October 1st, 2014
by Greg Guenthner, Daily Reckoning
Most folks see technical traders as lucky market magicians. They know nothing about the principles of technical analysis, so they quickly dismiss the practice as witchcraft or coincidence.
I understand where many of these investors are coming from. I mean, it’s hard to embrace the chaos that is the stock market. We’re only human — and most of us desire predictability and absolutes above all else. It’s no wonder so many investors have trouble shaking the buy-and-hold philosophy that has shaped their investing worldview.
But even if you consider yourself a fundamentals-driven investor, you have to incorporate some technical analysis into your strategies. If you open your mind and apply technical indicators to your fundamental ideas, I promise you’ll begin to rake in the profits that were once so elusive.
And your brokerage account won’t be the only beneficiary. Once you start to use a few small technical tricks, you’ll begin to feel more confident in your investment choices and their potential outcomes.
Meshing technical with your fundamental ideas is easy and painless. To get you started, I’ve created a few short ideas you can use the next time you plan on buying (or selling) an investment. All of these tips take less than five minutes to implement, so there’s no excuse for you to ignore them.
Everyone likes a deal. So it’s no surprise that fundamental investors love stocks that are cheap relative to earnings, sales or book value. After all, why wouldn’t you want to buy a cheap, out-of-favor stock and hold it until its true value is realized?
In theory, it sounds like a can’t-miss plan. But the realities of the market can easily derail this strategy. Instead of buying any old “cheap” stock you come across, you should consider modifying your strategy to exclude any names that might trap you in a losing position.
Here’s how you do it:
First, avoid buying stocks at or near 52-week lows. I know it might be tempting to pick up shares. After all, the stock is cheaper than it’s been all year. The typical investor logic here is that shares couldn’t possibly trade any lower.
But they can. And they probably will. Just because a stock hits a new low does not mean that it has found a bottom. Stocks move in trends — up, down or sideways. If a stock is moving lower, you have to assume it will continue to do so until the price tells you otherwise. Even as an investor, you should never try to buy into a downtrending stock.
Let’s say you’ve done your research. You like a company. You think its shares are cheap, but the stock is locked in a downtrend. Instead of buying, place the stock on your watch list and keep an eye on its chart. If and when the price appears to hit a floor and move higher, you can begin to plan your entry. Your best bet is to look for double bottoms or rounding bottoms. These patterns will help signal a stock might be ready to turn higher.
When you’re not bottom-fishing, you might come across a potential investment that’s trending higher. All this means is the stock is displaying a series of higher highs and higher lows on a daily or weekly chart.
In the case of an uptrending stock, you will want to time your entry to coincide with support. Naturally, as a longer-term investor, you want the best price possible — even when you’re buying a stock that’s moving higher.
Use moving averages or draw trend lines to determine where you should be a buyer:
In this chart, I’ve drawn a simple trend line. The arrows indicate where you should look to buy the stock. You don’t have to be too precise. Just construct a line that best fits your particular chart. From there, you can use your judgment to determine when to plan your initial buy — or when to add to an existing position.
Of course, you also want to sell your position for the best possible price. Fortunately, technical analysis can help you pinpoint where shares might be running out of steam. So if you have an investment in your portfolio that you believe has realized its potential value, you can use resistance lines to plan your sells.
Here’s the exact same price chart from above. Only this time, I’ve added different annotations:
By drawing a resistance line above this uptrending stock, you can see where share price tends to become exhausted. The arrows show where price touches or briefly crosses resistance. Again, your trend line doesn’t have to be exact. You’re simply using it as a general guide to help sell shares close to near-term highs.
Whether you’re new to the markets or a seasoned veteran, you should try to employ time-tested trading techniques on your investments.