Stockology

Technical analysis is the topic for today. I mentioned in the previous post that it would be impossible to cover every aspect of technical analysis in a blog, not to mention one post in a blog. But I’ll do my best to go over some more common indicators and ones I use on a daily basis.

First of all, a stock chart is a chart that tracks the price of a stock. So if you were to look up Microsoft’s chart on Yahoo! Finance or something, the chart would show Microsoft’s stock price plotted out on a chart. As far as aesthetics are concerned, there are a few chart types: Line chart, Bar chart, and Candlestick chart. I think the default chart on Yahoo! Finance is a Line chart.

Personally, I use the Candlestick chart. (No particular reason, they all display the same information, just from a different perspective.) Aside from the price, there are a bunch of indicators used on a chart to help identify patterns and whatnot. The most common indicator on a stock chart is the volume indicator. That should be pretty self-explanatory. Volume is usually shown as bars. So each day’s trade will have a corresponding volume bar. If a lot of shares were exchanged on a particular day, the volume for that day would be high.

Say Dell came out with earnings that disappointed Wall Street analysts. The stock price plummeted 10% and volume was unusually high. What could you derive from that situation? (Hint: There weren’t a lot of buyers…)

Another indicator that’s widely used is the moving average. I’m not even going to try and define a moving average in my own words, so here’s the definition from Investopedia.com: A moving average is the average stock price over a certain period of time. You calculate it by adding the closing price of the stock for a number of time periods and divide it by the total number of time periods.

So, to get a 5-day moving average for Apple, you’d add up the closing price of Apple for the last 5 days and divide it by 5. I don’t know anyone who uses a 5-day moving average. I use a 20-day, 50-day, and 200-day moving average. Moving averages are good for identifying trends. If the price of a stock today is higher than the average price of the stock for the last 20 days, it’s gone up. Get it? If the price today is higher than the average price for the last 50 days, it’s gone up!

Some more tidbits from Investopedia.com: Traders watch for short-term averages to cross above longer-term averages to signal the beginning of an uptrend.

Think of it this way, if the average price for the last 20 days is higher than the average price for the last 50 days, the price has gone up! Sounds really simple and kind of obvious, right? The truth is, it is! But because so many people use these indicators, stocks have been known to find levels of support at moving averages when they’re going up, and ceilings at moving averages when they’re headed down. In simpler terms: say the stock of a good company has been going up and up and up. It’s bound to take a breather and come down a little bit before going back up. That breather is likely to be at or near a moving average.

You really have to see it in action to get a better idea of how it works.

The last indicator I’m going to cover today is the stochastic oscillator. It’s a momentum indicator that compares a stock’s current price to a price range over a period of time. There’s a crazy formula that’s used to calculate the stochastic, but I’m not going to get into that…

Basically what it does is indicate whether a particular stock has been overbought or oversold. It’s shown on an oscillator so that you can gauge the stochastic against the stock’s chart. The stochastic is plotted on a chart scaled from 0 to 100. The way I use it is this: When the stockastic is below the 20-, it’s oversold. When it’s above the 80-, it’s overbought. I place my ‘buy’ trades just when the stochastic is breaking out above the 20-, and place my ’sell’ trades just when the stochastic is dropping out of the 80-.

It doesn’t always work, because an oversold stock can continue to be oversold, but at least it guarantees you buy it at a relatively low price. And vice versa.

Fundamental analysis and technical analysis. These are two terms that you might hear today far less frequent than you might have maybe a decade ago. The reason is that most investors today take a hybrid approach of combining both fundamental and technical analyses when making investment decisions.

That said, it’s still important to know what the heck they are. First, know that no matter which method you use, the name of the game is to predict a stock’s value.

Fundamental analysis is evaluating financial statements, macroeconomic trends, industry trends, management competence, and some others I can’t think of right now, to try and value a stock. This is the more old-school method of valuation analysis. Typically, it involves a lot of reading, and quantitative and qualitative analysis. It means knowing what the company does, downloading a company’s quarterly and annual reports and pouring over those, keeping abreast of news to keep informed on industry and macroeconomic trends, and listening in on conference calls to see if you agree with the direction the management is leading the company.

Basically it’s a lot of work. Necessary work. When you hear people say, “I did my homework on this stock,” it means they conducted fundamental analysis on the company. 

The newer school of thought is technical analysis. Technical analysts believe past performance of a stock is indicative of future price performance. Basically, technical analysis uses charts to identify patterns, then tries to use these patterns to determine what will happen. In more detail: Volume and a gamut of oscillators are used to help in the analysis. These include, but are not limited to, moving averages, relative strength indices, stochastics, bollinger bands, and a whole bunch of others. It’s impossible to cover all of these because 1) there are just too many, and 2) I don’t know all of them. But I will try to go over a few of them in Part 2.

On a side note, one of my lifetime goals is to get in a time machine, travel to the future, and pick up a stock almanac (kind of like Biff with his sports almanac in Back to the Future). Then I’ll be the founder of “Almanac Analysis,” where all you do is buy the stock you already know is going to go up. Simple, no?

Moving on…

It used to be fundamental analysts hated technical analysts. The two groups were always arguing over whose method of valuation was better. Fundamental analysts thought it was a joke to look at some charts and decide whether or not a stock was going to go up or down. Technical analysts, on the other hand, believed that “charts don’t lie.” They think all the news, past performance, future earnings projects, and everything else, is already factored into the price of a stock. Obviously, arguments can be made for either side.

I mentioned earlier that these days, most investors take a hybrid approach to investing. Part of it is being more informed. Think about it this way. If a whole lot of people are making investment decisions based on studying a company’s financials, industry, etc. and knowing it inside out, wouldn’t it be pretty prudent to know why they do that and maybe taking a look at those things yourself? And vice versa. If a whole lot of people are making investment decisions based on looking at a chart and some squiggly lines, (aside from it being intriguing) wouldn’t you want to know what they’re up to?

The overall investing community has also done a good job of fostering both methods. You won’t find a financial website that doesn’t have both financial statements and charts. Likewise, any brokerage you open an account with will provide both research tools (typically refers to fundamentals research), and charting tools. For now, just know that the two exist.