Technical Analysis - Lesson 5

Learning how to read stock charts is a skill that all investors can benefit from. Technical analysis of stock trends helps investors to determine how the markets in general, and their stocks in particular, are likely to behave in the days ahead. When deciding whether to buy (or sell) a stock, examine both the fundamentals of the company and the technical health of the stock.

Here are some of the terms you’ll need to know to understand how to read stock charts:

Momentum: We measure a stock’s momentum by examining its Relative Performance (RP) line. The RP line compares the stock’s price to a market index. If the RP line is trending higher, that stock is outperforming the market as a whole. If the RP line is falling, the stock is underperforming the market as a whole. At Cabot, we compare all stocks to the Wilshire 5000, a broad-based index of U.S. stocks.

Price Chart: We prefer to look at bar charts, which show the high, low and closing prices of a stock for every day (or week, or month, depending on the chart you’re looking at).

Volume: The number of shares of the stock that have changed hands that day (or week or month). This number can usually be found on the price chart.

Moving Averages: Moving averages smooth the fluctuations in a stock’s price. To get a moving average, you simply add up all the closing prices for a stock over a certain time period (say, 50 days) and then divide by the time period (50). You will get the average price at which the stock has closed over that time. Do this calculation every day, for the previous 50 days, and that’s how you get the ‘moving’ part. We usually watch the short-tem (25-day) and intermediate-term (50-day) moving averages.

There are a bunch of other technical indicators you can look at, but many of them serve to confuse rather than enlighten. You really want to analyze longer-term stock charts, which capture the real picture of the supply and demand relationship for a stock.

Stock Selection and Momentum

Our stock selection system is based on momentum analysis. Any new stock we buy must have positive momentum. A stock has positive momentum if its RP line has been advancing for at least 13 weeks (the number of weeks in a quarter). We’ve found that this period of time is usually enough to establish a new momentum trend, and once a trend (either positive or negative) is in place, it tends to stay in place for a relatively long period of time. That’s why you want to own stocks that are going up!

Once you’ve selected a few stocks that have positive momentum, you need to take your search to the next level. At this point, look for stocks that have particularly strong RP lines, indicated by corrections of two weeks or less. Brief corrections (timewise) tell you that there are lots of buyers in the market who are willing to snap up the stock on any decline. This is exactly the type of situation you want to be invested in! Ideally, the corrections should be both brief and shallow, but brevity is more important than depth.

Once you’ve selected stocks with a positive RP line, analyze their strength by asking: How long have the corrections been over the past six to nine months? How deep have the corrections been? How steep is the RP line? (The steeper the line, the more the stock has been outperforming the market.) How has the RP line acted during market corrections? (A stock whose RP line remains strong when there is turmoil in the general market indicates super-strong buying pressures.)

All in all, you should only be buying stocks with positive momentum. The perfect RP line will have a steep slope, with corrections that are brief and shallow. Finding stocks with strong RP lines is half the battle when seeking successful investments.

Price

After examining the RP line, we shift our attention to the stock price. Often, the price chart and the RP line will look similar. But sometimes they will differ, often during market corrections. The strongest stocks hold up the best during corrections, and have price charts that resist the downward pull of the general market. In this case, you’ll see the price trending sideways but the RP line will be heading toward the heavens! This is because, relative to the overall market, the stock is making a lot of progress.

When looking at the price chart, you’re looking for the same characteristics you looked for in the RP line—brief and shallow pullbacks with an overall steep uptrend. And steep rebounds after corrections are also a telltale sign of strong sponsorship.

As a side note, checking the new highs list in your newspaper on a daily basis is one of the best ways we know of to discover new stock ideas.

Volume

Studying volume is helpful, but there are no hard and fast rules when using it. In general, you want the stock’s volume to confirm its uptrend by rising to a higher level on days when the stock advances, and fall to a lower level when the stock declines. This indicates that the supply and demand relationship is truly in your favor, since there’s lots of buying power but little selling pressure.

Volume tends to confirm your convictions rather than leading you to a great stock idea all by itself. Once in a while, though, a stock will soar or plummet on massive volume, which is what we call a Volume Clue. It’s a sign that big investors are getting in or out. In particular, look for stocks that rise 10% or more the day after reporting earnings—these stocks often have further to run.

Moving Averages

We look primarily at the 50-day moving average because it’s long enough to allow for corrections but not so long that the trend hasn’t turned down by the time the stock touches it. But there’s an even better reason: great growth stocks tend to find support (meaning that they stop declining) when they reach this moving average. Buying a stock as it’s bouncing off this moving average is often a good strategy. Any stock you’re considering for purchase should have stayed above its 50-day moving average for most of the time over the past few months.

The 25-day moving average isn’t as vital, but it, too, often lends support to the strongest market leaders. In a powerful situation, contained drops to the 25-day moving average can offer buy points.

A Stock is Never Too High to Buy

Here at Cabot, we frequently remind each other to have no preconceived notions about the stock market or any individual stocks. We’ve learned from experience that the big winners are usually the stocks that have already appreciated many times off their lows. And just when people start thinking that a stock is “too high,” it usually begins its next major advance!

You always want to buy on reasonable short pullbacks of, say, 5% to 15% off a stock’s high, but don’t think a stock can’t rise further just because it’s had a few good months. Don’t let your emotions about a stock’s value get in your way. Focus on using our proven system of technical analysis instead.

Summary

We’ve covered a lot of material in this lesson, and it’s pretty complex, so don’t expect to fully grasp all of it at once. It’s going to take some practice with your own money before you are comfortable with (and can get the most benefit from) our momentum system.

Let’s review the main points:

When looking for potential purchase candidates, look at both fundamental and technical analysis. (We’ll cover fundamentals in the next lesson.)

When doing technical analysis of stocks, you should focus primarily on the stock’s momentum and price chart, along with its volume pattern and 50-day moving average.

A stock MUST have positive momentum before you consider buying it. Your goal should be to find RP lines with steep slopes and corrections that are brief and shallow.

When looking at stock prices, look at the price chart, not just the daily fluctuations of the stock. Look for price charts that have steep upward trends, with brief and shallow corrections. These are the same characteristics a desirable RP line has.

A stock’s volume pattern can confirm your initial opinion of a stock, but is unlikely to lead you to a great stock idea all by itself. Look for heavy volume on up days (showing accumulation) and lighter volume on down days.

The 50-day moving average is a helpful stock market indicator in two ways. First, your potential purchase should have held up above this line for the past few months. Second, look for a pattern of sharp rebounds after touching the moving average, and then time your purchases after the stock begins to bounce off the moving average.

Mike Cintolo loves charts and uses lots of technical analysis to determine which stocks to include in Cabot Top Ten Trader.

Next: Fundamental Analysis

Want more information on technical analysis? Check out our Advanced Technical Analysis page!


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