Trading can be complicated. You can use fundamental or technical analysis and the two are not the same thing. People who love charts enjoy the Elliott Wave principle and Volume weighted average price or VWAP, as it is called. Real number-crunchers love Fibonacci retracement.
There’s more. Each of the trading tools and investment techniques has its place and has its fans. Some can be used in partnership with others, some are stand-alone ideas. All are just guides, not a guarantee. But to be a great trader, you need to get technical.
Here are some of the main technical trading techniques you may have heard of:
- Absolute return investing
- Averaging down
- Dividend investing
- Elliott Wave principle
- Fibonacci retracement
- Fundamental analysis
- Momentum investing
- Technical analysis
And here are our summaries in no more than 500 words each:
Absolute return investing
An absolute return fund is designed to make a positive return regardless of the underlying market conditions, rather than compare its performance with another benchmark, such as a stock market index or an average of other funds.
It could be investing in equities, bonds or a combination of assets and such a fund can use shorting as well as going long to get results. It can also invest in derivatives to boost performance.
An absolute return fund should be less dependent on the overall performance of the underlying markets. An absolute return fund manager might look for individual stocks that are undervalued or, if opting to go short, overvalued.
How to achieve absolute return
There is no one technique to achieve an absolute return, so it’s a loosely defined technique. Some set a target, which might be a specific percentage return or a return above another published rate, such as Libor or CPI. Or they might target a specific bond’s return and aim to make more.
But aims are just that. They are not promises. The success of the fund managers offering absolute return funds is, shall we say, varied. Many don’t make a positive return at all.
For more on absolute return investing read: Absolute return investing – a strategy for all markets?
Averaging up and down
Averaging up or averaging down means buying more shares in a stock you already own. It can be used for going long, or for short selling.
Investing in more shares at a higher price than your original investment is known as averaging up. The new shares cost more than the ones you have bought previously so the average price per share has increased.
If you buy more shares as the price falls, your average price will now be lower. This is known as averaging down.
Great names in investing, such as Warren Buffett, use averaging up. There are fewer fans of averaging down. But the techniques can also be used within day trades – adding to a still open position.
When you average up you usually buy half the volume of your last purchase at each stage – if you buy 1,000 shares first, you would buy 500 later and then 250 and so on. This called Pyramiding.
Risk-averse investors control the average price that they pay for stocks by making smaller and smaller purchases as the price gets higher, protecting themselves from price volatility.
You can also increase your stock holding in this way when going short, as the price falls. And it can be done in intra-day trading, not just long-term.
Averaging down does not involve pyramiding. It often involves buying the same number of shares each time as the price falls, reducing the average price and lowering the price at which a bounce-back in the stock price will return your position to overall profit.
The risk, however, is that you are adding to a potential losing position. Averaging down works if the stock has been undervalued and the fundamentals mean the market will correct that falling share price.
If the stock is a fundamentally bad stock, you are just throwing good money after bad. There is also the risk that momentum will keep pushing a falling price lower. You might be able to ride that out if you are investing for the long term, but in day trading it could be a killer.
Averaging: the maths
Averaging up, if you buy 1,000 shares at £10 each then 500 at £12.50 and then 250 at £15, you have a pyramid that includes 1,750 shares at an average price of £11.43. If the price rises to £17.50 and you take your profit, you will have made more than £6 a share profit or about £10,500. If the price drops to £12.50, your investment is still in profit.
Averaging down, if you buy 1,000 shares at £10, followed by 1,000 at £7.50 and a further 1,000 at £5, you end up with 3,000 shares at an average price of £7.50. The share price need only recover t above £7.50 for you to be able to exit without a loss.
For more on averaging, read: Can the law of averages work for you?
Dividend investing, sometimes called equity income investing, means focusing not just on the share price but on how much in dividends a company pays.
You take the total dividend payments as a percentage of the market capitalisation of the firm to calculate the yield. This is effectively the individual dividend as a percentage of the share price. You then invest in firms that offer high returns for your money.
While some take the money as income – a higher income generator than many savings products in low interest rate environments – others reinvest the dividend income in high yield stocks.
It is not just about the dividends. Often, companies with solid dividends are attractive to other investors and this helps push up the share price. A positive announcement on dividends will usually boost a company’s share price.
After all, dividends are paid out of profits not needed for investing in the industry, research and development (R&D) or to build up contingency reserves.
Dividends suggest a healthy company in a strong market position with good long-term prospects.
What to watch for
Be warned: precisely because healthy dividends suggest a profitable, well-run company, unscrupulous firms pay them to cover their faults or disguise a fraud.
