By using point and figure charts, your investment adviser is using price as the ultimate indicator to manage the risk of your investments. That’s why, here at Mullooly Asset Management, I strongly believe in the practice of technical analysis. In this article, I explain what exactly “technical analysis” means.
Technical analysis is a way to study investments only using prices. By comparison, fundamental analysis is a way to study the value of an investment using practically everything else. Prepared as charts, some forms of technical analysis use (or incorporate) trading volume and moving averages, rates of change, among other measures. But the primary measure for technical analysis is price.
Using technical analysis can help you determine whether an investment is in an uptrend or downtrend. These types of tools can help to determine if a particular investment is merely pulling back in an otherwise orderly uptrend, or starting a new downward trend.
In 2010, more and more investors are starting to include some form of technical analysis to help them make better investment decisions. Tom Dorsey, of Dorsey Wright & Associates, often equates using technical and fundamental analysis to using two hands to play the piano. Where technical or fundamental analysis may only tell you one side of the investment story, using some combination of both the technical picture and the fundamental backdrop allow you to get a better image of what is actually happening with an investment.
There are different types of charts used in technical analysis:
- Line Charts
- Bar charts
- Candlestick charts
- Point and Figure charts
There are more, but these are four well-known types of charts. Additionally, there are some fairly well-used terms in technical analysis, like bands, oscillators, stochastics, relative strength, which will be covered in other articles.
Line charts often use the closing price of an investment, then connected one day after the next. It can give you an image to help paint a picture if this investment is trending up or down. A bar chart takes the information from the line chart and adds a dash where the opening price is each day and another dash where the closing price is each day to the chart. The open price for the day will be on the left side of the bar, the closing price will be on the right side of the bar. If the bar for the day (or the week) has a higher dash on the right side (close), this means the investment has moved up. Candlestick charts add even more information, showing the difference between the open price and the closing price. Depending on what happened that day (or week) will determine the pattern that is added to that candlestick chart.
Point and figure charts were created by Charles Dow, the first publisher of the Wall Street Journal and creator of the Dow Jones Industrial Average. Even though Dow was actually a fundamental investor, Dow created these point and figure charts (called “figuring” in his time) to help eliminate the day to day rumors, wiggles and “noise” in a stock.
Technical analysis really does not care about a company’s market share, or a new product coming out, or whether or not that corporation met their quarterly earnings estimates. All that really matters with technical analysis is the price.
And this is where technical analysis really differs from fundamental analysis. Technical analysis believes that all the news is already known. People will buy and sell for all kinds of reasons. These buyers and sellers may be short-term flippers, or someone with inside information, or a long term investor. The point is: if enough people show up to BUY a particular security, this indicates something “in demand.” When enough folks decide it is time to sell a security…regardless of the news or event, this investment now has “supply.”
When there is demand for something (anything: tomatoes, oil, real estate, stocks), prices must rise. When there is too much supply (too much oil, too much milk, anything), prices must fall. Technical analysis helps to determine (in a visual chart) whether the investment you are looking at is in demand or in supply.
So, while the fundamental backdrop for an investment may paint a glowing image for a bright and sunny future, the technical picture could show sell signal after sell signal, and a cascading stock price.
Want to know more? Check out this article: Technical Analysis Better than Fundamental Analysis?