Investing - Part II

Technical Analysis

All righty then. It's time for post #2 titled Technical Analysis or "I really hate creating a business plan for work from scratch today."

Those of you who are looking for a great detailed thesis on tech analysis will probably be disappointed. My approach to tech analysis, like the one I have for fundamental analysis, is to keep it simple. There won't be any discussion of Fanucci Fans or anything like that, just simple, but effective tech analysis that anyone, with a little study, can apply.

Most traders that I used to talk to did not use technical analysis. They were scared of it. They thought that it would have be complex, involving something like taking the third derivative of the sine wave of the exponentially weighted moving average for the last sixty days. Most brokers fear technical analysis for the same reason - that's why you can ask about it and the canned answer will always be "You can't get anything from reading the charts. They only tell you where a stock has been, not where it is going."

And to a point, they're right. The old standard brokerage line of "Past performance is no guarantee of future results" is true.

The whole concept behind technical analysis (sometimes also called charting) is that history does repeat itself. Not all the time, but in many, many cases, it will. Tech analysis is designed to try to put the odds more in your favor.

So where do we start? The first thing to do (and the one that a lot of clients absolutely refused to do) is to pull up a chart. Go to http://www.bigcharts.com (many brokerage firms also make online charting available through their sites) and pull up just the simple, default chart on a stock.

Just from this simple chart we can already identify the most basic, and one of the most important, pieces of analysis. Draw a line connecting any two points on the chart. Congratulations, you have just drawn a trendline. If it is rising from left to right, you're in an uptrend. If it's falling, you're in a downtrend. That was easy, huh?

Why is the trend important? It's an old axiom, the trend is your friend. Market psychology is such that once a trend is in place, it tends to stay in place until something significant changes. If you're looking at buying a stock that's in a downtrend, you need to make sure that you have a solid reason as to why you think that the downtrend is being broken. Same if you sell a stock in an uptrend. What is making you believe that the trend is about to break? If you can't answer the question without hesitation, then you may want to reconsider the buy or sell until you've had more time to figure out why you want to make that move.

But can you tell that a trend is about to change or reverse? In many cases you can. To do so we need to look at a few other simple to apply indicators.

I would always start by looking at the moving averages. Simply put the moving average is the mean of the prices of a given period of time. Most of the time I would use the 10, 50, and 200 day moving averages in conjunction with one another. When we superimpose the three moving averages on top of the price chart, we immediately notice that the prices and the ten day average track very, very closely. The fifty day average is usually a bit off of the price range, but it still gives a general feel for the gyrations of the stock. The 200 day average you'll notice will be very close to a long term trend line.

So how is the moving average useful? Sometimes it gives a better picture of the actual movements of a volatile stock. But mostly, it gains use through the law of large numbers. The law simply states that large numbers tend to deviate towards the mean. Your moving average is a mean. So the law tells us that eventually the price of the stock and the moving average are going to converge.

This is where most people failed in their moving average analysis. They would understand the law and its implications. So if they saw a stock that was trading above its moving average, they would automatically assume that a sell order was needed, as the price had to drop in order for the MA and the price to converge.

Remember, the moving average moves. If a stock is above the MA its price can either move sideways, or the sharpness of the trend decrease, and the MA will begin to converge with the price. In other words, it is entirely possible for a stock to converge with its moving average, without ever dropping in price. So being above the moving average doesn't necessarily indicate a sell signal (the opposite is also true, a stock below the MA doesn't automatically trigger a buy signal either).

So how can we use the moving averages? They can indicate situations where a particular stock is too far removed from its MA, which would indicate that the angle of the trend will need to decrease or possibly reverse in order to satisfy the law of large numbers.

So now we've identified that a stock is in a particular trend and that the moving averages are showing it getting too far ahead of itself, what can we use to tell if it is ready to make a reversal or if the trend is just simply likely to moderate, but continue? This is where we get into the semi-scary part (for most people) of technical analysis. We now would want to use oscillating indicators.

Oscillators are indicators that factor in prices, volume and time to create derivative indicators. One of the most popular oscillators out there is RSI, or the Relative Strength Indicator. It essentially consists of a horizontal line graph with two parallels, one usually at 20 or 30, the other at 70 or 80. If the graph is over the top parallel, it usually indicates an overbought position, below the bottom parallel is supposed to indicate oversold. This isn't set in stone as a stock making a breakout from a trading range can sometimes show overbought or oversold for days or even weeks on end with no real effect on the performance of the stock.