Others might fear the consequences of ceasing attractive dividend payments even when the company can no longer afford them. Some have even borrowed just to pay dividends.
Firms with long-term market problems or reputation issues, such as those involved in markets avoided by ethical investors, often pay healthier dividends to attract capital.
Also, a falling share price may make the yield on a stock look artificially high and attractive. And share prices often drop just after the dividends has been paid, so be aware of such price movements when doing your sums.
Steady investment technique
Typically, companies pay dividends once or twice a year. And many larger, blue chip, firms have long-term dividend policies set at similar, consistent rates to avoid major fluctuations.
It is less likely there will be any stellar share price performances in a dividend-based portfolio but overall returns can be hugely rewarding. It is a methodology used by several leading investors.
For more detail, read our: Dividend investing for outsized returns
Elliott Wave Principle
Named after Ralph Nelson Elliott, a US accountant who invented the Elliott Wave Principle in the 1920s and 1930s, it is a system for using charts to forecast trends in market prices.
Elliott charted contemporary and past stock market behaviour to isolate recurring patterns and used those to project the market’s next moves.
Core to it is the belief that markets trade in repetitive cycles, which Elliott referred to as waves. The idea is that crowd psychology creates natural waves that oscillate between optimism and pessimism.
Elliott called the principal direction of prices “impulsive waves”, with price corrections that go against the overall trend as “corrective waves”. In a bull market the corrective waves go down. In a bear market, the corrective waves go up.
It gets more complicated. Impulse waves are divided into a set of five waves of smaller magnitude, themselves alternating between impulse and retrace stages. Waves one, three, and five are impulses while waves two and four are smaller retraces of waves one and three.
Meanwhile, the corrective waves are divided into three waves of lesser magnitude. These would be a counter-trend impulse, a retrace, and another impulse. For the mathematicians out there, the relationship between waves is linked to the Fibonacci number sequence too (more on that next).
There are also different names for wave patterns in different timeframes. There are 10 in total covering decades down to intra-day trading. The final three smallest are named minute, minuette and subminuette.
The key is that this means traders can use the Elliott Wave Principle for long-term trading right down to intra-day trading.
How to use the Elliott Wave Principle
The first thing to do is to study various charts and attempt to spot a five-wave impulsive phase and a three-wave corrective phase. A trader can take a position to benefit from the main direction of travel but look to exit or take contrary positions when a reversal appears imminent.
Elliott Waves do not always correctly predict markets and there are critics that so much has changed in terms of technology and society that the theory behind them is out of date and works less well compared with current markets.
For more information, read: Trading with the Elliott Wave Principle
The Fibonacci sequence is a set of numbers 1,2,3,5,8,13,21,34,55 that continues ad infinitum, with each number being the sum of the two preceding numbers. Most important is the ratio between the numbers, which is 1.618 if you divide the larger by its smaller neighbour and 0.618 the other way round.
In percentages, any number in the sequence is 61.8% of the following number. This figure is called phi (not pi, which is to do with the circumference of circles). You can also get two other numbers by dividing one number by the number two places apart and three places. These give 38.2% and 23.6%.
A natural wonder
The Fibonacci sequence is prevalent throughout nature – you’d be amazed at just how often it crops up, including in your own DNA.
But enough of the maths and science. How do traders use it? On a chart of a stock’s prices you mark lines at 100% for the highest price and 0% for the lowest price and add one for 50% (not a Fibonacci number). But then you add lines at 61.8%, 38.2% and 23.6%.
You will frequently find resistance or support points at these numbers. Whichever way the price is moving, you will often find it can reverse when the price reaches these percentages.
Fibonacci arcs and fans
You can also use these ratios to create Fibonacci Arcs, drawing circular arcs radiating downwards from the 100% mark at 38.2%, 50% and 61.8%, like rings on a target, which will indicate the probable range of price movement.
Fibonacci Fans follow the same principle: draw a vertical line at the right-hand edge of the graph and divide into the same percentages, drawing lines across the graph from the bottom left-hand corner, starting at a given time period, to meet those percentage marks. The resulting lines will show areas of probable support and resistance.
Many trading platforms have automated graphing systems that allow you to create your own Fibonacci traces for your chosen stock over a set time period.
For more details on Fibonacci, read: Fibonacci retracement – trading the pattern of the cosmos
Fundamental analysis involves empirically deciding what you think an asset is worth and then comparing that price to the current market value to see whether it is underpriced or overpriced. If it is underpriced then that is a signal to buy and hold. If it is overpriced, it is signal to sell or to short.
