Using Technical Analysis For Day Trading

Based on reader’s request, we are writing a follow up to our previous post (Common Mistakes Retail Investors Should Avoid) and this time we want to talk about what to consider while using technical analysis for day trading. There are many rules and techniques but we’ll talk about the best practices while applying technical analysis. Professor Aswath Damodaran from NYU has written a beautiful paper on this topic and you can see the empirical evidence in his paper for the points mentioned below.

If you decide to use a charting pattern or technical indicator, you need to be aware of the investor behavior that gives rise to its success. You can modify or abandon the indicator if the underlying behavior changes. This is particularly useful if you have not spent a significant time understanding how irrational market can get at times. To avoid big losses, use your intuition along with technical analysis and keep a close eye on the market movement.
It is important that you back-test your indicator to ensure that it delivers the returns that are promised. While running these tests, you should pay particular attention to the volatility in performance over time and how sensitive the returns are to the holding periods. Holding period is very critical to the results of your test.
The excess returns on many of the strategies depend upon timely trading. To succeed at your strategies, you may need to monitor prices continuously, looking for the patterns that would trigger trading.
Success at charting can be very sensitive to how long you hold an investment. Having a strategy to exit trades per predetermined levels is very important. It’ll help keep the human emotions out and make you a winner in longer run.
The strategies that come from technical indicators are generally short-term strategies that require frequent and timely trading. These strategies also generate large trading costs that can very quickly eat into any excess returns you may have. Be conscious of the transaction costs per trade. Automated trading could be a big disaster if you don’t take into account the effect of transaction costs.