Many new traders ask, “Does technical analysis really work?” This question is debated by seasoned professionals, too. I want to share with you what I’ve learned over the years.
Generally speaking, most investors fall into two camps when it comes to analyzing stocks: fundamental analysis and technical analysis. Some use a combination of both, which I believe is the best approach, and I’ll explain why.
*Sara wrote a great article on finding the value of a stock.
1. Fundamental analysis examines the health of a company using balance sheet data, revenue projection models and just plain common sense.
A fundamental analyst might say, “I’m buying XYZ because they have little debt, great cash flow and big profit margins, and everyone around the world seems to love their widgets more and more every day.”
Pros
- Most of us agree with this thinking and can gather the data fairly easily.
- It is generally a smart practice to invest in a company with sound financials that is witnessing material revenue growth.
Cons
- The problem with fundamental analysis is that you are still making predictions about the future that may not come true.
- Fundamental analysis can be a lengthy, complex process.
- Remember that even if a stock looks financially healthy and is relatively cheap compared to its peers, that doesn’t mean that it will always rise in value. A stock’s price is also determined by the supply and demand of its shares.
- Cisco Systems, Inc. (CSCO:NASDAQ) and Research in Motion Limited (RIMM:NASDAQ) are examples of stocks that are financially stable but have not been performing well as of late.
2. Technical analysis looks at a chart of a stock’s price movements. Analysts look for patterns to determine future movements in the stock. There are hundreds of “indicators” that can help find buy or sell points, or price trends and momentum.
Indicators have been created by investors over the years. They take the data in the chart and apply a mathematical formula. This produces a line, dot, band or other visual cue for the analyst to interpret.
A technical analyst might say, “I’m buying XYZ because the stock price is above its 50- and 200-day moving averages and has strong momentum at the moment.”
Pros
- Patterns in price and volume can help us identify trends. They can also find price levels where investors tend to buy or sell.
- This analysis goes quickly once you know and understand the indicators you want to use.
- Technical analysis can help you rationalize the price you are paying. In other words, if you researched a company and simply bought it without looking at a chart, you have no way of knowing where the stock is in relation to its past.
Would you want to buy a stock that is at an all-time high and has just risen over 40% in the past month? What if you then looked at a chart and noticed that it had done that three times in the past, and that each time it hit a new high it then sold off 20%?
Cons
- There is an overwhelming amount of different indicators out there. It is tough to find the ones that are most effective for your style of trading.
- It takes skill and experience to identify trends and patterns.
What technical indicators should you use?
There are dozens of different technical indicators to choose from. Some are better than others.
I suggest that you focus on some of the more commonly used ones for your strategy. I believe that basic indicators, followed by many investors, are more reliable than more obscure methods.
Such common indicators include moving averages, volume, Fibonacci levels, Bollinger Bands, trend lines, ATR, MACD and Stochastics.
Take a look at this chart. On it you’ll find some of these indicators. The moving averages are the green, orange and red lines in the top section. Bollinger bands are the gray area, also in the top section. Trend lines are the parallel lines drawn in black.
Under the top section, you’ll find MACD — moving average convergence divergence (which we explained here). Next is stochastics, followed by ATR — average true range.
It might sound confusing, but these indicators each tell us something about how the S&P 500 Index moves. That can help us make decisions about where it might move next.
Typical chart set-up with the indicators mentioned below
*My book “Your Options Handbook” contains details about all of these indicators and how to use them.
If you are simply going to apply technical analysis on one stock, it’s a good idea to make sure the basic fundamentals of the company are sound, and that the big-picture data on the economy supports your idea before you jump in.
Hints and Tricks
Support and resistance levels give us price ranges to enter or exit a stock. Sometimes it helps to draw a trend line (like the one in black above) to find those levels.
Average True Range (ATR) and volatility help us measure how much a stock “normally” moves and if it is behaving oddly. This indicator may be either showing you an opportunity or warning you that there might be an underlying problem.
Moving averages help identify trends. A simple technique is to make sure a stock is above its 50- and 200-day moving averages if you are going long. On the chart above, these are the orange and red lines. Once the stock price gets below the 50-day moving average, it may be time to sell.
Summary
I believe that technical analysis works mainly because so many people believe in it and use it. It almost becomes a self-fulfilling prophecy.
It has been used in some form or fashion for thousands of years, dating all the way back to Chinese rice farmers. The patterns and indicators sometimes seem unusual, but amazingly, many still manage to find their way into a stock’s chart. You would be amazed at what pops up.
Use a combination of both types of analysis. You would be foolish to omit one or the other.
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