An intro to data-driven moneymaking on the stock market
Picking stocks is a bit like picking horses at the track: The gamblers, who pick horses based on how funny their names are, probably aren’t going to win. However, the gamblers that come to the track having done their homework and with a strategy in hand improve their odds.
How do you evaluate a horse? By its breeding, owners, or jockey? Or, do you ignore all that and look only at the horse’s recent performance? Questions, questions…
Like racing fans, successful investors implement systems when it comes to picking stocks. The two main “systems” are fundamental analysis and technical analysis. These approaches determine how investors pick and research their stocks.
In this first tutorial, we’ll take a close look at technical analysis — the ins and outs and what it all means. To begin our examination of the system, let’s take a look at the basics:
Price, Trends, and Volume
When investors talk about technical analysis, they’re talking data. They are not referring to the financial statements issued by a company (P&Ls, income statement or balance sheets); they refer to charts that show what how a company’s stock has done over time.
The underlying idea is to map the average of a stock’s performance, and then look for points on that “map” that suggests something different from the expected route.
Here’s what to look at:
A key principle: prices follow trends. Upward trending stocks like to trend upwards, and they like to do so at about the same pace as last week, last month, and so on. It takes an aberration in the trend to catch the technical analyst’s interest. They’re looking for places where a trend may change.
Support and Resistance
Stocks like to stick to channels. That is, there is a price below which a stock, according to its identified trend, tends not to fall, and there is a similar point above which it historically has not tended to climb. Analysts like to call the one support and the other resistance. Let’s say a fictional biotech supplies manufacturer, Lilo Chemicals, has, for the past 15 months, traded between $112.72 and $120.01. The lower number is what would be called its support level, and the higher is its resistance.
The reason for this has to do with what market-watchers believe is the underlying psychology of investors. Let’s look at this in practice, as investors await a stock price to break resistance.
If Lilo breaks $120.01 (the previous resistance), investor psychology changes. It is no longer a barrier and technical analyst will buy Lilo shares. This will hopefully become the new trend.
Notice that we haven’t once mentioned Lilo’s value as a company. This is all about prices. What has the stock previously cost and it’s trend.
Those who trade with the help of technical analysis seldom make a move on price alone, however. In addition, they match a change in price with fluctuation in volume. If a lot of people are suddenly buying Lilo’s new $122 stock, that’s a more supportable position when it comes to making a purchase than if the volume of trading stays low. This “Consolidated Volume” is a good indication that new support or resistance is being formed.
The analyst is looking for empirical evidence of confidence in the newly upticked trend. Analysts also watch volume for predictions of price change. If the number of people trading an upward-trending price suddenly bottom out, even if the price is still climbing, that can be an indicator that Lilo is about to undergo a change.
Long Game vs. Short Game
Generally, the technical analyst thinks about stocks in the shorter term. Looking at what shares are doing on a chart can be about the next seven days, the next seven minutes or even the next seven seconds.
Rather than looking for a stock that is undervalued, buying it, and then holding onto those shares until their value increases — the fundamental-style investors’ strategy — technical analysts tend to want quicker turnarounds (of course there are exceptions).
Think of the fundamental fellow as an investor and the technical chart-watcher as a trader. It’s a basic philosophical and practical difference between the two.