Veritas Option Trading:

Technical Analysis 101

By ER Agnew

Smashwords Edition

Copyright © 2009 Veritas eBooks is a registered trademark of ERA Information Technology LLC. All rights reserved.

Table of Contents

Introduction

Note on How to Trade

Support & Resistance

Strategy Spotlight: Range Breakouts

Trendlines

Channels

Simple Moving Average

Strategy Spotlight: Moving Average Crossovers

Chart Patterns

Double Bottom & Double Top

Head & Shoulders

Strategy Spotlight: Triangles

Indicators

MACD

Strategy Spotlight: Stochastics

RSI

Bollinger Bands

Fibonacci Retracement Lines

Recommended Reading List

Important Notice

The information in this book is FOR EDUCATIONAL PURPOSES ONLY. The author and the publisher provide NO specific trading advice or recommendations. When trading or investing in the financial markets, you should always seek the advice of a qualified financial professional.

Introduction

Whether you are new to investing or you have experience in the stock market but are looking for new strategies, you always want to find an edge that puts the odds of success in your favor. Most people chase after whatever is hot right now, but even if they find a successful strategy, they often lack the discipline to stick with a solid plan that could have been very successful. My goal in writing this book is to get you out of this cycle and to help you develop a solid trading discipline by using technical analysis to get an edge in the markets.

Most individual investors are probably already familiar with the world of fundamental analysis, where professional and amateur analysts pour over the books and financial statements of companies to try to determine how much a company is worth, and therefore where the stock of the company will trade in the future. The problem with this strategy is that there are literally thousands of other people doing the same thing, and some of them might have access to better information or are willing to spend hours looking over the numbers, trying to come up with their own edge. The average investor usually doesn’t stand a chance in this situation.

Trading by using only fundamental analysis also leaves you exposed to a wide range of external factors that can cause you to suffer losses. Say, for example, that a company you are following is announcing its earnings results soon, and you decide to buy their stock because you think the earnings will be better than expected. The results come out and the numbers are good, but a majority of investors are disappointed with the guidance the company gives for the next year, and the stock drops. You were correct in your analysis, but you still lost money! For another example, let’s say you really like a company in a certain industry and you buy the stock. Your company could continue to perform well, but the industry as a whole could go into a slump, pulling the price of your stock down as well. Maybe the price of your company’s stock doesn’t go down as much as that of its competitors, but you’re still losing money! Your focus should always be on absolute performance, never relative performance.

So what is technical analysis, and how can it give you an edge? Quite simply, technical analysis removes a lot of the external factors discussed in the previous paragraph by focusing only on the internal, market-driven phenomena that affects a stock, such as price movement and changes in volume, as well as indicators based on these factors. Technical analysis helps you find patterns in the movements of stock prices, and these patterns allow you to trade with a high probability of success.

After reading this book, if you have any questions or concerns, please feel free to send me an email at ER@veritasoptiontrading.com.

Note on How to Trade

I have been trading in the financial markets for almost a decade now, reading countless books on the subject of trading and how to trade, and I have picked up a lot of the nuances regarding what it takes to trade successfully. It would be wrong of me to assume that someone reading this book who is new to trading would be familiar with all of these fundamental ideas for trading successfully. So I want to take a moment and go over some basics of trading in the real world, and hopefully this will provide a foundation on which we can build our technical analysis skills.

I noticed a pattern of two very important ideas after reading numerous interviews with very successful traders, like those found in Market Wizards, The New Market Wizards, and Stock Market Wizards, all by Jack Schwager (I highly recommend these books to get a feel for what trading is all about). The first thing I noticed is that all of these traders used different strategies and styles, styles that were often conflicting or opposing. If these traders used opposing strategies, then how could all of them be successful? This led me to my second realization: these traders all had different styles, attitudes, and backgrounds, but they all had one single characteristic in common that led to success, and that characteristic is discipline in their trading. These traders all had a simple set of rules that worked for them and their styles individually, and they always followed these rules. This is what I mean by discipline, and I believe this discipline is what allowed these traders to succeed, regardless of the trading strategy they used individually.

So what are some examples of these rules? Each trader probably came up with some of their own rules based on their experiences in the markets and what suited them personally. However, I believe there are some rules that can help all traders improve their chances for success if the rules are followed without exception. My number one rule is money management. The rest of this book, and the majority of trading advice in general, focuses on when to enter a trade. But how do you know the correct time to exit the trade? That is what money management is about. If you are buying a stock, you should determine what you are comfortable losing before you get out. For example, you buy a stock at $100, and the most you would feel comfortable losing is 10%. Hopefully the stock will go up from $100, but if it falls to $90, you sell without hesitation. It is a natural human tendency to want to hold on to that stock and wait for it to come back, but letting losses run is the quickest and best way to lose all of your money. Avoid letting losses run at all costs (“cut your losses,” in other words). Also, when entering a new trade, it is a good idea to have an exit point in mind when the trade does go your way. If you trade with clearly defined exit points in mind before entering the trade, you will avoid the agonizing and worrying over what to do as time passes. Your entry and exit points have already been determined, and all you do is follow the plan. This is money management in action, and this is what allows you to trade successfully without losing all of your money. Trade without a plan at your own risk.

I recommend doing a little research and reading, and finding a style that works for you, something that “clicks” and you feel comfortable with. You could find a trader who has a style you like, and emulate what he or she does. The most important factor in successful trading is having a plan, and following that plan while the trade is still on. After you have exited the trade, you can examine your plan and make any changes needed, but changing the rules in the middle of the game is always a recipe for disaster. Remember that discipline is the key to the game. Find a plan that works for you, and follow it. It really is that simple.

Now that we have covered the basics, let’s move on to the good stuff!

Support and Resistance

The most fundamental concepts in technical analysis are support and resistance. Support is simply a level that the price of the stock approached but did not break. You could say that buyers stepped in at this price level and “defended” the stock by not letting the price go below this level. Resistance is basically the same concept, except that it works in reverse. The stock price approached the resistance level but was not able to break through. This is the level where sellers step in and sell their stock holdings, causing the price to decline from the resistance level.

The good news is that support and resistance levels are very easy to determine, simply by looking at the chart of a stock. For example, here is a 6 month chart for GLD, an Exchange Traded Fund (ETF) that tracks the price of gold:

The orange line represents support. As the price neared $85, buyers stepped in and supported that price level by preventing the price from dropping below $85. You can see that the price touched and bounced off this line twice in April, meaning that $85 is a pretty firm level of support for this stock. On top is a blue line representing resistance. As the price neared $100, sellers stepped in and did not allow the price to rise above $100.

There are two other things to point out regarding support and resistance, both of which can be seen in the chart above. The first point is that support and resistance lines can be valid or invalid across different timeframes. For example, $90 has been a clear support level in the month of June, but back in February and March that was not true. $90 has been a valid support line only since mid-June. On the other hand, $85 and $100 have been valid support and resistance lines, respectively, for the entire 6 month period. The $90 support line also illustrates our second point: when a stock breaks through a resistance line to the upside, that line will often become a line of support. Looking at the chart above, the price approached $90 in late April and early May, but couldn’t break through. After the price broke though $90 in mid-May, $90 became a line of support in June. The reverse is also true: when a stock breaks through a support line to the downside, the former support line will often become a resistance line.