Why Technical Analysis Does Matter

by: Barry Ritholtz

There's a very straightforward discussion of technical analysis in the online version of Barron's, by Technician Michael Kahn. He outlines the three basic goals of TA as a tool:

• Seeing where the stock is currently trading and figuring out how it got there (using trends, support and resistance levels).

• Determining the power of a trend (as well as signs of a pending end of a trend). Includes Technical concepts as trading volume and momentum.

• Making comparisons of the stock to the market, its peers in its own industry and even to its own history. (relative performance and moving averages are covered here).

Kahn also delivers a checklist of key technical tools:

Trends and trendlines: There is no secret to finding a trend. If prices are generally rising and making higher highs as well as higher lows, then we have a rising trend. We want stocks that are in rising trends.

Support and Resistance: These are terms that simply tell us what price levels are likely to bring out the buyers (demand) or the sellers (supply), respectively. What we want to see is a current price that has either just moved through resistance (demand overwhelmed supply) or one that is far from the next resistance level.

Moving Averages: Moving averages, or simply price averages, are just average prices over a user-defined period of time, usually 50 or 200 days. They help us determine if a trend is turning, as prices cross the averages. We are looking for price to be above selected averages but not too far above them.

Volume and Momentum: These two indicators confirm the health of a trend or warn of an impending change. Is buying spreading to other investors, as evidenced by rising trading volume? We also want to know if days when prices rise outnumber and result in bigger price moves than days when prices fall (momentum). If either volume or momentum starts to fade, then we can surmise that the trend is weakening.

Relative Performance: Relative performance charts simply divide the price of a stock by a relevant market index or industry group. The theory is that we should buy strong stocks in strong sectors and this is how we find them.

Lastly, the series shows how to put the theory and tools to work. The author gets specific about the process of morphing from a "stock idea" to an actual buy or sell decision:

1. Look at the trend. We want a rising trend or one that is just starting to do so.

2. Find nearby support and resistance levels. We are trying to find stocks where demand exceeds supply and new supply is not likely to develop soon

3. Determine if the current trend is healthy. We want prices to be above a relevant moving average but not so far that the stock is prone to a snapback decline as profit taking sets in.

4. Check volume and momentum indicators to be sure that they are not fading as the stock price rises. A falling indicator warns that there might be technical problems before price action sours.

5. Find out if the stock is leading a benchmark. Is the particular stock at least matching the performance of the market and its peers?

6. If the stock passes all these tests, we have a candidate for purchase.

Its a good two part article, well worth reading...

Why Technical Analysis Matters
Michael Kahn
Barron's, MONDAY, NOVEMBER 6, 2006   

Putting Stocks to the Technical Test
Michael Kahn
Barron's, MONDAY, NOVEMBER 13, 2006