Whether a decision to trade comes from personal research or recommendations or tips from brokers or a research service, before placing any orders a prudent trader will always double check any ideas.
One way of doing this is to acquire two simple charts of the underlying investment you are interested in.
One should show recent performance on a daily basis over the last three to six months and the other the weekly performance over a number of years.
Behind this exercise is gaining an independent perspective of any suggestion. This perspective will give you an immediate idea where the investment is positioned.
For example, is the investment near a recent peak?
One of the risks many traders face in a market that is enjoying a rally is buying at or near the top.
Any chart examination can be enhanced by applying a moving average price line on top of the actual price line. The benefit of a moving average is a smoother price that acts as a trend indicator.
On a daily price chart the moving average line might be around 20 days. On a weekly chart it could be around 26 weeks. Most astute traders think twice being going against this trend.
If the trend line is pointing up, it is better to trade from the long side and if the line is pointing down, you either look to the short side or stand aside.
Another guide is what is described as an envelope to the moving average. This involves drawing two parallel lines to the moving average, one above and one below, which attempt to contain 90-to-95 per cent of the information. Envelopes are also called channels or bands.
These lines can illustrate the price range of the investment and provide a picture of the average limits of public bullishness or bearishness.
When prices move outside the range, it can suggest an over-excited market or an excessively gloomy one. In these circumstances, smart traders don't run with the crowd.
Two other slightly more sophisticated indicators that can be used to help assess a trading suggestion are the MACD and the stochastic.
The MACD — which stands for Moving Average Convergence Divergence — is another trend indicator. It is based on the ongoing difference between two moving averages — one long term and one short term.
It can be plotted in a histogram or graphic format which emphasises the peaks and troughs and can show who is in charge of the market — either bulls or bears — and just how strong their control is.
The stochastic is a technical tool which provides a guide to a market's momentum — defined as the speed of a particular trend. It does this by comparing the latest closing price to a trading range over a chosen period.
The idea is that where the trend is rising, prices tend to close near the high and when the trend is falling, prices close near the low. A stochastic can be used as a signal to either confirm a decision or a warning to take care.