Fundamental analysis means looking at the specific numbers relevant to that asset and considering that in the wider context of the political environment, the global economy, the local economy, the sector or industry. And it means crystal-ball gazing about the likely future technical or social changes that might impact on that asset.
It is heavily research based. For example, if looking at an individual stock – and billionaire investor Warren Buffet relies on fundamental analysis for his investment decisions – that means examining:
- Profit margins
- Return on equity
- Price to earnings ratio
- Price to book ratio
Bonds, commodities, forex
Fundamental analysis can also be used to decide whether a bond is undervalued, whether a commodity is trading at the right price or whether one currency is artificially high or low. The same principles apply – detailed research.
You might look at a bond’s coupon, or interest rate, offered on the bond compared with the current interest rate, as well as the likely ability of the bond’s issuer to pay off the bond when it matures. And you stick that next to data about the prevailing economic outlook and peer-group bonds.
With a commodity we might look at the supply and demand for that commodity. Will there be enough supply to meet future demand or will the price rise due to a shortage not matching demand. Geopolitical factors come into play.
With forex you might look at the country behind each currency, the relative strength of the economies and the political stability.
Markets not always right
The key is you decide what the right price is and decide to trade on the basis that the market will eventually realise its mistake and correct the price accordingly.
For more details about fundamental analysis read: How to invest using fundamental analysis
Momentum trading means buying stocks with proven performance history and dumping stocks that are not performing.
It is based on evidence that, at certain times, stock or other assets generate a momentum of their own. Rising prices will continue to rise and falling prices will continue to fall.
Momentum investing relies on spotting those trends and riding the wave, then identifying when the trend is coming to an end and taking profits.
Markets are not logical
Momentum takes advantage of markets when fundamentals or technical analysis are being ignored. There may be no justification for a particular asset to be climbing at its current rate but a momentum investor takes advantage of the trend.
An asset or group of assets, or even a whole class of assets, can become popular. It might start with a few investors taking a long position but others, seeing support rising, will pile in. Others then follow. Often automated trading systems that electronically monitor trading patterns will also kick in and add to the momentum.
It becomes self-fulfilling. The more investors joining, the higher the price rises, so the more who want a piece of the action.
The problem is this can lead to overpricing and eventually there will be a correction – of at least 10% of the price. Worse still, it can lead to bubbles that then burst with a crash in price, of more than 20%. The shrewd momentum investor plans when to exit before the market adjusts itself.
There are some technical indicators momentum investors can use. A price rising above its moving average might be seen as an indicator to buy, for example. Changes in volumes of trades may indicate support is waning and prompt a sell.
But much is down to your own research and strategy. The one common error with momentum investing, however, is a failure to realise how long momentum sentiment can last. Fear that the plug may be pulled any minute often means traders exit too soon, missing out on further momentum gains.
But be warned, if a sector is experiencing momentum, the temptation is to become over-exposed to that sector in its entirety – putting all your eggs in one basket. That is not a sound risk management strategy.
For more information on momentum investing read: Should stock traders stop momentum investing?
Martingale involves doubling your stake if you lose so you can recoup your losses in the next trade. It can be high risk, even when the chances of success are exactly 50/50 – and most trading situations are not.
The progression for Martingale goes 1, 2, 4, 8, 16, 32, 64, 128 and then 256 times the original stake, and so on, so it does not take too long a losing streak for a trader to be risking a large sum of money just to get back to even, plus their original stake. Ten unsuccessful trades in a row would require 512 times your original stake.
Variations on the Martingale theory
- The mini Martingale. Here the trader limits the number of times they double up. This stops larger losses but does not guarantee a winning streak.
- The anti or reverse Martingale. Here the trader doubles the stake every time they win. Fine if you get out after a win. Not so fine if you don’t because you will be wiped out with one loss.
- The grand Martingale. This follows the same rules as the basic Martingale theory but each time a bit extra is added on to the stake, so when a win comes along the winnings will be more than the original stake.
There are few who recommend the Martingale approach because of the inherent risks. It is used in some forex trading environments where the losses are usually more limited – a stock could crash but a currency, backed by a government, is less likely to fall so much and never to zero value.
It is also linked to averaging down – buying more of an asset when the price falls to take advantage of a bounce back. Instead of buying the same amount again you buy double the amount, reducing your average price faster.
The problem is that Martingale is linked to gambling and seen as high risk. In theory, a game of chance with a 50/50 possibility of winning will always be beaten by the Martingale system. It just might take many goes and an almost unlimited amount of money to do so.Roulette wheels had two extra blank (green) spaces added to alter the odds from 50/50: Shutterstock.
