What can technical analysis do for you?
Once an obscure investing tool, this advance system has hit the mainstream. Here's what it can offer investors.
It was September 2008, and the stock market was in chaos.
The Dow Jones Industrial Average ($INDU) experienced its largest point decline, plunging 777 points in just one session. The support of the 50- and 200-period moving averages were slashed like a hot knife through butter, while the Volatility Index ($VIX) rocketed through technical resistance as if it wasn't even there. The financial media was full of pundits declaring a complete technical breakdown in the stock market.
Many were left asking what it all meant. Part of what it meant was that the once esoteric quasi-science known as technical analysis had gone mainstream.
In the days before the personal computer, practitioners of technical analysis used quotes out of the newspapers or quote books to draw charts and make projections. Intraday data were very difficult to obtain outside of the exchange. Charts were painstakingly plotted on graph paper with a ruler and pencil. New highs and new lows were marked and repeating patterns noted in an attempt to determine whether a price trend was likely to continue or reverse.
Today, every trading platform has a charting package, often at no additional cost. PCs permit the crunching of stock market data in all timeframes, from the tick to the month and everything in between. Rather than being an esoteric investing tool, technical analysis has become the norm. Many of the same concepts and ideas apply today, just as they did back when investors would chart by hand. One of the most used and important concepts of technical analysis is the idea of support and resistance.
If you are a regular reader of my articles, you are familiar with the terms support and resistance. However, I wouldn't be surprised if a few readers did not fully understand what these terms mean and how knowing about support and resistance can dramatically increase your investing profits.
What is support and resistance?
I define support and resistance as areas on a price chart that appear to provide either support to falling prices or resistance to the price moving higher. The measurement of support and resistance depend on the timeframe involved. For example, support on a daily chart would be different than support on a 15-minute chart.
Support and resistance can either be horizontal lines on a chart or consist of a moving average. A simple moving average consists of the average of a certain number of periods, plotted as one point on a graph.
For example, a 20-period simple moving average on a daily chart adds together the past 20 days' movement, then divides by 20 to obtain the average movement. The end result is generally an upward or downward sloping line on the chart that can act as support or resistance. Often, when explaining technical analysis topics, a picture can be better than a thousand words.
Here's an example of an upsloping simple moving average that is acting as support.
Horizontal support or resistance is a little trickier to identify on a price chart. My basic definition is any price level that has been hit two or more times in the same direction that has either supported price from moving lower or prevented price from moving higher. However, a single-period high or single-period low can also be considered support or resistance. Remember, the more time price hits a certain level, the stronger the support is thought to be. In addition, support or resistance, once broken, will turn into the opposite.
Here are current examples of horizontal line support and resistance.
As you can see, on Safeway's daily chart, support exists in the $22 range. Safeway investors would be wise to use this support level as a stop-out point should price drop below it. In addition, a technical buying opportunity will present itself should the price hit the support level and then start to bounce higher.
Micron Technologies (MU)
This is a great example of both support and resistance. The lower line in the $9 area is classic support and the upper line located at $13 is classic technical resistance. Buying on a breakout above the upper line or on a breakdown to the lower line, if it holds, makes perfect technical investing sense.
Risks to consider: Technical analysis is an inexact discipline. It is ideal for illustrating what has happened and for providing a context from which to make investing decisions. It is most effectively used in conjunction with other analytical techniques rather than by itself. I like to think of technical analysis as a map used to plan decisions, but with the caveat that outside factors that can change the trip at any time.
Action to take: Review your portfolio from a technical perspective. Look at your holdings on a daily chart while plotting support and resistance levels and the 50- and 200-day simple moving averages. Does the map match your expectations? You may be very surprised at what you find.
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Do it once a year. This allows the best-performing asset classes to take off and run.
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