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How to get an edge when picking direction

December 19, 2018

December 19, 2018

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How to get an edge when picking direction

Investors and traders alike have long held strong views on what the best methods are for identifying opportunities. Technical analysts seek an edge by assuming past behaviours are likely to repeat themselves, while fundamental analysts are attempting the same but by identifying undervalued and or growing companies, believing they are more likely to appreciate over time.

Using technical and fundamental analysis, and combining both.

Investors and traders alike have long held strong views on what the best methods are for identifying opportunities. Technical analysts seek an edge by assuming past behaviours are likely to repeat themselves, while fundamental analysts are attempting the same but by identifying undervalued and or growing companies, believing they are more likely to appreciate over time.

When it comes to which method is superior, it often comes down to timeframe and personal preference.

The legendary investor Peter Lynch states, “Charts are great for predicting the past”, and famous UK investor Anthony Bolton says, “If I were on a desert island and allowed just one investment tool, it would be the chart”.

Both investors were incredibly successful and chose a method that worked for them. One was purely fundamental and the other a combination of both.

For this article I am assuming that we are all using fundamental analysis as our primary method to identify an investment opportunity.

I will look at situations in which technical analysis may help improve your investment decisions.

What is technical analysis?

Technical analysis is the study of price history and volume data, looking for patterns that can determine future movements. A stock’s price is determined by the supply and demand of its shares. If we can predict supply and demand, we can predict the direction the stock will move.

The main method of technical analysis is charting, where we look at price history to identify key historic buying and selling points to predict a future selling or buying point.

Another form of technical analysis is technical indicators, which are usually mathematic formulas that are represented on graphs, as shown below.

Using technical analysis to help choose a stock

Let us assume you have used fundamentals and narrowed yourself down to two banking stocks, everything appears equal and you have no real reason to choose one over the other.

Technical indicators could assist in deciding and here are some you may consider (each indicator is explained at the end of this story):

  1. Is the 50-day moving average above the 200-day moving average?
  2. Is the share price above the 50-day moving average?
  3. Is the share price above major resistance?
  4. Is the ADX (average directional index) above 25?

 

If the answer is yes to all these questions for one the bank stocks, you may form the view that it has broken a key resistance level, its momentum is with the buyer, the stock is trending up and the trend is strong.

Would you prefer to buy this bullish stock over a stock that was trending down or range bound? If the answer is yes, then technical analysis may help you in this scenario.

Using technical analysis to choose an exit level

You bought shares in XYZ five years ago and they have performed well, but you no longer have a strong opinion on the growth plans and feel they may be fully priced. With a healthy gain but plenty of embedded tax, you are not in a rush to sell, but watching and considering your options.

Here is an example of some technical indicators you may consider:

  1. Is the 50-day moving average below the 200-day moving average?
  2. Is the share price below the 50-day moving average?
  3. Is the share price below major support?
  4. Is the ADX above 25?

If yes to all these questions, you may form the view that it has broken a key support level, the momentum is with the seller, the stock is trending down and the trend is strong. If this was the case it might help time your exit; inversely, if it was trending up you could feel good about staying in the stock for now.

Using a number of indicators together helps me establish a view with confidence. However, there are thousands of different indicators and I would advise you to keep it as simple as possible.

As an investor, technical analysis can be a useful tool at times. People make decisions in different ways, so how useful, and when to use them, is up to the individual. But it makes sense to include both technical and fundamental analysis in your toolkit.

An explanation of the technical indicators

  • Moving averages (MA) are one of the most widely used indicators and designed to smooth out the noise from random price movements. I look at the 50-day and 200-day moving averages and when the 50 (MA) crosses above the 200 (MA) it may indicate a bullish trend; when the 50 (MA) crosses below it indicates a bearish trend.
  • Key support and resistance. The top or bottom of the range, levels where buyers or sellers have taken control, and often key psychological levels.
  • ADX shows how strong the trend is. It is a great additional filter that can show if the trend is present or absent. Anything below 20 shows the trend is absent or weak.

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