How Charts Help With Trading, Part 2

In Part I of this series on technical analysis, Michael Kahn discussed what charting really is and what it is not. You can read part 1 of "How Charts Help With Trading" by clicking here.

In this conclusion, we’ll discuss how to put charts to use and how they help traders and investors alike make better decisions.

Let’s break this down a bit for practical use. If we know how prices got to where they are now (trend), the structure of the price movement (volatility and rate of change) and the structure of the pauses along the way (chart patterns) we will understand the ebb and flow of the public mood.

If we know how to spot full participation by the public (volume) and when price action gets a bit too exuberant (momentum) we will understand supply and demand. Putting it all together helps us know when it is time to close a position, either because it was not a good one, it has reached its full potential or the market simply changed its mind.

Let’s delve a bit more into each of these aspects. For starters, no matter what market analysis method is used, everyone will agree that trends exist. Information is slowly disseminated to the public in an imperfect manner and as the public acts on the information, the markets move. They continue to move until either the last group has acted or an outside influence, such as news, ends the trend. Sounds a lot like physics, doesn’t it? A body in motion tends to remain in motion.

Perception and Reality

As mentioned earlier, one aspect of the technical discipline is explaining the difference between valuations and actual market prices. If a stock is worth 75 on paper based on discounted cash flows, projected growth and overall economic conditions, why is it trading at 90? The difference is in the market's perceptions of the stock and how people believe the company will do in the future. Charts will help us determine if and when perceptions change.

Supply and Demand

The basic tenet of economics is also one of the pillars of technical analysis. No matter how great a company’s business model and profitability may be, the stock is not going to go up unless somebody wants to buy it. That’s demand and technical analysis can gauge the price levels that are likely to bring out that demand. It can also gauge the price levels likely to bring out supply to halt advances.

Whatever the reason for changes in supply and demand, to a chartist they do not matter. All that matters is that they changed and all we can control is what we do about it. The market breaks out of a trading range and we buy. As it does, more market participants buy and a trend is born. On a chart, all of this is clear.

Risk vs. Reward

Another great part of technical analysis is its ability to tell us when decisions are right and when they are wrong. In the example above, the market moves above the top of its trading range and we buy. However, this time we are alone in that act and the market sinks back. Without much ado, the signal is negated and we close the position for a small loss. That’s part of the game but more importantly a disciplined chartist will never let a small loss turn into a big loss.

Technical analysis also allows us to forecast a likely target for any trend or breakout, not to predict the future but to assess how much profit we may make if we are right vs., how much we may lose should the trade sour on us. If the reward is commensurate with the risk taken to get it then it is a good decision. If not, we move on to better uses for our capital.

Summary

Technical analysis is just a tool we use to decide what to do and as any tool, from hammer to scalpel, the end result depends on the skill of the practitioner. The key goal is understanding the ebb and flow within the market to make the only decisions we can make – buy, sell or hold.

Michael Kahn writes the twice-weekly "Getting Technical" column for Barron's Online and edits the daily Quick Takes Pro newsletter. He is also the author of three books on charting, the most recent being "A Beginners' Guide to Charting Financial Markets." Read his blog at www.quicktakespro.com/blog.