It was the Martingale system that prompted casinos to introduce maximum table stakes and to introduce two extra blanks on the roulette wheel so the chance of winning became less than 50/50.
For more on using Martingale read: The Martingale approach and averaging down
Technical analysis is using charts and graphs of an asset’s prices and volumes of trades to predict market movements and taking advantage of them.
Two key concepts critical to technical analysis are support and resistance.
Support it is the price level at which demand is thought to be strong enough to prevent the price from falling further. Resistance is where the price level is thought to be strong enough to prevent the price from rising further.
The break-out is when a current price has moved through resistance (demand outstripping supply). When support or resistance levels are broken, the supply and demand forces that created these levels are assumed to have moved, in which case new levels of support and resistance are likely to be established.
Those also interested in shorting watch for when the direction of travel is breaking through the support level.
Graphs and charts
In simple terms, technical analysis plots points on graphs and identifies patterns that have historically indicated a typical price movement. Often straight lines drawn approximately through the high and low prices will also create patterns that indicate trading patterns.
There are many different mathematical and graphic techniques for predicting price movements and helping to decide where to set stop loss orders or take profits orders, but the fundamental information required is threefold:
- Identify the trend
- Weight that by volume
- Compare with historical records
All of these are important. An identifiable trend may not be significant if the volume of trades is low. But one asset might historically have traded differently from another and different indicators may be more important.
It is about spotting the trend, seeing how much support there is for that trend and knowing what this asset has done in the past in the same circumstances. History does not always repeat itself, but often it does, and an asset is likely to behave similarly in similar circumstances.
Technical analysis helps sets a structure to your trades, helps calculate targets, risk ratios and exits strategies. Even traders who rely on fundamental analysis may additionally use technical analysis to help refine their trading strategies and either endorse or reign in their proposed support for what they perceive as an undervalued stock.
For an introduction to technical analysis read: (to come)
For information on reading charts, read: How studying charts can help spot trading patterns
Scalping is a term for taking tiny profits from small price movements. It is applied to the forex market where, during a day, prices can fluctuate and astute traders can make several trades taking advantage of those small fluctuations. Individual trades may be of just a few minutes duration, often called five-minute trades.
Scalpers pick a currency pair and then watch charts of just a few hours of trading. The news, an economic announcement, an interest rate rise, a political or social event can all have an impact, even briefly, on a currency’s strength against a specific paired currency.
These super-rapid price fluctuations, up or down, are measured in pips. A pip is the smallest movement, up or down, any currency makes. Successful scalpers don’t look for big gains or profits. Consistent success is down to small profit/loss ratios. Scalping is high-intensity work.
A scalper will set entry and exit prices and may use stop loss orders too. They spot a possible price movement and set the price at which they will take their profit, allowing for costs, commission and charges. They may make a dozen or more scalps in a day.
For a more detailed explanation forex scalping, read: Forex Scalping – a beginner’s guide
VWAP - volume weighted average price
Volume weighted average price (VWAP) is a trading benchmark that reflects the ratio of an asset's price to its total trade volume. VWAP is calculated by adding up the money traded for every transaction and then dividing by the total shares traded.
VWAP is still seen by many traders as a great technical indicator simply because it represents both price and volume.
Unlike moving averages, VWAP assigns more weight to price points with high volume. This allows the trader to understand price points of interest, gauge relative strength, and identify prime entries/exits.
Using VWAP for good investments
Traders find it useful because it simplifies decision-making strategies by identifying the true average price of a stock by factoring the volume of transactions at a specific price point. It is not simply based on the closing price.
VWAP works bests where the bid/ask spread is small, so in less volatile assets. The indicator becomes less sensitive to price action as the market day extends. Later in the day, the "lag" can become significant. VWAP might be of more value to day traders at the start of the day because it is more responsive to price moves.
When the price is high, it is above VWAP and when the price is low, it is below VWAP. It is thought that when a stock tries to break above or below the VWAP level multiple times throughout the day, traders and analysts can see that it is a good price at which to either buy or sell.
Other uses of VWAP
Big investors, such as pension funds, also use VWAP to stagger their trades so they don’t adversely influence the price – they either buy or sell in tranches over a stretched-out time period of perhaps several days, rather than all at once.
If they suddenly sold a huge tranche of shares they might send the price down, so they sell in smaller batches. Similarly, if they’re buying, they don’t want the price to start rising quickly so they buy smaller amounts repeatedly.
You might also like to read:
- How to use VWAP when investing
- A-Z of trading and investment terms, jargon and slang
- Growth versus value investing: a dichotomy