Technical Analysis: A Key Component In Your Trading

While at a party recently, I had a conversation with a retired physician. An astute and very successful long-term stock investor for decades now, he had recently read one of my columns. This gentleman has been very successful with individual stocks for many years, basing his trades on fundamental decisions.

This started the wheels turning in my head. There are many successful investors out there who have never even heard of technical analysis, let alone utilized it in their trading decisions.

A Little History

While technical analysis has been around for hundreds of years [Japanese candlestick charting techniques is one of the oldest forms of technical analysis and evolved from methods utilized by 18th century rice traders], it is only been in recent decades that mainstream active traders have begun to study and implement the methodologies.

Many point to the day trading tech stock boom of the 1990s and the advent of the Internet and the personal computer as key factors, which opened the floodgates on this method of market analysis.

Looking back, in the 1960s and 1970s technical analysis was considered as reliable as tea leaves and the major Wall Street firms downplayed their reliance on that form of market analysis.

Technical analysts were virtually hidden in back research rooms. Some of the top technicians on Wall Street today have shared stories with me about how their firms, at that time, would rely on their analysis and recommendations, but present the ideas to clients under the guise of some fundamental factors.

It's Old

However, technical analysis has been practiced in the United States since the late 1880s, well before fundamental analysis took hold as a mainstream discipline. During those times, income statements and balance sheets were not as readily available as they are today. But, price, the foundation for technical analysis, was always available.

Remember tape reading? Early technicians were simply tape readers, or those who watched prices go up and down on the tape to identify support and resistance levels, points where demand and supply stall movement. Point and figure charting can be traced back to the 1880s, while it wasn't until the 1930s that fundamental analysis emerged as a market discipline.

What's the Premise Here?

For those who have spent their investing careers studying price/earnings ratios, quarterly profit reports, new product launches and management teams, technical analysis actually offers a respite from this type of study.

Technical traders and investors note that it is virtually impossible for an individual or even a research team to identify and understand every fundamental supply and demand factor in the marketplace.

Price Says It All

Price, both current price and historical price, encapsulates it all. That is where the market adage arises from: "It's all in the charts." The philosophy is that the current price of a stock, a commodity future, a foreign exchange rate, represents the immediate opinion within the marketplace of all players. In other words, all currently "known" fundamental information is priced into the current level of the financial instrument.

Key Principals

Technical analysis, very simply put, is the study of price and the history of price in an attempt to gauge current and future trends. The three underlying principles that drive technical theory are:

• All news is discounted in price.
• Price moves in a trend (sideways, up or down).
• History tends to repeat itself.

A Good Read

I'm reminded of a quote from a very popular trading lore book: Reminiscences of a Stock Operator by Edwin Lefevre: "The principles of successful stock speculation are based on the supposition that people will continue in the future to make the mistakes that they have made in the past." The demons of fear, greed and the herd mentality create some pretty interesting patterns on the charts.

Fear and Greed

Market bottoms tend to form during extreme periods of investor and trader fear, while market tops tend to develop amid times of extreme greed. Tops are created amid buying excesses. I don't need to remind investors of the bubble-top that burst so dramatically in the Nasdaq index in March 2000.

Many portfolios and retirement accounts were painfully decimated during the tech stock collapse. Human psychology really hasn't changed that much over the centuries. Markets move from greed at the top to fear at a bottom. Looking at a daily, weekly or monthly price chart may help remove some of the emotional factors, which are the culprit of so many trading and investing mistakes.

Read the Pictures

Pattern recognition, simply a visual read of a chart looking for specific formations can offer important insights to traders and investors. Patterns and formations, which repeat throughout markets, and throughout timeframes can offer traders and investors on clues on better entry and exit points.

TA Useful For Investors Too

For my retired physician friend, I have but one suggestion. Keep doing what you've been doing. You've been very successful at it. But, while technical analysis is generally the methodology of choice for intraday traders or even swing traders, it can be helpful for longer-term traders as well. How?

Long-term players generally rely on fundamental factors to initiate their positions. Fine. But, technical analysis can help one determine more profitable entry and exit points. I believe everyone who is investing or trading should become comfortable with looking at charts.

The starting point is trend. While many folks think in terms of either a bull or bear market there are actually three types of trend: an uptrend, a downtrend and a sideways or neutral trend, also called a consolidation move.

The simple definition of an uptrend is a series of higher highs and higher lows on whatever timeframe chart you are monitoring. The concept of trend is the foundation for many old market sayings, such as "the trend is your friend," or "don't buck the trend."

Find Pullbacks and Support Zones

If a long-term trader identifies a company they want to own. Take a look at a chart. It all goes down to the simple concept of buy low and sell high.

Markets don't move in straight lines. They consolidate they move up, they pull back and correct. They plummet occasionally on bad news and score a spike low before bargain hunters swoop in and push the stock price quickly back up to previous levels. The long-term investor doesn't want to pay up for his or her stock. No one wants to pay up for anything. It all comes down to timing and technical analysis can help you pinpoint more profitable entry zones.

Multiple Timeframes

It's worth looking at action on the chart on a monthly, weekly and daily timeframe before entering that buy order.

If the market is trending higher, connect the dots (the lower peaks on pullbacks): that is a trendline. When stocks are "correcting" or pulling back to a support trendline that can be a good spot to buy. Or has a stock been consolidating between readily identifiable support and resistance zones for months, say between $100 and $125?

If an investor wants to buy for the long-term, look for retreats to the bottom of a sideways consolidation zone near $100 for buying spots. You've heard the adage: add to your winners. Investors can play the breakout. Once the stock breaks out through the resistance level at $125, that could be a good time to add to your position as you are likely to catch a new upswing in a bull trend.

Taking Profits

Technical analysis also offers clear upside targets and price objectives. While the long-term buy and hold investor may not want or need to exit a trade. If there is a specific reason that one wants to take some full or partial profits and trim long exposure, technical analysis can help identify realistic price targets, which could signal the end of a trending move.

Going back to the simplistic example of the stock consolidating between $100 and $125. Months of sideways zig-zag trade occurs, with an upside breakout above $125. Investors can calculate a so-called "measured move" objective. Simply take the width of the consolidation zone (in this example: $25) and add it onto the breakout point ($125 + $25), which equals an upside price objective or target at $150. That price target can be a good spot to take profits, if one so desires.

Getting Started

Have I at least whetted your appetite to learn a bit more? There's no reason to spend a lot of money on seminars or software packages, there are a couple of important and basic books that can help an individual gain a basic introduction to the principles and concepts of technical analysis.

It's as easy as a visit to your local library. Two classics that I'd recommend as starting points are: Technical Analysis of Stock Trends by Robert Edwards and John Magee. Another comprehensive must-have title is Technical Analysis of the Financial Market by John Murphy. Have fun.