After years of tranquil trading, stock market volatility returned with a vengeance in 2018, making some investors seasick from the way equities lurched from headline to headline.
Overreacting to stock market dips and rallies can wreak havoc with your investment plans and portfolio performance. One way to tune out the noise of short-term market movements is to use technical analysis. This methodology analyzes trading statistics, such as the speed and direction in which stock prices move, to forecast price movements.
[See: 9 Investing Steps From Warren Buffett’s Playbook.]
Technical analysis can help traders and investors spot patterns and trends on charts to determine when a stock is worth buying or selling. Some market watchers use technical analysis in conjunction with fundamental analysis, which attempts to measure a stock’s intrinsic value using economic or financial data; others only use technical analysis.
Tap into crowd wisdom. Sean Brown, chief executive officer at YCharts in Chicago, uses technical and fundamental analysis together. He says technical analysis is like buying a home based on its historical price or historical tax bill, while fundamental analysis looks at the home itself and the neighborhood.
“Technical analysis is an added source of perspective when you feel good about a stock from a fundamental standpoint,” Brown says. “It takes the emotion out of it. It may either confirm that it’s a good time to buy or may give you some signals that maybe this stock is overbought right now and you have to be careful.”
Because technical analysis only studies share price behavior, it takes the emotion out of trading, says Greg Morris, a technical market analyst and author of “Investing with the Trend.” The beauty of the strategy is its objectivity. “It’s not some analyst’s opinion about what’s going to happen in the future or what earnings are going to be,” he says.
Technical analysis is much like using the wisdom of the crowd, says Dave Toth, chief technical market analyst at R.J. O’Brien in Chicago. “You have to be comfortable with the assumption that at any point, that price and that chart pattern embodies the entire world’s best view of the price for that market at that time,” Toth says.
Closing prices are the key to gauging momentum. There are many different price indicators technical analysts can use, and that’s where the strategy can overwhelm new users. But most technical analysts try to keep their own analysis simple by following momentum trends based on the stock price’s direction and the velocity of the move.
The key to determining how a stock price will move is the daily closing value, says John Person, author of “Mastering the Stock Market,” a book about technical analysis. “For me, the trick always has been to look for markets that can sustain positive monetary gains or positive momentum [by closing] greater than past highs,” he says.
[See: 7 of the Best Stocks to Buy for 2018.]
A common way to use technical analysis is to look at the price close over a specific period using moving averages, Morris says. The ones typically used are the 50-day moving average, which reflects about 10 weeks of closing data, and the 200-day moving average, which accounts for nine months of data.
Here’s how it works. Let’s say you wanted to follow Boeing (ticker: BA). Then you would plot the 200-day moving average on a chart, Morris says. When Boeing’s share price moves above the average, buy the stock. When Boeing falls below the moving average, sell.
“You don’t have to set a percentage stop-loss on that,” he says. A stop-loss order is set in advance and specifies a price when a stock should be sold to limit losses. “You just let the indicator be the stop-loss level; that’s as simple as it gets, and it works.”
Eric Ervin, chief executive officer at San Diego-based exchange-traded fund provider Reality Shares, uses both the 50-day and 200-day moving averages. A bullish pattern to watch is the “golden cross,” when the 50-day average moves over the 200-day moving average, which is a sign short-term and longer-term momentum are working in tandem. When the 50-day moving average falls below the 200-day, it’s a bearish sign known as the “death cross.”
Ervin says people who use technical analysis should study how individual stocks act because some stocks, like those in the tech sector, may be more volatile than others. As a result, investors may need to adjust which moving averages to use.
Person says technical analysis can be used for really short-term positions that may be held for days or weeks, or long-term positions held for a few years. For longer-term positions, look at how the stock price behaves when a market starts trading at the beginning and the end of the month.
“Everyone wants to beat the S&P at the end of the year or on a quarterly basis,” he says. “Monthly and weekly chart analysis is paramount to helping an investor identify the stocks that they’re looking to trade, even if they’re not active in the market on a day-to-day basis.”
The strategy has its limits. Technical analysis can remove the emotion from trading but only if you remain disciplined. “You have to trust your system, and that’s easier said than done,” Toth says.
And technical analysis is not perfect. In volatile markets, traders say they can get whipsawed in the short term if prices bounce around the moving averages.
Because technical analysis can give investors clues about when to buy or sell a stock, the strategy can help investors avoid market extremes if they stick to entry and exit points based on market signals, Morris says. “The trader or investor has to have the discipline to stick with it, or it won’t work,” he says.
[See: 9 ETFs for Nervous Investors.]
Technical analysis isn’t about trying to time market tops or bottoms, either. But it is about smoothing out the trading experience, Morris says. “I’m very honest about this,” he says. “You’ll probably underperform in big bull markets, but you’ll also avoid the bear markets.”
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Beat Back Market Anxiety With Price Analysis originally appeared on usnews.com
