock now has strong upward momentum, making it an excellent candidate for a swing trade. The minimum upward objective for the swing trade would be the recent highs of 8.20 and determination of where to set the stop would come from an examination of the minor trend which can be seen in figure 4.
Figure 4– 10 Minute chart of Stats Chippac Ltd.
The final timeframe to be studied is the minor trend and the goal on this timeframe is to capture a more accurate entry price. The minor trend for the investor is found in figure 3, the hourly timeframe. If the investor was looking to enter the stock while it exhibited upward strength, he may choose to enter at the same level the swing trader was targeting at 7.30.
For the swing trader who is contemplating a purchase of STTS, the short term trend is best recognized by studying the price action on a 10 minute timeframe which covers 10 days of trading activity. As we saw on the 60 minute chart, the ideal purchase would have occurred as the buyers gained control of the short term trend when they pushed the stock past short term resistance at $7.30 and the 10 minute timeframe shows this level in greater detail. While the 10 minute timeframe does not offer any particular advantage over the 60 minute timeframe in the case of STTS, it does often provide greater detail that allows us to fine tune not only our entry price, but also where to place our initial protective stop.
The concept of utilizing multiple timeframes for trading is one that every market participant should consider because it allows for a greater level of objective analysis of what the market is actually doing rather than relying on our opinions for making important trading decisions. Using three different timeframes allows market participants of all timeframes to; find the idea (primary trend), create a plan of action (secondary trend) and capture more accurate entries (minor trend). In the end, multiple timeframes allow us to become better at holding our winners and cutting our losers, a goal common to all market participants.