How to Use Technical Analysis

Jeff Macke

Technical analysis, or charting, is the art and science of graphing past price movements of an asset in attempt to divine their next moves. In a world of sophisticated financial analysis and correlations between various arcane assets, charting is often dismissed as voodoo. Despite claims to the contrary, it's a dirty truth of Wall Street that everyone analyzes charts.

Fundamental analysis is much more important for the long-term. Macroeconomics, as we've seen, can make hash of a graph overnight. Charts are dispassionate and visual. They reduce the noise both in and outside of your head.

Why Use Charts?

Because sometimes they work; which is much better than most investing metrics.

Too much trading is dangerous, but paying more commission is a better deal than pointlessly hanging on for dear life when you can see a sell-off coming. Breakout viewers got a heads up last May when the S&P500 broke through it's uptrend, ultimately falling 19%. There were plenty of missteps in between but losses were always, always, limited.

Your brain will tell you whatever you want to hear in terms of holding on to a losing stock. Prices and graphs don't lie. If trends hold up, you hold or buy on the line. If they break, you sell on any close 1% below support and retreat. That's a plan; an exit strategy for trading. Once you have a way in and a way out you can try most anything you want.

The How-To Guide

There are tomes dedicated to charting methods and strategies. Then there's the ruler and purple crayon. For the latter all you need is a marker, a ruler, and the information provided here.

First, print up a price graph of a market or stock. Make sure it's long enough to show at least one trend reversal but short enough to be relevant. Six months to 5 years is generally sufficient. From there it's a matter of looking for a trend with as many "touches" as possible.

In the attached video there's a one year chart S&P 500. In it you can see the October low at 1,100 followed by dips the following two months. In 2011, it was the dips in November and December that defined an uptrend. When the market held that trend in December the S&P500 was 1,200. The rally didn't completely breakdown until May 4th at 1,370, give or take.

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So now what?...

Once the trend is broken look for support. The first candidate level this year was 1,350. It didn't work, meaning it was time to take the loss. Next stop is 1,300, a level stocks had bounced against multiple times.

So far it has held. So far.

The bullish trade is to buy off support at 1,300 and sell if the market closes 1% or more lower. That takes discipline, will generate a lot of fees, and requires what for most people is an unrealistic amount of attention paid to the market. The Book Of Crayon says you buy on moves to 1,300 and sell on a close below 1,285. What you do is up to only you.

The market is in the middle, between 1,350 and 1,300. We saw this exact same set-up last summer and it ended in tears. Charts can't tell you if it's going to happen again but they can give you a basic guide to what levels to keep an eye on if it does.

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