Technical analysis provides an important tool

Charts aren't the final solution to making smart investment decisions. They don't provide all the answers but they are an important investment tool. If you are a serious investor you need charts as much as a plumber needs a pipe wrench. Sure, he could do his job without the proper tools but could he do it nearly as efficiently and effectively? And, if the tools are readily available, isn't it foolhardy to continue working without them?

Charts, and technical analysis, will completely change your way of relating to potential investments. They provide a filtering mechanism or framework for selecting investments that provide a good potential for profit.

Let me show you how very quickly.

Within minutes of looking at a price chart I can tell whether I'm interested in further information on a particular market or not. This saves me hours of wading through miscellaneous reports, analyses, trading tips, and newsletters. Once I've selected potentially profitable investments I plan my strategy according to sound principles, including fundamental analysis.

This business-like approach to investing may not offer the thrills of buying and selling on the spur of the moment but it does lead to greater profits and restful nights. You may be thinking, "I don't know what all the fuss is about. Investing boils down to simply knowing when to get in and when to get out."

You would be perfectly right; successful investing comes down to a matter of correctly answering these two questions:

If you've lost money on some of your investments you already know what all the fuss is about.

Price Charts

The price range and change in value of any - yes, ANY - item of trade can be graphed over time to give you a picture of both historical and current prices. If you had your home appraised once a month over a 5 year period, for example, you'd have the raw data for a price chart which would be an accurate record of housing price trends in your neighborhood for that time period.

Support and Resistance

Investments are bought and sold in the marketplace, most often through open bid. Stocks, commodities, precious metals, etc. are being auctioned each and every business day on a global scale. Buyers and sellers are competing to get the best price and make the most profit (or get out with the smallest loss).

It's just like going to the grocery store and buying fresh chicken through open bid. If there are only 5 chickens left and 12 interested purchasers (demand greater than supply) the price will be relatively high. On the other hand, if there are 36 chickens and only 12 bidders (supply greater than demand) the purchase price will be relatively low.

In the first scenario prices will go up and up until buying resistance is met. Buyers will simply not pay higher prices based on the current market in chicken. In the second scenario prices will meet support when purchasers feel the price is so low that they want to stock up their freezers thereby creating extra demand and supporting prices.

A price chart is a graphic record of this psychology of the marketplace with respect to the price of a particular stock, commodity, fund, precious metal, etc.

Figure 2. A simple set of trendlines showing support and resistance. The up arrows indicate troughs (points of support)and the down arrows indicate peaks (points of resistance). It is often almost uncanny to see how perfectly the successive highs and lows line up along a developing trendline.

Three Simple Rules

Buy when the price is going up and sell when it is going down. Go with the trend. it sounds so simple, doesn't it? Yet, how many times have you purchased an investment without even considering the long term trend - the direction prices are headed? The price of a stock or commodity, any market for that matter, acts like a fully loaded freight train. Once a direction is established it becomes resistant to change. And the longer it heads in one direction the greater the momentum.

Day traders are in a category all their own, of course! (And they're usually the first to admit it!) The long term trend is relatively meaningless to a daytrader - however daytraders must still anticipate the direction of the trend no matter how short-lived or ephemeral. If you daytrade you just play by a different set of rules; the fundamental actions of the market don't change.

Establishing Trends

How do you establish trends? By drawing lines on price charts which connect as many highs as possible on one side and as many lows as possible on the other. These lines, called trendlines, are actually zones which contain the price (see the section on Trendlines).

When drawing trendlines try to make the line as meaningful as possible. In charting practice and theory, a line based on one peak or one trough means nothing. You require at least two points to draw a meaningful line - anything less is fantasy. Two highs or two lows is the bare minimum. The more points you can connect the more significant the resulting line (see Figure 2 above to see what I mean by connecting points).

Technical Indicators

Technical indicators can be as straightforward as a simple moving average or as complex as a Parabolic SAR. ChartHelp.com shows you how to apply some of the many indicators available to your own specific needs and resources.

Martin Pring, a well known analyst, states the art of technical analysis is "to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed." (Technical Analysis Explained by Martin J. Pring, 1991)

Trend indicators such as trendlines, price patterns and moving averages identify a change in trend after it has taken place. Momentum indicators, such as ROC, RSI and MACD, can warn of strength or weakness in the market, often well ahead of the final turning point.

Consider the popular MACD indicator, for example, in the charts below. The MACD chart is shown underneath the price chart. As you can see from the example below MACD can help catch a reversal in the overall price trend, providing very useful buy and sell signals and alerts. Here we can see where the down trend was broken, providing the first alert that a market reversal could be underway. When MACD broke through its signal line we had a confirmation that the market had reversed. And a second confirmation came when MACD broke upwards through the zero line. The market then began a strong uptrend and MACD even proceeded to let us know when it was time to sell! See the section on MACD for much more information on using this handy indicator.

Figure 3. The MACD indicator and some of its common signals.

There are dozens of technical indicators like MACD that are just as useful for timing entry and exit points. Once you become familiar with a few of them, you will have a much better set of tools available for making your investment decisions than the majority of investors.

Steps to a Successful Trade

The steps involved in making a successful trade are generally as follows:

Price charts and technical analysis can help you determine what to buy and sell and when to enter and exit.

Let Your Profits Run

Have you heard the old market saying "Cut your losses short and let your profits run?" There's a great deal of wisdom distilled into this one simple statement.

Cut your losses short by predetermining how much capital you are willing to risk on any investment and getting out as soon as you've lost that much even if it's only on paper. Paper losses are real losses. Don't let anyone kid you. You can't afford to hang onto a loser because everyone else is telling you it will turn around. Going with the long term trend should keep you out of losing situations but don't allow losses to accumulate. When your pre-determined amount is lost get out!

Very honestly this is the best advice I can give you. Another old saying comes to mind, "Look after your losses and the profits will look after themselves".

How do you let your profits run? By sticking with the long term trend. As long as the price is on the right side of the long term trend hang in there. But as soon as the long term trend is broken take your profits. It pays to keep checking your price charts after you've entered a market so you know when to get out. If it is a long term investment checking the price charts once a week should be enough.

Summary

Price charts and technical analysis can help you make investment decisions more easily and in a more business-like manner. They should be considered an additional tool and not the complete investment tool kit. The biggest benefit of using charts and technical indicators is that they offer an objective framework for evaluating and profiting from an investment. A price chart gives you an immediate graphic record of all factors influencing the historic price of a commodity or security. Indicators can provide very effective tools for determining the best time to buy and sell.