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Hello, tradeologists. In this part of the Big Picture, we’re going to talk a little bit further about technical analysis, and exactly how you can use it in order to help determine where prices might go.
In other words, we’re not trying to predict where prices are going to go. All we are trying to do is get an idea of the probability of prices moving in a certain direction. Does it mean that they are always going to move in the direction of the highest probability? No.
Many times, prices will act contrary to what logic would dictate. In other words, if we believe there is a high probability that the market will move up, and it reverses and goes down instead, that is a significant event. Also, we can use different tools in order to determine where prices might go, and might not go. Again, with the idea of determining the probability of the prices moving in that direction.
There is just no way that we are going to be able to predict future prices. It just can’t happen with any degree of certainty. There are so many different factors in the market, that would determine where that price actually will go, when it happens. The only thing we can do – I’m going to emphasize this as much as we possibly can – we only look at the probabilities of the price moving in a certain direction.
We have a couple of different tools that we utilize, in order to make that determination. I have already told you about some of them, which are support and resistance points. The important things to remember about support and resistance points are, if it’s hit a point, and it bounced off it dramatically, that is either a significant support or resistance point.
I have the weekly chart of the Dow Jones Industrial Average here. Let me go do a daily chart here. I do most of my analysis on the daily charts. The little red circles here that you see are points at which the market had moved to, and then bounced dramatically off of. Those points become significant, the next time that the prices come to that level.
Sometimes, more than others. For example, on this particular point, it did come back up here, but it didn’t drop significantly. It actually rallied through to the other side. This point has become significant here, a number of times over the future of the price movement. In other words, this happened back in early December. That particular price support level became resistance here, here, here, and here again. It turned out to be a rather significant price level.
This was also a very significant price level. Prices bounced off of this as support. After it broke through, it eventually came back up again twice, to this very same price level. Prices dropped dramatically from there. That turned out to be a significant price level.
The important thing to remember is that prices do become more interesting, more supportive, or more resistant, at certain prices. For some reason, they hit certain points in the market, and then bounce off of those. If you can identify those ahead of time, you’ll have a lot easier time determining the probability of future market direction.
If I was going into the stock market, how do I really determine the general trend of the market? First of all, I look at a couple of different things. I look to find out whether or not the index, or the stock that I’m looking at, is making higher highs, and lower lows. If it is, then I have determined that the market is in an uptrend. I have to have at least 2 higher highs, and at least 2 lower lows, before determining that the market is in an uptrend.
For example, we would not have had a higher low, if it weren’t for this low. We had one higher low here. Then, we have a high. I don’t know if that’s a higher high yet, because I have only had one of those. I do have 2 higher lows. Now, I’m looking for a higher high.
After the market had rallied up to this point, I do have my higher high. I have 2 higher lows, and I have 2 higher highs. At that point, it’s highly probable that we are in an uptrend.
At that point, I’m looking to purchase the pull-back from this high. From the second higher high. That would be this point right here. At this point, I would go long the market. You can see that it did very well, the very next day.
Another thing that I always take a look at, before I take any positions in the market whatsoever, is something called the VIX. I will go to the VIX in a second. I just want to point out a couple of other things about determining the probability of future price trends.
Generally, in an up-trending market, prices will advance, and then pull back sharply. They will advance, and then they will either pull back sharply or slightly. These are called flags. These are probably the most reliable continuation pattern in the market. This type of pattern is a pattern in which prices advance, and then slowly begin to decline.
In this case, the pattern failed. It declined, and then shot right back up again. It’s still considered a flag. It’s a slow deterioration over a number of days, away from the high that was established prior to this pattern. In this case, I think a lot of people probably would have been faked out by the fact that they saw this flag pattern, which is a common technical analysis flag. It is a pattern that is commonly used by technical analysts.
They saw it break down here. They probably would have thought, at this point, that we were entering a new downward phase of the market. When, in reality, we have a higher low that was established, between this low and this low. Any time that you have a higher low, you could establish a position in this area.
Technically, you wouldn’t want to establish a position unless it broke the high of this bar here. Anytime you broke through the high of this bar, then you could go long on the position. That would have worked out very well. This flag was actually an indication that the market would continue higher. This pattern of slowly eroding prices, going down in a slow stair-step manner, is actually a fairly common pattern that most people recognize, but don’t know how to trade.
For example, if this pattern had resulted in an up-side move, breaking through either this high or this line that was established here as a down-trend line… If it had broken through there, they would have taken this as a signal to go long on this particular index. As it was, it broke down through here instead. It hit a support line and bounced back up again, to continue its up-trend.