'We're overbought.' 'We've got resistance.' 'This rally needs to be confirmed.' 'We're testing support.'
Tune in to the financial commentators, and they'll toss off these items like a play-by-play announcer at a ball game. But what the heck are they talking about? Although these talking heads are discussing straightforward stock market issues, they're so deep in jargon that they confuse as much as they clarify. I'll explain what these pundits are talking about, and show you how to profit from their technical reading of the stock market's tea leaves.
Fundies vs. Techies
Most of us are fundamental investors. We analyze company financial statements, look at what the economy is doing, digest quarterly results and generally try to focus on stock prices that are mispriced in relation to what they are really worth.
Yet many investors also rely on technical indicators for part or all of their analysis. I've met many people that spend a lot of time analyzing stock charts but couldn’t even tell you what the companies do. These folks have a deep trust in the belief that stocks follow regular trading pattern, and that you can figure out the best times to buy and sell simply by spotting trends on a chart. Most of the chart-reading tricks are applied to the broader stock market, but some can also be applied to a particular sector or a specific company.
What Investors Should Know
Here's a look at five indicators every investor should know.
1. The Arms Index. This was developed by Dick Arms more than 40 years ago. The Arms Index takes the number of stocks that are advancing (A) against the number that are declining (D), and comes up with an A/D ratio. You then look at the volume of stocks advancing versus declining, which yields an A/D volume ratio. Divide the first by the second to see if the market is overbought (and ready for a pullback) or oversold (and ready for a rally). Whenever the A/D volume ratio is higher than the A/D ratio, that's a bullish sign for stocks; the reverse is a bearish sign.
2. The McClellan Oscillator. This is a favorite of CNBC's Jim Cramer. The McClellan Oscillator calculates the net number of stocks that are advancing. Any reading above zero is bullish for stocks. Thankfully, you can now skip the math and simply go to sites such as StockCharts to see the latest reading.
3. Bollinger Bands. Bollinger bands help to analyze whether the stock market will soon enter into an unpredictable and choppy phase (known as volatility). This approach simply plots a line above and below a stock market chart, and as markets start to move with wider swings, the plot lines become wider. Even as the band is 'loosened,' investors can still see if the market has risen or sunk too quickly, moving outside of those bands. When it falls below the band, the market is due for a rally, and vice versa.
4. Head and Shoulders. Market watchers like to see a stock or the whole market break out to a new high. That’s often a harbinger of even more gains to come. But what happens when a stock or the whole market pushes right up to a recent peak (or the 52-week) high, only to see it pull back? That's seen as a possible sign of trouble. And what happens when it tries again to breach that peak, but doesn't even make it as far as before? Well, that's a head and shoulders pattern downward move.
5. Moving Averages. Although I generally rely solely on fundamental analysis, this is a technical analysis tool I swear by. First, a little background. Over the years, I've come across many stock opportunities that looked great, but just sat there, going nowhere. Over time, I simply gave up on them.
I finally realized that you need to wait for a stock to start to make its move before buying in. Sure you may miss the first leg of the upward move, but you're also not settling for stocks that go nowhere.
That's why moving average (MA) analysis is helpful. In a nutshell, you want to buy stocks that are starting to move up beyond a 50-day, 100-day or 200-day MA. For example, a stock may have started off the year at $30, slowly drifted down to $10 and then sat there for a stretch of time. The longer it languishes at $10, the lower the MA is likely to drift, perhaps to around $12 or $13. Once that stock starts to rebound up, past that $12 or $13 mark, you know that sellers have been flushed out of the stock, and buyers are starting to step in. You may not be the first to arrive at the party, but you’ll be happy to have company pushing up the share prices.
You can find good examples and up-to-date chart tools for all of these terms on the Internet. I suggest you play around with each of them to find out what works best for you. These indicators are no substitute for good old-fashioned fundamental research, but they can serve as a complementary set of tools.