Technical Analysis Trading for Quick Profits

"The trend is your friend."

"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble. . .to give way to hope, fear and greed."

                                                                        -Benjamin Graham

Fundamentals are the focus of my successful approach to investing in small-cap stocks. Ultimately, it is the fundamentals that determine the long-term direction of a stock. But long-term growth and strong fundamentals alone don't assure successful investments though. As with most things in life, timing is everything when it comes to investing. Fundamental research must be complimented by technical analysis, a useful tool for determining the ideal time for buying or selling a stock.

*****One simplified way to think about it is: fundamental analysis helps you decide what to buy; technical analysis helps you decide when. 

Today, we'll briefly examine some of the basic technical theories and principles.

In the time before the Internet, technical analysis was a cumbersome process because it demanded constant monitoring of a stock's price and volume, as well as calculation of moving averages and other metrics. Historically, technical analysis was not available to the average investor. However, technical analysis has been reborn due to automatic calculation of stock charts, multiple moving averages, instant calculation of even the most complex formulas, and—most important of all—simple and inexpensive access to streaming quotes. All of these are essential, and the good news is that today, even an amateur technician has a stream of data that would make the best-heeled technician of just 25 years ago green with envy. If you have a personal computer and an internet connection, everything you need to perform technical analysis is at your fingertips. 

*****Many technical analysts, known as technicians, believe that price and volume are the whole story, that tracking price action anticipates and foretells the next price direction. There is a degree of truth to this belief, and I urge everyone to employ technical indicators. Technical analysis can become a self-fulfilling prophecy, with every trader examining the same charts, looking at the same movements and trends, and making the same trades as a result. This is the case now more than ever, with increasingly popular program trading by institutional investors. But rather than using technical analysis exclusively, I know a combination of fundamental and technical tests makes the most sense and yields the best returns.

Even if you are dedicated to the study of the fundamentals, a range of technical indicators is valuable. These indicators serve as a means for quantifying market risk, confirming what the fundamentals reveal, and signaling a change in the current trend.

For the uninitiated, technical analysis seems to be more like magic than a useful system of patterns, trends and charting methods. Neophyte investors tend to associate technical investment philosophy with high-flying, risk-taking day-traders – making huge profits on tiny market fluctuations – and sometimes losing it all when a trade goes the wrong way. 

And while that's certainly true for a small segment of technicians, the truth is that basic technical analysis has a part in anyone's investment strategy – even long-term buy-and-hold types can benefit. After all, the difference between a successful investor and an unsuccessful one is sometimes just a few percentage points. 

I know that's a big claim. All you hear from the buy-and-hold crowd is to simply buy-and-hold and that trying to second guess or time the market is a fool's errand. Many mutual fund managers wouldn't be doing their job if they didn't tell 401(k) investors to simply pile a chunk of their paycheck into their fund every month. 

*****Technical analysis simply says, "The stock market isn't random. It behaves in very predictable patterns – documented by trillions of transactions over a period of more than 100 years."

There are plenty of big-picture technical indicators that can help people decide when they should throw more money (or less) into a mutual fund. 

So, technicians spend their time looking for these well-worn ruts of market habit. When you invest with a trend that's happened thousands or millions of times before, you can certainly go wrong – but you increase your odds of success. 

We'll tackle some of these technical aspects in the next issue, but as a starting point, just keep in mind the important distinction between the different kinds of analysis:

Fundamental analysis focuses on analyzing the company's financial statements, management, competitiveness in the marketplace, and sector. Using this approach, the story of the company and the financial performance establish a comparative means for judging a company and its financial and competitive strength.

Technical analysis focuses on the chart of a stock and the movements in share price. A technician looks for market strength or weakness based on current trends in the stock, chart patterns, and breakout signals.

Combined analysis uses elements of both fundamental and technical schools. I like to combine many different trends and consider them valuable in different but equally important ways. It is also necessary to note that some key ratios, such as the P/E ratio, combine technical (price) with fundamentals (earnings) to track a stock.

A technician believes that price and volume are the whole story, that tracking price action anticipates and foretells the next price direction. There is a degree of truth to this belief, and I urge everyone to employ technical indicators. But rather than using them exclusively, I think a combination of fundamental and technical tests will make the most sense.

Tomorrow, I'll examine some of the most commonly used technical patterns.