10) Stock Picking Strategies: Technical Analysis

by · October 16, 2010

Thus far we have talked about fundamental analysis.  In this section we shall explore technical analysis (TA) which is the opposite of fundamental analysis.  Technical analysts or technicians analyze market activity, prices, volume and other statistics and select stocks gathered from these data.  Those who follow this method look at the different indicators and made inferences about the future stock prices.

The Philosophy

John Murphy, technical analysis guru explained the basics of TA in his book “Charting Made Easy”.  Here he outlines the core of technical analysis as well as the tools and underlying theories.

“Chart analysis (also called technical analysis) is the study of market action, using price charts, to forecast future price direction. The cornerstone of the technical philosophy is the belief that all factors that influence market price – fundamental information, political events, natural disasters, and psychological factors – are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down.”

The most important assumptions of TA are:

a) Markets are efficient

b) Prices move in trends

c) History repeats itself

TA Don’ts

Technical analysts don’t care for intrinsic value and other things that fundamental analysts look for.  They usually ignore management style, business models and competition.   TA are more concerned about charts, graphs and trends and usually trade companies they know very little about.

Is TA for long term strategy?

No.  Technical analysts live a very active lifestyle.  They constantly monitor the ups and downs of stock and take action based on these fluctuations.  An investor who uses this strategy can go long or short on a stock depending on what direction the data is moving.

Speed is important to technical analysts.  Whilst value investors have to wait patiently for the market to correct the undervaluation of their company, TA have to decide almost immediately whether to hold or discard stocks using stop-loss-orders to mitigate losses should a company not perform to par.  It takes a lot of trading skill to get in and out of sticky situations like this.

Support & Resistance

Support and resistance are common concepts in the world of technical analysis.  Traders usually buy and sell stocks at these levels because they indicate how well a stock might (or might not) perform.  When TA expect a stock to start decreasing after a decline this is the support level.  Once it begins to increase after a decrease this is the resistance level.  When a stock hits support levels, TA will enter into a long position, while they enter a short position once resistance level strikes.

Picking Stocks With TA

Technical analysts have a whole caboodle of tools to help them pick stocks.  While no one tool is infallible, a TA must interpret these data with subjective process.  Here are some popular examples of chart patterns used by technical analysts for stock picking.

As the name suggest, this chart pattern looks like a cup with a handle.  This is a bull market pattern and the end of the handle indicates is when it is a good time to buy as profits great when the market breaks out at this point.   This is a popular chart as it is very easy to spot.  Here’s what a cup and handle chart looks like:

No this is not the shampoo. The head and shoulders is considered a bearish pattern and looks like a head with two shoulders, as the name suggests.

Conclusion

Just like any other stock picking strategy, technical analysis relies on different techniques compared to fundamental analysis.  But regardless of the style used, mastering technical analysis takes time, experience and savvy.

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