During the past couple of weeks, I’ve posted a few articles on basic techniques for people wanting to learn how to use technical analysis in their own trading.
More specifically, I focused on my favorite indicator, the exponential moving average . I covered the basics of the indicator and demonstrated the difference between the simple moving average and the EMA.
The EMA is much more responsive to short-term price fluctuations, and demonstrates better response to momentum and volatility.
You can see how much more responsive the EMA can be compared to the SMA by looking at the chart below…
But keep in mind that although I’m demonstrating this method with stocks, it applies to futures, commodities and currency markets.
And if you’re a day trader, you can change the bars from daily to a five-minute chart and apply this method to E-mini futures contracts as well.
How to Use Technical Analysis: The Setup
Now, I like to adjust the EMA to look back 20 days.
This gives me a good time frame to work with and makes the EMA more responsive to short-term market swings.
You can experiment with different settings, but I suggest you start off with the 20-day.
The basic principle is to use the EMA to measure pullbacks away from the trend.
The goal is to find a stock trending strongly above the EMA. The more distance between the stock and the EMA, the better the trend.
The next step is to wait for the stock to trade completely below the EMA for five days or less.
If the stock is below the EMA for more than five trading days, the trade is nullified.
If the stock trades completely above the EMA within the five trading days, you’ll want to enter a buy-stop order above the first bar that trades completely above the EMA.
Placing Protective Stop Loss
When learning how to use technical analysis, we also need to figure out where to place our stop-less level so random price fluctuations or market noise don’t cause us to get stopped out prematurely.
Place your stop at the EMA level immediately between the last bar that traded completely below the EMA, and the first bar that traded completely above the EMA.
This may sound a bit confusing, so take a look at this example…
Where to Place Your Profit Target
The final step when learning how to use technical analysis is to place our profit target at a level that provides solid risk-reward..
Most professional traders use a profit-to-risk ratio of 2-to-4. This means for every dollar you risk, you should profit anywhere from $2 to $4.
This particular method is based on short-term price momentum and volatility. Therefore, using a profit target designed to keep us in the market for a long time won’t work with this type of strategy.
A good tip is to always plan your exits based on the characteristics of your entry method.
I use a simple 2-to-1 risk level with this strategy. I want to see strong momentum coming into the market as quickly as possible after I enter my order.
I simply measure the distance between my entry price and the stop-loss level, and multiply the number by two.
I then add that amount to my entry price, and that becomes my profit target for the trade.
This number gives me a reasonable risk-to-reward ratio and an opportunity to take quick profits from increased volatility before momentum dries up again.
In this particular example, the distance between my entry price and my stop-loss level was approximately $2.25.
I would multiply that number by two and add that amount to my entry price, which in this particular case was $28.60.
I then add $28.60 to $4.50, which makes my profit target $33.10.
In this final example, you can see where the entry and the protective stop-loss level are placed.
And because we’re selling short, we’d subtract our risk level from our entry and that would give us our profit target.
In this particular case, the risk level on the trade equals $3.
We would multiply that number twice and subtract it from our entry price.
So because our entry was at $158 and our risk level was $3, we’d subtract $6 from our entry price.
That will give us a profit target level of $152.
Things to Keep in Mind
When learning how to use technical analysis, always remember that momentum strategies based on volatility have lower profit-to-loss ratios than other technical trading methods.
Remember, the 20-bar EMA can be adapted to any market and time frame.
The only market I don’t recommend you trade using this method is options.
If you want to learn more about how to use technical analysis in your own trading or this strategy, check out these other articles: How to Analyze Stocks Using Technical Analysis and The Best Short-Term Trading Strategy for Beginners.
All the best,
Senior Strategist, WealthPress