Technical Analysis and Charting: How to Build a Trade

When you walk into an ice cream store, one thing that hits you is the number of flavors. And once you decide which flavor or combination of flavors you want, you have to figure out how you want it served—dish, sugar cone, waffle cone, and so on. And then how much—single scoop, double scoop, or more.

You’ll often go through a similar experience when deciding what to trade. With so much data thrown at you, that process can get tough. Some traders have no problem analyzing mountains of data. Others take comfort in looking at a chart so they have some sense of which way price may be moving. But even charts can get complicated—there are so many indicators, drawing tools, and patterns to choose from. And too many choices can lead to a state of “analysis paralysis.”

The good news: there’s a more logical approach to finding a potential trade and narrowing down the number of indicators to place on a chart.

Scan the Stock Universe

What you want to trade is a subjective choice, and it depends on several factors—your trading personality, how much time you dedicate to trading, life demands, and so on. Whatever the case, it’s a good idea to have a strategy for narrowing down your alternatives so you can focus on a handful of symbols.

The Stock Hacker tool on the thinkorswim® platform from TD Ameritrade can help you reduce the universe of stocks to something more manageable. Before you engage it, think about what you’d like to trade. Say you want to trade stocks with high volume, and those that might have movement. Here’s how you start the “hacking” process and scan for stocks that meet these two criteria (see figure 1).

1. Select the Scan tab on thinkorswim.
2. Choose your setup. There are four choices across the top: Stock Hacker, Option Hacker, Spread Hacker, and Spread Book. Each category has several filters. For example, Stock Hacker has filters for stocks, options, studies, fundamentals, and patterns. Before setting up your scan, you can also select a category of stocks, and choose to intersect your original category with another one. For example, you might set All Optionable stocks to intersect with All NASDAQ Stocks.
3. Choose your first filter by selecting Add filter for stock. The filter is added to your Scan setup. From that drop-down list, select from the alternatives and then choose a range. Maybe it’s earnings season and you want to find stocks that are likely to have some movement. You might select Market Maker Move from your choices. A chart will display the distribution range of the selected filter. Select your desired minimum and maximum range using the drag-and-drop tool.
4. Add a volume filter to find stocks trading on high volume. Then select the minimum and maximum range of the volume. To the right of your selected scan criteria, you’ll find the number of matches. If you’re still seeing too many stocks for your filtered criteria, narrow down the number of symbols on your list by adding additional filters or adding a condition group, such as not including stocks under $5.
5. Sort the most heavily traded symbols by selecting the Sorted by drop-down list to the left of the Scan button. Select Basic Price & Quote, then Last.
6. Finally, select Descending. Satisfied? Hit Scan and get your hacked universe of stocks listed and sorted to your liking. If you’re not satisfied with what you see, edit your filters some more.

Chart the Trade

Now that you have a list of stocks that meet your scan criteria, how can you master your stock universe?

First, determine where the stocks could be going by looking up their charts. Right-click on any symbol in your scan list, select More info on stock XYZ from the drop-down list, then select TOS Charts. Choose where on your chart grid you’d like to see your stock’s chart displayed. This will take you to the Charts tab. Maximize the chart and you’re ready to begin mastering the art of charting.

You can now ask these three questions:

1. What’s the trend?
2. How strong is the trend?
3. When should you get in (and out) of a trade?

It’s possible to look at a price chart and quickly identify the trend. But sometimes it may not be clear-cut. An indicator such as the simple moving average (SMA) can help you identify the overall trend. From the Studies menu (beaker icon) on your chart, select Add Study, then Moving Averages (yes, you have plenty of choices), then SimpleMovingAvg. The SMA will be overlaid on the price chart. Right-click on the SMA, then select Edit Study SimpleMovingAvg. You can change several of the SMA inputs, but we’ll keep it simple and change the length of the SMA from nine to 50 (see figure 2). This makes it a little easier to see which way prices are moving. If prices are above the 50-day SMA (blue line), generally prices are moving up. If they’re below the 50-day SMA, generally the trend is down.

Next, add a lower indicator (lower pane) to determine the strength of the trend. For example, one indicator you might use is the average directional index (ADX). Add the indicator using the same steps you used for the SMA. Generally, a rising ADX indicates a strengthening trend, whereas a falling ADX indicates a slowing trend. Think of the 20 and 40 levels as the thresholds. If the ADX is below 20, the trend may be weak. If it’s between 20 and 40, the trend may be strong, and if ADX is above 40, the trend could be extreme.

If you’ve decided to trade this particular stock, when should you get in and out of a trade? On the chart in figure 2, prices are above the 50-day SMA, and the ADX indicates the trend is starting to strengthen. Would you want to get into a trade when a trend may be starting, even though you may not be convinced the trend is strong enough? The trend could continue its bullish move and get stronger. It could also pull back. The 50-day SMA has acted as a support level in the past. Although there’s no guarantee that will occur again, you could wait and see if price pulls back to that level before resuming an uptrend.

Still having a hard time deciding? Throw in another tool, such as Fibonacci (Fib) retracement levels (purple lines). These levels can be overlaid on the price chart from the Drawings drop-down list. Select Drawing Tools, then Fibonacci retracements (% icon). Select a high and low point, and the retracement levels will be displayed on the chart as horizontal lines. The 50-day SMA is approaching the 23.6% Fib retracement level, which could end up being a possible support level. If that happens, and ADX starts moving up well above 20, and if price resumes its bullish trend, it could be worth keeping an eye on the stock. No indicator, or set of indicators, is going to work all the time. But it may be worth going through a handful of stocks in your scan results and finding three to five indicators that aren’t redundant and work well together. Once you’ve got your charts set up, answer a few relevant questions, such as:

• Is the stock clearly trading above or below the SMA?
• Is the ADX indicating the trend is strong, that is, moving up?
• Do the Fib retracement levels suggest price is approaching a possible support or resistance level?

There’s no guarantee a trend will continue. But if you answer “yes” to these three questions, it’s likely you may have filtered out a stock or two that could be right in the heart of a bullish or bearish run.

If only choosing ice cream flavors could be this methodical.