Technical Analysis

By: ispeculatornew
Date posted: 12.12.2007 (3:34 pm) | Write a Comment  (1 Comment)

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I use a little technical analysis (TA) in my investment decisions but for the most part I think technical analysis is a bunch of nonsense. However, I think becoming familiar with TA can make you a better investor.

Technical analysis is the strategy of reading price charts to evaluate whether a stock is a good investment/trade. Technical analysis is in contrast to fundamental analysis which is the strategy of studying a company’s fundamentals (revenues, earnings, etc.) to determine potential investments.

A lot of traders who hold stocks for a very short period of time (day traders, swing traders, momentum players) use TA as their primary evaluation method for buying or selling stocks. However, trying to consistently predict the price movement of a stock over a short period of time is very difficult, if not impossible. In fact I’ve read an article stating that most day traders lose all of their capital within a year.

Even though I think a lot of concepts promoted in TA are foolish I think using chart patterns based on investor psychology can be beneficial in making investment decisions. Two of the TA concepts that I use are support levels and resistance levels.

Support levels are basically price levels that a stock has fallen to in the past but has not passed through. The fact that the stock price did not break through a certain support level in the past can inspire confidence in new investors when the stock price retests those levels. Assuming the stock is still considered a good investment new investors will have assurance buying at those levels. Consequently, the stock price will find support at those levels.

If a stock you like has dropped to a previous support level this can be a good time to pick up some shares.

Resistance levels are price levels that a stock price has topped out at in the past. The fact that a stock couldn’t break through a certain resistance level in the past may cause some investors to sell when the price reaches that level again.

There is also another psychological reason for resistance levels. Let’s says a stock stayed at twenty dollars for half a year and then had a bad quarter and dropped to twelve dollars. Some of the investors who bought at twenty dollars will continue holding the stock with the hope that it will go back up to twenty dollars and they can then sell and break even. If the stock is able to make it back to twenty dollars these investors will be very happy to sell because they no longer have a loss. This fear of taking a loss will provide some resistance at twenty dollars.

If a stock breaks through a resistance level you should be less eager to take profits, especially if the stock doesn’t have another defined resistance level. You should be patient and see how far the stock price runs.

While I do buy into TA concepts such as support and resistance levels, I think trading based on random chart patterns doesn’t make much sense. Unless you can determine that there is some element of investor psychology rooted in the chart pattern I wouldn’t factor it into your investment decisions.

In fact I think a lot of TA concepts are just self fulfilling prophecies. If enough people think that a stock emerging from a cup with handle pattern is going to go up in price then it is going to happen.

The fact that a lot of people do buy into chart patterns and TA concepts is one reason you should become familiar with them. The more knowledge you have about what is affecting a stock’s price the better off you will be as an investor.

Also, as I have previously stated I think there are some legitimate TA concepts that are rooted in investor psychology.

If you use these concepts in conjunction with fundamental analysis you will make better investment decisions.

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1 Comment

  1. Pingback by Intelligent Speculator » Blog Archive » Wizetrade — December 13, 2007 @ 5:16 pm

    […] is using technical indicators to determine whether a stock should be bought or sold. If you read my last post you know that I believe most technical analysis is a bunch of nonsense, especially in an instance […]

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