Analyzing and interpreting stock charts may look very daunting at the onset. Obscure lines, various timeframes, candles moving up and down, hundreds of indicators. All of these can be interpreted many ways depending on what a trader is looking for. However, for the average trader, there is a simpler method to this madness.
To help illustrate it better, think of the entire stock chart as a road map. Every chart candle is part of an intricate road network that can only be navigated through the use of chart patterns and signals so you can safely reach your desired destination.
Chart patterns is the route. It shows you how far you can go in the chart. In short, it provides you a Range. A Range shows your potential profit should the chart move according to your analysis. As you navigate through these chart patterns, you need a reliable way to tell you when to go, stop or wait, otherwise, you may end up in an accident. No one wants that. So, we have in technical analysis what we call as Trade Signals to be able to tell the right time to buy, sell or hold a stock.
In this post, we will be providing a basic overview on how you can generate, interpret and respond to Trade Signals for better trade performance.
What are Trade Signals?
A Trade Signal is a specific technical set up in the chart that tells a trader when to buy, sell or cut losses. This technical setup is usually generated by a combination of technical indicators, candle formations and volume.
Traders always have specific trade signals they are looking for within a chart pattern. This is the timing component of their strategy that allows them to accurately gauge the best point of entry and exit in order to land a profit.
Types of Trade Signals
Trade signals can be grouped as either Bullish or Bearish.
Bullish signals generate the Buy/Entry signal while Bearish signals generate the Sell/Exit signal. These are incorporated to every Trade Plan to be able to aid the trader in assessing the proper time to buy and sell stocks for every specific chart pattern.
These signals are combinations of indicator setups and candle formations that are validated by above average volume.
Here are some basic trade signals to watch out for:
Disclaimer: Note that there are dozens of other trade signals available and this post will only show basic variations that commonly appear on almost all trade setups.
A. moving average (MA) Crossovers
A Moving Average Crossover is illustrated in the chart as two different moving average lines crossing over one another. A Crossover can either be a bullish or bearish signal.
Bullish MA Crossover (Buy Signal)
A shorter time frame MA is crossing above a longer time frame MA
Bearish MA Crossover (Sell Signal)
A shorter time frame MA is crossing below a longer time frame MA
The most prominent MA Crossover is the Golden Cross and the Death Cross.
B. moRNING AND EVENING STAR CANDLES
Morning and Evening Stars are doji candlesticks that usually form at the support and resistance range of chart patterns.
(Similar candle formations that can be used as trade signals are Hammer & Hanging Man, Shooting Star & Inverted Hammer, Spinning Tops, among many others.)
A Morning star usually appears at the bottom of a downtrend or at a key support range in the chart. This signals that sellers are exhausted and buyers are starting to take control. This is validated when the next candle is a higher high candle.
The Morning star is a buy signal
An Evening star usually appears at the top of an uptrend or at a key resistance range in the chart. This signals that buyers are losing momentum and sellers are starting to take control. This is validated when the next candle is a lower high candle.
The Evening star is a sell signal
C. Relative Strength Index (RSI) OVERBOUGHT AND OVERSOLD
The Relative Strength Indicator (RSI) is the most common indicator used to determine overbought and oversold conditions in the price chart.
The classic interpretation of RSI is that price is due for a trend reversal from an uptrend when it reaches 70 and is bound to reverse from a downtrend when it reaches 30. This however varies from different chart setups and must be validated by volume and other technical indicators as necessary.
For the most part, the RSI is used to generate buy or sell signals when it lines up alongside price action patterns on key levels. We'll outline some of these signals later to illustrate it better.
It is important to note that the RSI can stay for extended periods of time in the Overbought level during a strong uptrend and can stay for prolonged periods in the Oversold level during a downtrend.
A price bounce below or at RSI30 is a buy signal when paired with other bullish signals and patterns.
A price rejection above or at RSI70 is a sell signal when paired with other bearish signals and patterns.
D. DIVERGENCES
There are two types of divergences. A Bullish Divergence and Bearish Divergence. When used in conjunction with other technical signals, it becomes an accurate tool to enter and exit stocks especially in the short term time frame.
A Bullish Divergence is illustrated in the chart when the RSI starts to make a new higher low while the price of the stock is establishing a new lower low. This signifies weakening selling pressure that might result to an uptrend shift.
The Bullish Divergence is a buy signal
A Bearish Divergence is illustrated in the chart when the RSI starts to make a new lower high while the price of the stock is establishing a new higher high. This signifies weakening buying pressure that might result to a downtrend shift.
The Bearish Divergence is a sell signal
E. Breakouts and Breakdowns with above average volume
Breakout with above average volume (Buy on breakout signal)
A valid price breakout above a key resistance level must ALWAYS be accompanied by above average volume. This is important because resistance levels tend to harbor a lot of sellers. To be able to absorb all the profit taking at resistance and sustain the breakout move higher, buying volume must heavily outweigh the selling volume.
Breakdown with above average volume (Sell or cutloss signal)
A valid price breakdown below a key support level must ALWAYS be accompanied by above average volume. When a breakdown is validated by a surge in selling volume, this points to a potential shift to a downtrend. Key support levels harbor a lot of buyers. In order for the price to dive further, selling volume has to heavily outweigh the amount of buyers.
Trade Signals and your Trade Plan
Trade Signals serve as the timing component of any Trade Plan. However, it is important to remember that every trader has a different trade plan than others. Some are doing a long term position trade while others are actively trading short term setups. As such, trade signals will vary depending on the time horizon and trade pattern of a specific setup.
To illustrate, here are some examples of chart pattern setups with identified trade signals:
Short Term Chart Pattern with identified trade signals
Chart Pattern Structure: Breakout from base formation
Range: 15% - 18%
Trade Signals:
Buy:
Morning star candle forming at key support
Breakout with above average volume
Price bounce at key support
Sell:
Evening star candle
RSI rejection above 70 (overbought)
Price rejection at key resistance
MEDIUM Term Chart Pattern with identified trade signals
Chart Pattern Structure: Trend Reversal (Downtrend to Uptrend)
Range: 50%
Trade Signals:
Buy:
Morning star candle forming at key support
RSI bounce below 30 (oversold)
Price bounce at key support
EMA9-MA20 bullish crossover
Trendline breakout with above average volume
Sell:
RSI rejection above 70 (overbought)
Bearish divergence
In a Nutshell
Trade Signals are the timing component of your Trade Plan. It will tell you when to buy, sell, hold and cut your positions. It is an objective source of information that appropriately allows you to respond to the market at the right time. As such, properly plotting and analyzing chart patterns and responding to trade signals allow you to execute your trade plan with confidence. That is the way of a profitable trader.
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