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Trading Lessons: How to Use Technical Analysis

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The sidelines exist in order to preserve capital.

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After a very strong run on the names held by my firm, I find myself at an interesting juncture. Yesterday, it was made clear that bearish patterns weren't just going to roll right over, once again throwing a wrench into a traditional technical-analysis (TA) approach.

Let me explain a bit further.

Assuming you've become fed up with fundamental investing -- which still has you long some loser of a stock that someone else is calling "cheap" -- you venture out into the unknown, curious to see who's actually weathered the recent storm. You stumble upon technical analysis, and -- once you get past the fact that it isn't some voodoo investing plan, complete with lot-casting or Tarot cards -- you start to understand what makes certain patterns work and why.

You realize that it isn't about predicting the future, but rather about seeing investor psychology in terms of a picture. You start learning and understanding basics such as pennants, wedges, the Holy Grail, and cup-and-handle. You back-test your newfound knowledge, beginning to judge whether these patterns would have actually helped you out.

Pretty soon, you're sold, and ready to start putting capital to work with TA as your guide. You notice that many patterns are setting up in bearish wedges, meaning that -- after a thrust lower -- stocks are consolidating around those lows, implying that another move lower is on its way.

Daydreaming about the yacht you'll buy with your TA riches, you begin to lay out a line, taking in some attractive shorts in anticipation of a certain drop.

Then it happens: Rather than a continuation lower, you meet with a doozy of a snapper that not only gobbles up your stocks, it also runs your stops and leaves you with a ding in your portfolio that wasn't there 24 hours before.

Stung by your foray into technical analysis, the fact that your "value play," General Electric (GE), was up on the day, adds salt to your wounds.

It's at this point when new TA traders typically throw in the towel, and when seasoned vets start wondering whether so many are now following TA that it might just not work any more. In my experience, this is precisely when you shouldn't abandon it -- it's a strategy that's remained true for centuries. Instead, you should understand that the sidelines exist in order to preserve both financial and emotional capital.

There's nothing that says traders have to trade each and every day, and, in fact, many of the greatest traders in history stepped away at those points when the picture wasn't clear.
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