I admit: I’ve been lucky.
Technical analysis was something I learned at the beginning of my investing career. My earliest investing mentors had learned from the experiences of Livermore, Darvas and O’Neil. So I was surrounded by people who naturally combined fundamental analysis – with an emphasis on sales and earnings growth, and technical analysis – with an emphasis on price and volume.
But over the years, I’ve noticed that not all investors are as open to using technical tools in this way. The concept of “technical analysis” brings out two groups who misunderstand its applications: Those who think it’s utter nonsense (the terms voodoo and tea leaves get used frequently), and those who get so wrapped up in various indicators and oscillators that they forget that technical analysis is a means to the end, not the end itself.
I understand both viewpoints, believe it or not. True, I learned early on to use price and volume as methods for timing buys and sells, and gauging market conditions. But at the very beginning, I, too, resisted the idea that it’s possible to discern patterns from stock charts.
Cup with handle? Double bottom? In those early months, when all the charts just looked like a bunch of lines, I not only couldn’t see the freakin’ patterns, but I was getting angry with those who insisted they were real!
I guess I’m just a trusting soul (maybe you’d call it naïve or gullible – or whatever), because I really didn’t think that William O’Neil could publish a book and a daily newspaper all full of patterns that nobody could actually see! So I stuck with it, and eventually got the hang of identifying those common patterns on daily and weekly charts.
More importantly, the relationship between price and volume gives you signals about what the professional investors are doing. If a stock rises in heavy trade, that shows you pros like mutual funds, hedge funds or pension funds are buying. Since they account for about three-fourths of the market’s direction, their actions are bound to have an effect on individual stocks as well as the indexes.
You can track the volume along with the price on charts from a range of free services. As I’ve gone back and studied the charts from my own successes, I’ve clearly had the best success when buying at or near optimal buy points on patterns. Apple (NASDAQ:AAPL), Green Mountain Coffee Roasters (NASDAQ:GMCR), Netflix (NASDAQ:NFLX), Netease (NASDAQ:NTES), Baidu (NASDAQ:BIDU) and Ulta Salons (NASDAQ:ULTA) are just a few of the names that I successfully stalked in the past year, waiting until the right moment to pounce.
One thing that helped me understand the value of charts was really internalizing that price and volume spikes represent human emotions. A lot of people treat the stock market as it it’s this purely analytical, quant-driven activity. Nothing could be further from the truth. Of course, there’s program trading or computer-driven buying and selling by the quants. Not arguing that. But when you see unusual spikes to the upside or downside, it’s usually driven by some surprising piece of news – and those are real humans behind the big volume. They get greedy and want to grab a chance at profits. Or they’re scared so they panic and sell. Or maybe they’re scared they’ll miss out, so they buy!
When China-based search engine Baidu zoomed 15% higher the week ended January 15, volume was more than 230% above normal. The heavy buying wasn’t due to computers magically homing in on BIDU. Instead, it was because of news: Google (NASDAQ:GOOG) was making noises about pulling out of China. Investors saw a chance for Baidu’s business to increase. Being human, they got a bit greedy over the potential increase in profits, and they got scared they might miss the party if they didn’t buy now!
So what happened next? As the major indexes suffered some declines in January, BIDU also pulled back. It’s perfectly normal for a stock to jump higher, then retreat. That’s human emotion at work again: Some investors are greedy and/or scared, so they take profits. Others get nervous as they see the market declining, so they sell shares in perfectly healthy stocks.
But Baidu showed one of the key hallmarks of a technically sound stock: It found support near its 10-week moving average. That’s a sign that the professional investors actually were not bailing out; instead, after some initial selling, most were holding their shares at that key support level. Again, it’s not computers, but people – emotions and all – who are behind the action of these patterns that repeat over and over again.
And, as often happens, Baidu rebounded from its support near the 10-week line and is now trading higher again.
Don’t believe me? Check out some of Jesse Livermore’s writings from the 1930s. He identified chart patterns that continuously repeated. So did Nicolas Darvas in the 1950s. And more to the point – so do investors today like William O’Neil and the crew at his newspaper. So does James “Rev Shark” DePorre. It’s human nature, being repeated again and again and again.
There’s one thing that the “I don’t believe in charts” crowd has in common with the “I use every indicator known to man” crowd. Neither believes that technical analysis is actually a very simple-to-use tool. It only takes a little practice, and a little guidance from knowledgeable mentors, to understand proper applications of price and volume charts. And along those lines, it’s also not necessary to overlay too many indicators. I know stochastics, MACD and Bollinger Bands are very popular. People are convinced that candlesticks or point-and-figure charts will dramatically change their investing results. The truth is: A basic understanding of simple price and volume movements, as well as ability to recognize support at simple moving averages, will get you very far as an investor. No further embellishments necessary.
When it comes to adding complexity, I’ve seen over and over again that more is not better. I’ve had people come to my classes who are upset that my methodology doesn’t include more oscillators. But over the years, many of these folks have confided to me or my colleagues that they really aren’t getting very good results. And I’m sure it’s because they are focusing on the tools, not the outcome. What good is it to understand stochastics, if you aren’t making money in the market?
I’m not saying that you can’t be successful if you use some of these so-called sophisticated indicators – of course you can! But for a variety of reasons, a high percentage of the folks I meet who try to work more complexity into their systems find that it does not increase their success ratios. It’s very easy to spend hours, days and weeks trying to master an ever-growing list of indicators. You might even sound impressive when you can talk about some of these, but at the end of the day, it’s easier to spot a buy point using price, volume and a 10-week moving average line!
In the coming months, we’ll be launching a very simple chart-reading school at our site, www.simplegrowthinvesting.com. But for now, see if you can spot easy-to-see phenomenon such as heavy-volume buying and 10-week support. It’s really pretty simple, and it works!