Stock Charting 101: Even Investors Can Use Technical Analysis

Welcome to the first day of Charting 101, Class. We’ll touch on the theory of reading market momentum.

Wall Street pioneer Charles Dow once said that when it comes to markets, “What is more important than Why.”¹

The What emerges from the chart points and lines that traders use to track whatever market or markets they need a little history on. The goal of course is to decide if you see an indication of what might be coming next.

Traders are sometimes placed (or put themselves) in two camps:

1. FUNDAMENTAL TRADERS: those that follow fundamental analysis (such as company earnings, valuation, revenue growth, and other financial metrics).
   
   

2. TECHNICAL TRADERS: those that follow technical analysis (historical stock prices and momentum indicators).

There’s another way to divide the two: fundamental disciples typically focus on the long term. Technicians focus on shorter-term position trading in what they see as trending stocks. Technicians don’t necessarily dismiss fundamental analysis entirely. Rather, they assume that everything fundamentally known about a security at that moment is already discounted in its price. In reality, most traders probably straddle the line between the two.

The main premise of technical analysis is that collective group behavior tends to reveal itself when a stock reaches an important point in its price history. These attitudes towards stock price events appear as relatively familiar cycles and patterns that can be used to help traders make their decisions of the future momentum and direction of a security. In other words, charting ought to work better than guessing.

Connect The Dots

While price charts provide the patterns, the individual technical indicators that emerge from those patterns signal the entry and exit points for potential trades. Technicians learn to watch for cycles. They can look back at the behavior of other traders through the price action of charts during certain events or seasons of the year and develop a strategy.

Ultimately, a trader is looking to connect higher highs and higher lows (closing or intraday levels depending on your timeframe) to determine potentially bullish trends. Or, they look to connect lower highs and lower lows for potentially bearish trends. Then there’s volume, particularly as it relates to momentum and potential breakouts, which occur when a stock price breaks above or below a trendline. At its simplest, the stronger the volume behind a move, the more convincing that move may be.

There are charting indicators that help traders build a more complete picture as well. One group of indicators, known as “oscillators” typically measures current stock performance relative to past performance. You’ll hear terms like relative strength index (RSI), moving average convergence divergence (MACD), and Stochastics tossed around, which all fall in the family of oscillators. For the moment, it’s not important to know what each one of these indicators does specifically. What’s important is that they attempt to create a more complete picture as to where a stock sits in a trend and how much steam it might have left. Of course, before you use any of these, or other, indicators in your own trading, it’s important to know both what the indicator purports to depict, and your own opinion of the indicator.

(Don’t worry if you don’t understand MACD and Stochastics at this point. We’ll tackle these concepts one at a time in upcoming editions of “The Chartist.”)

Pick (and Stick) To A Plan

Keep in mind that chart-watching is just one part of a larger trading plan. Many traders potentially fail because they did not develop a trading system or use consistent methodology. A system might achieve two things:

1. ENTRY AND EXIT RULES These allow traders to decide potential opportunities that are consistent with their own personal criteria rather than merely using guesswork. Through the study and use of charts and price behavior, a technical trader can implement their own personal trading plan, which will emphasize a consistent, non-emotional set of criteria defining the types of trades they will look for. A disciplined trader adheres to their own plan, viewing a potential trade through the lens of these very personal, non-emotional, and clear entry and exit signal trading rules.
   
   

2. RISK MANAGEMENT PLAN A personal trading plan contains a risk management plan by which a single trade or series of related trades will not create a loss so great that it could do great harm to the trader. You keep risk in line by not deciding to risk a little bit more “this time.” Disciplined traders decide the maximum amount of capital to be risked on each trade, and also take proactive measures to potentially manage their risk should that trade go bad.

It’s your money, your goal set, your risk tolerance, and regardless of whether it’s a good or bad idea, it’s your decision. What technical analysis boils down to: if you’re eyeballing the stock of a cement company that you predict will grow at 30% a year for the next five years, depending on your risk profile. Perhaps that’s enough for you to decide to buy some shares and stick it in your IRA. However, if you’re shooting for smaller profits (and hopefully even smaller losses) on the day-to-day fluctuations of a stock, fundamental analysis alone isn’t going to help you much. Typically, short-term price swings may be based more on emotions, recent news, the overall market’s direction, and even randomness, than on balance sheets. At least, that’s how technical traders see it.

That’s not to dismiss the importance of fundamentals in the short term or technicals for the long term. It’s mostly about time horizons. The longer you plan to hold a stock, the more important the fundamentals become. The shorter the time frame, the more the technical trader says charts and momentum matter. Emotions show up in the charts, as do the latest earnings, and trading activity. So the more you understand that data will constantly impact the price, the more you can appreciate that learning at least a little bit of technical analysis for any trading style may be worth your time.

1 Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today: Charles Dow, Richard Russell, et al. (W&A Publishing, 2009)