(Welcome to a somewhat unusual edition of Investing 101 (not that too many of these columns are ‘usual’). We’re going to cover an aspect of investing that many passive, value-oriented investors such as myself don’t usually consider, technical analysis. Of course, just because it’s not my favorite subject, doesn’t mean it isn’t important to know. So, as we often do, it’s time again to get some of our questions answered.)
Q: What is Technical Analysis?
A: Technical Analysis is a method of investing (actually, speculation) that maintains that the current and past prices of a security tell you everything you need to know about the security. The goal of a technical investor is to use the patterns of past prices to determine how the price of the stock will shift in the future. The technical investor does not concern himself or herself with the fundamental value of the underlying stocks, per se, instead studying the momentum and current prices of the stock based on trading patterns.
Q: Sounds pretty neat; how do they track these trends?
A: The most common tool used by the technical trader is a chart of past stock prices. An example is shown below, showing the S&P 500 Index from 1996 to 2006 (taken from markettechnician.com):
The idea is, by studying the patterns of charts like this (usually covering shorter time frames, days, weeks, or months) and applying a range of tools in order to determine where the stock prices will go, it becomes possible to determine how the stock prices will change in the future, and profit by either buying the stocks or shorting them.
Q: Whoa, cool! How do you read these charts?
A: Hold on there, that’s a rather complex question. Technical analysts claim that there are dozens of indicators to determine where stock prices are headed, and plenty of patterns that appear in the charts to guide their trades. Even a basic overview could fill a week’s worth of posts, and frankly, I’m not a bit enough fan of technicians to devote that level of time and effort to examining the process.
Q: Sounds like you don’t enjoy technical analysis; what’s that about?
A: I’m a bit leery of any investment or speculation strategy that focuses on stocks in isolation from the underlying companies. While it is true that stocks will often increase or decrease in value for reasons that have little to do with the underlying fundamentals of the company, the idea that such increases or decreases can be predicted purely from previous stock prices strikes me as unlikely. In general, I tend to lean more toward value investing (at least, in theory; in practice, so far I’ve only invested passively without much consideration of either valuation or technical indicators).
Q: Then, why bother to write about technical analysis?
A: A few reasons. It is a major factor in many traders’ investment choices; even if you don’t apply technical analysis (or even know what it means), the concepts and ideas of technical traders can influence the value of your investments. Furthermore, I by no means feel that my way is the only way to invest; if you have the right mindset, you might find technical analysis more useful than I’ve portrayed it. Even if you don’t become a day trader, jumping in and out of investments according to technical signals, it can be helpful to have at least a basic understanding of technical analysis. With many of your fellow investors following technical signals, knowing whether they are planning to buy or sell will help you to know what will happen to the prices in the short term, and thus whether your stocks are about to become cheaper or more expensive.
This concludes our introduction to technical analysis; it’s not quite my cup of tea, but if you are interested, there are plenty of resources out there to continue your research. Enjoy living the life of a technician!
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