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An Introduction To Technical Analysis
Technical analysis has been around since the beginning of the financial markets. For as long as there has been historical price data, human nature has looked for patterns within that information to derive some indication of future results. During the 18th Century, Homma Munehisa began to develop techniques that evolved into what is known as today’s Japanese candlestick charting method. In the late 1800s - early 1900s, Charles Dow wrote a series of editorial pieces for the Wall Street Journal, the paper he founded. He was the first editor. After his death, 255 of his editorials were organized into what is now known as the Dow Theory. At this point, there is a plethora of different technical indicators. Sometimes traders or investors will focus on one specific theory like the Elliot Wave. But, more often than not, market technicians, as they are known, will overlay a couple of different indicators to form their analysis.
The most basic form of technical analysis is support and resistance levels. These can be determined by looking at the historical price chart of any security. Support lines are created by drawing a trend line on a chart from one low point, to the next lowest point. Conversely, resistance lines are created by drawing a trend line from one high point to the next highest point in a chart. (See graph of General Electric (GE - Free General Electric Stock Report), daily chart for the past 10 months).
When we draw a support line from the low experienced in September 2010, to the low at the end of November, 2010, and extend that line to the present day, it is possible to see how that line has become a support level for the stock’s most recent downturn in June. Conversely, we draw a trend line from the high experienced in mid-September to the high in mid-October and extend that line forward, this represents potential resistance. That resistance was hit in mid-February, and GE’s price has declined ever since.
Trend lines are much like any other investment analysis tool; they will not always work. Also, they need to be continually updated as the graph grows with successive trading days. But, with some practice, they can be an asset that provides valuable insight into where a stock’s price may be headed. If we knew that GE was approaching resistance in mid-February, once the stock began its decline, we could have reduced our position. Conversely, if GE broke through that resistance line, that would have been a solid bullish signal. We would probably want to be patient, as prior resistance levels usually become future support levels. There is a good possibility that we would have had an opportunity to add to our initial position somewhere near that previous resistance level.
However, as we can see, the reality of the situation is that GE was met by resistance, and then continued to decline. Reducing the position would have locked in some profits, but left us with the bulk of our investment intact. If the stock reversed and continued to climb, we would not miss the boat entirely. Of course, you may be asking, now what? Moving averages can also be a valuable tool in assessing an entry or exit point on a stock.
A moving averages is just that; it is a trend line that is calculated by computing the moving average during some specified time period.The 50-day moving average and the 200-day moving average are two very popular time frames. The 50-day trend line is the red (longer) line on the chart above. It can be used as a support and resistance line in conjunction with other technical indications. Going back to the previous example, GE has met resistance and we trimmed our position. Now, if our technical system incorporated moving averages, we can see that GE found momentary support on the 50-day moving average in early-to-mid March. If the stock falls below that trend line, we would look to sell a portion of the original position. And consequently, these actions locked in profits on the remaining position. The assumption being, that we never want to fully sell out of the position, if we like it because of the company’s solid underlying fundamentals. However, there is no reason to just buy-and-hold it, and not try to maximize profit potential.
For the next few months from March to May, GE pretty much traded right around its 50-day moving average. In June, it started to decline, and continued to do so until it found support on its 200-day moving average. This trend line also coincides with the original support line derived from the lows experienced in September and November. At this point, the investor may be looking to start adding to the position again. And that may be a prudent move assuming those support levels are held. If they are broken, it may be wise to sell the remaining position, and await some sort of bottoming out in the stock.
At this point, we can revert back to fundamental analysis to determine whether we want to continue holding the equity at all. GE is trading at a relatively low multiple to book value. And with that figure hovering around $11.64 per share (as of March 31, 2011), we would not expect the stock to trade below that level for very long, as value-seeking investors would likely step in, and drive the price higher.
However, assuming the support levels do hold, it may be wise to buy back the full position, including the initially invested funds as well as the gains from the first round of trading. This way, the investor’s position size in increasing, and so will his/her return. And the entire process begins anew.
Although, technicians and fundamentalists typically do not see eye to eye, we think it may be possible to gain an investment edge by technically trading fundamentally sound equities. Even the most-staunch fundamentalist must acknowledge the fact that technical analysis does exist. And, as this process of trading becomes more widespread, it will become a bit of a self-fulfilling prophecy. So even if you do not want to use these tools to trade, it is a good idea to familiarize yourself with them.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.