Charting Demystified: A Simple Guide To Technical Analysis
Sunday, June 06, 2004
In our May 5th edition, The Professional's Guide To Minimizing Losses, we talked extensively about investor psychology and why people make so many mistakes. The biggest and mostly costly error is making the decision to own a stock for all the wrong reasons. Readers know the SmallCap MarketWatch's creed of owning stocks that are catalyst based but let's recap.
We like to own companies that are trading at a significant discount to its competitors. This is referred to as a "value catalyst" because at some point the market realizes the valuation gap and start bidding up the stock because it looks "cheap" compared to peers. This philosophy has produced numerous winners for us in the past and will do so in the future.
The second reason for owning a stock is what we call an "event catalyst". That means we expect something to happen in the future that propels a company's valuation up because of a fundamental development. This is very tough to do on a consistent basis but it can be accomplished through due diligence and market savvy.
Once an idea passes muster the next step is to develop a game plan that outlines:
Setting an exit price if a stock moves down is in our opinion the most important piece of the puzzle. It is also the rule most ignored by investors. The next time you hear people talking about their latest and greatest stock pick ask them when they plan on selling. Chances are it's at a price significantly higher than where it was originally purchased. You will probably never hear that they would sell if it goes down because the thought never crosses their mind.
It is crucial to have convictions in your investment ideas. However, admitting that a mistake was made will preserve capital and save you tons of dough over the long run. We are not talking about buying or selling at each uptick or downtick here. When it comes to figuring out if an idea has gone bad, "value catalyst" ideas are the hardest to gauge. No one can predict when the market will decide to close valuation gap on a stock. The best course of action is to set the appropriate exit prices and to adhere to them closely.
Fortunately, "event catalyst" ideas are much simpler to deal with because there is a defined reason for owning the stock in the first place. The premise is that a fundamental development is expected to propel a company's valuation. When the development occurs it is time to sell because the catalyst has now occurred and there is no good reason to still be in the stock. However, sometimes a stock will run prior to the actual announcement and the "buy on rumor sell on news" effect occurs. So when is the best time to sell? The answer is at the price you are comfortable with. Remember that we all wish to buy at the low and sell at the high but let's be realistic.
Now that we have covered the basics it is time figure out how to use technical analysis in figuring out entry and exit points.
Basic Technical Analysis
There are so many technical indicators out there that it is impossible to keep track but today we are going to talk about just one them. The indicator we depend upon the most is the simple moving average (A simple, or arithmetic, moving average is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods) using the 50 day as well as the 200 day periods.
In many ways the 50 DMA and 200 DMA are self fulfilling prophesies. Their popularity has preprogrammed investors to use them as the main lines of support and resistance. Now, let's use these indicators in a real life example. Our favorite stock charting website is and is a distant second.
We always plug in any potential idea into stockchart.com and in this example the always volatile Priceline.com (PCLN) is shown.
There are many ways to interpret this chart and the following is our interpretation:
It is uncanny how the blue line (50 DMA) has been a constant support level while the red line (200 DMA) presents tremendous resistance. In April the channels began to tighten and the stock broke out of its 200 DMA resistance for the first time. The 200 DMA did not become a support level and the stock quickly headed south but again the 50 DMA provided support. The stock proceeded to break its 200 DMA twice more and formed a triple top which is considered extremely bearish. It made sense that the stock then moved lower as people began to give up but fortunately support was found at its March low of $22 and change. PCLN made a quick rebound into its 50 and 200 DMA trading range. As the moving averages converged the most common action is a breakout to the up or down side. In this case the stock moved higher and pierced its triple top.
It is evident in this example how the moving averages play an integral part of Priceline.com's chart. This seems to be the case in many stocks from our experience. Why is it that the 50 DMA and 200 DMA are so effective?
Charts & The Mind
The 50 DMA and 200 DMA are tools to help people gauge what others paid for their stock. They present price points where people may decide to enter or exit their positions. Let's think about why moving averages make such good support and resistance levels. Whenever a stock moves down and hits a support level whether it is the 50 DMA or 200 DMA the chart basically asks investors if they are going to bail or if they will stick it out. Human nature dictates that people hate admitting mistakes and selling would constitute admitting that the investment was a loser. Thus, many view support as an opportunity to buy and resistance as an opportunity to sell.
Resistance levels are tough to penetrate and for good reason. There are owners of the stock at higher levels that may look at the stock's advance as an opportunity to cut losses. A stock swoons and investors write off the company as a stinker or perhaps as a tax loss to be sold later. Then one day the stock comes roaring back and the first reaction of the shareholder is to sell because the advance is viewed more as a gift.
The stock market is entwined with our psyche because it is our decision on when to buy and sell that means everything. Except for those people that have incredibly bad luck, chances are good that after a person buys a stock at some point it will be at a higher price. Unfortunately, it may also move lower than the purchase price as well. At the end of the day a profit or loss is determined by the person's decision on when to sell. Yes, the fundamentals of a company matter but the stock market is a living being that does whatever it wants with zero consideration for its players. Emotion causes stocks to be overly bullish and overly bearish. When this happens the market provides the greatest opportunities.
Conclusion
It's always easy to interpret charts because they are a glimpse of the past and in hindsight no one is ever wrong. However, to just buy or sell any stock without taking a peak at its chart is a mistake. This is not to say that charts alone can create winning ideas. On the contrary we would never enter a position just because the chart looks good. Those from the school of technical analysis will certainly disagree.
Our method is to find the company first then check the chart and this has proven to be a formula for success. Not all of the ideas we present turn out to be winners but the key is to be right more than wrong. When it comes to investing that is the magic formula.