So we tend to use RSI and another oscillator, the Williams percentage of %R, in conjunction with one another. We would always stack them one above the other, with the RSI on one line, %R on the line below. What we would then look for is when the moving average indicated the something might be up, we would look to the oscillators for confirmation. If the RSI and %R lines were converging, that could be a confirmation of a bullish signal. Conversely, if they were widely separated, that could confirm an impending decline in the stock price. A convergence or divergence without an indication from the moving averages, usually meant nothing, just as an indication without confirmation usually meant that there would be a moderation in the rate of change in the price of the stock.

These indicators all work together to provide a more complete picture, but even now we're not quite there.

A moment ago, I mentioned trading ranges. What is a trading range and how do find out what it is?

Simply put a trading range is the invisible boundary created by the trend. To see the trading range you want to use two parallel lines to connect most of the high points and most of the lows that the stock has traded at recently. You'll notice that the longer term trends tend to be in the same direction as the trading range.

What the trading range is showing you are the points at which the stock encounters resistance on the upside, and where it reaches support on the downside. In other words you have large positions wanting to trade at those prices and that tends to hold the stock in that range.

A breakout occurs when trading wipes out those large positions and the stock begins to move past the resistance or support point. If the move is sustained, the stock will eventually form a new trading range, either higher or lower than the current one.

Easy to profit from that, right? Just look for the stock to pass through one of the parallel lines and buy if it's going up, sell if it's going down. Can't miss right?

Wrong. Stocks like to test the limits, and even to push a little past them, before withdrawing back into the same comfortable range. So how can we tell if this is a real breakout or just a testing?

We use the moving averages, the trend, the RSI and the %R to tell us whether or not the move could have any strength behind it. We then give it a day or two to confirm that it is a true breakout. A couple of days of trading outside the trading range is usually a pretty good indicator that a new range is being set.

Why do we want to wait for that confirmation? Why not just take advantage of the situation as soon as it presents itself? After all, investing is all about maximizing profits, right? There is a saying in NASCAR, sometimes you have to go slow to go fast. The same holds true in investing. Sometimes giving up a little on each successful trade will save you from making numerous poor trades.

So there you have it, technical analysis made somewhat simple. I used to work with and talk to some of the best technicians you see on CNBC or MSNBC. Even with all their fancy formulas, theories, and ideas nearly every recommendation they came out with was based on one of these simple concepts. They might use candlesticks; they might use some other indicator, but they always had these.

To form the picture you want to look at these in the proper light. Nothing in the technicals is absolute. Fundamental changes in the company will always trump what the charts indicate - that was the main reason that I saw pure technicians fail, they wouldn't even begin to think about the fundamentals of a company.

Look at the trend first - long, short and intermediate term. The trend is the most influential of all the technical indicators. The trend truly is your friend.

Then look at your moving averages and oscillating indicators to see if there might be a technical reason for the trend to break.

Finally, look at your trading range. Try to identify confirmed opportunities with respect to the range (remember the goal is to buy low, sell high - in either order. You can do that even if stuck in a range, provided the range is big enough.)

Properly analyzed, the technicals will help to identify better entry and exit point for stocks that have passed your fundamental analysis.

Remember, nothing is assured in the market, before investing, you simply want to stack the odds as much in your favor as you can. A technical analysis of a stock is every bit a useful and necessary as a fundamental analysis. Don't hurt yourself by ignoring either.

And an aside for those who would comment that they only trade, they don't invest so they have no need to look at the fundamentals. I have seen people trying to trade without fundamental analysis. I saw them buy Enron the day before it went Chapter 11. Every December I'd talk to traders who got stuck with positions in companies that quit trading altogether before they unwound their position. Fundamentals can effect even a 5 minute trade. Believe me, I've seen it happen. Use all your tools, you owe it to yourself. Even if your fundamental analysis consists of only reading the news.

Resources:
Bigcharts.com - free interactive online charting
Equis.com - excellent for technical analysis term definitions

I also found two blogs that do a very good job of looking at the market through the eyes of a technician:
Trader Mike
Eminiblog

I'll try to get some sample charts up later tonight when I get to a computer with a real connection. Can't promise anything, though.

OK the charts are up! It wasn't as easy to find a good example as I had hoped, but we've got something to try to graphically show what I've been rambling on about.

To get straight to the other sections:

Part I - Fundamental Analysis

Part III - Options

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VI - Mutual Funds

Part VII - Asset Allocation

Part VIII - Bonds