Before a fundamentally oriented investor casts off technical analysis – or chart reading – as a flawed ‘black box’ approach, he or she may want to consider the advantages of implementing such a strategy. A few simple technical signals may spot optimal entry points into those high-performance company stocks.
Eventually, a stock will indeed be valued appropriately, for better or worse. It’s the interim periods that hold opportunities for investors though. An undervalued stock is a bargain, and an overvalued stock is likely to be a short-term exit opportunity.
The big challenge for most investors, however, is determining when a stock is undervalued and ripe for a rebound. Conversely, the other challenge for investors is determining when a stock is overvalued and on the verge of a pullback. After all, there are no industry-standard values or norms for either … only market opinions.
Though technical analysis won’t indicate if a stock is relatively overvalued or undervalued on a fundamental basis, a chart can act as a gauge regarding the market’s overall changing opinion on that matter. The net results are subtle, early clues of a bigger, looming move in a stock’s price.
There are three simple technical analysis tools any investor can use, and are usually available for free.
A moving average is simply the average price of a stock over a specific number of days, and is usually plotted directly on a stock’s price chart. The longer the time period of the average, the slower moving the line. The speed at which the moving average responds is a matter of personal preference, but the interpretation – or ‘signal’ – is the same … when a stock moves above or below its moving average, it serves as a buy signal or sell signal (respectively).
Since investors tend to hold stocks for longer periods of time, most prefer a longer moving average length. The more common preferences are 100 day or 200 day moving averages.
Stochastics is a mathematical function that has found a practical application in stock chart analysis. It is an oscillator, and is adept at finding instances where a stock has moved too high, too quickly (overvalued), or moved too low, too quickly (undervalued).
Graphically, stochastic lines that appear in the upper 20th percentile of a stochastic scale generally indicate a stock is at risk of a pullback. Stochastic lines that appear in the lowest 20th percentile of a stochastic scale generally indicate a stock could rebound in the near future.
Though less objective and more subjective than stochastics or moving averages, volume is still a powerful tool for investors. In general, it’s considered bullish to see more trading activity – or volume – on days a stock is making gains, and less volume on days the stock’s price is retreating. The standard is reversed for bearish instances.
Though there are hundreds of technical analysis tools, the three examined here cover the three basic trading strategies – momentum, overbought/oversold, and volume trends. The aim of those three trading ideas is the same goal investors have adopted – to buy low and sell high. None are perfect, collectively or individually. Then again, fundamental analysis isn’t perfect either.
Investors only make money if they sell their stocks at a higher price than they paid for them. While not a complete substitute for a fundamental approach, technical analysis can improve the odds of doing just that.