Some individuals use what is called “technical analysis” to select stocks and determine when to buy and sell. I would put this more in the realm of “fooling around” than “serious investing” since it causes you to trade too often. Also, frankly it does not predict the future direction of stocks all that well. It really is a bit like trying to drive a car by looking out the side windows and the rear view mirror. You get a good sense of where you have been and where you are, and you can kind of guess what the road looks like a short distance ahead if you assume the grade and the curve in the road will remain about the same, but there is nothing to say that the road won’t change. You might see a descent starting and decide to jam on the brakes – jump out of the market – only to see it was a minor dip before a long ascent resumes.
Serious investing, in contrast, is like starting out in Los Angeles and looking for places on the map like Denver that are much higher and heading towards them. You don’t know how many ups and downs will be involved in the mean time, but you expect to get to a much higher elevation eventually. The trick is keeping yourself from second guessing and jumping out in the middle of Death Valley.
While I do not believe in using charting to select stocks, charting is useful to determine how well stocks you have picked are doing and also somewhat useful in picking entry and exit points. That is to say, if you have some cash and are looking to buy, or need to raise some cash and are looking to sell some stocks anyway, looking at charts to determine a good day to buy or sell, or a good price to set as a limit, has some merit. Note also that a lot of the reason that charts are important is that other people are looking at them. If you can understand how others are likely to react it helps you determine the best strategy to take, particularly when you are looking to buy or sell anyway.
The first thing to understand about charting is what kind of charts should be used. Most people look at charts that have little or no value because they come up as the default on Yahoo and other sites. These charts just plot the closing prices for a given day, week, or month. For example, see the 1-year chart for Home Depot.
The reason this type of chart is not useful is that it only gives the price for a small fraction of time – the end of the day. Note that if you did need to only pick one time to plot. this is probably the most important point in the day to pick. The reason is that most people look at the closing price even though it is only one point in the day (or week, or month). Note that the news also gives the closing prices for the markets. Likewise, when papers did print prices for stocks, they typically would only print the closing prices.
A better chart to use is the OHLC chart, which stands for Open, High, Low, Close. As the name implies, it plots the opening, high, low, and closing price for a stock. If you select “Bar” on Yahoo, it will change to an OHLC chart. Here the opening price is shown as a line extending to the left and the close is shown as a horizontal line extending to the right. The high and low are shown as the vertical bar. Note now that you get a sense of what happened during the whole day instead of just where the stock closed. This means that if the stock was down most of the day but rallied at the end to close unchanged, you would see it. Because your eyes naturally compare the centers of the lines – the median prices – you get a better idea of where a stock is now trading versus where it traded the last few days. Obviously it is more important if a stock spent the whole day higher than if it only shot up at the end of the day.
Another type of chart that is of interest is the candlestick chart. This is the same as the OHLC chart, except the area between the open and the closed is boxed in. If the stock closes above the opening, the box is left open. If it closes down, the box is filled in. In this way, you can also see if the stock is closing up or down during a period of time easily. For example, notice in the late July period in the HD chart that the stock had several big down days with just a few small up days in the middle. It then rallied in August with a bunch of large up days. Note also that there is a gap upwards in the middle of August, probably indicating that some big news came out about the company. The fact that it was rallying before then means that some people probably knew about the news before it was widely released. Despite laws against insider trading, you’ll notice a lot of this activity if you pay attention to charts.
In the next post I’ll discuss trends and drawing lines.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.