Position Selection: Choosing the "Right" Stock
From a practical standpoint, technical analysis is more suitable to short-term trading, since it offers the most accurate method for identifying entry and exit points. At the same time, fundamental analysis can often provide a more accurate picture of the long-range outlook, yet it is miserably inefficient for predicting the near-term movement of stock prices. Nevertheless, analyzing the value of a company can help to forecast future profits (or losses) and since earnings significantly affect share values, it is important to have complete and accurate knowledge of a company's financial condition. We have all witnessed how a quarterly report can affect the short-term trading activity of a stock and the catastrophic losses that can occur when a company announces earnings that are different from the current consensus estimates. A worse-than-expected profit outlook will also cause stock prices to fall and when the news becomes public, analysts are quick to change their opinions on the company, downgrading the issue and causing further damage to its share value. Obviously, this is one of the few times when fundamental analysis might be helpful in a short-term trading scenario.
Although some extreme fundamentalists dismiss technical analysis as investment voodoo, simple charting techniques are proven tools that stand up to the test of time. A price chart does nothing more than reveal buying and selling patterns that would be almost impossible to discern by reading daily quotes in the newspaper. Charting clearly reflects the repeated accumulation that occurs at periodic lows and the climax selling (or distribution) that develops whenever a stock reaches a historic top. Various systems have been developed to help investors form an opinion about future tendencies (and likely catalysts) based on the past price activity of the underlying issue. Most analysis begins by determining the strength and direction of the primary trend and the foundation for additional forecast is predicated on the premise that once a trend is in motion, it will continue in that direction until a change in character occurs.
Which Approach is Best?
Those who are relatively new to technical analysis may think it is too difficult to learn, however the key concepts are really very easy to understand. In fact, this seemingly complex approach to stock valuation is founded on three simple assumptions.
1) The current market price of particular security or financial instrument is the true value of that issue at any given point in time
2) A thorough study of market-related data such as price, volume, and buying pressure (accumulation/distribution) will uncover identifiable trends or patterns in any issue
3) History eventually repeats itself
These assumptions can be combined with the study of historical data to provide investors the information they need to formulate profitable trading strategies because the technical indicators that lead to buy or sell signals are contained in various chart formations and patterns. The most common of these chart patterns or indicators are the "trend" and "trading range." Trends are generally categorized as up, down, or lateral while trading ranges are typically defined by support and resistance levels. It is important for an investor to be able to identify these trends or trading ranges and recognize the historical chart patterns that signal major turning points or reversals.
Trends & Trading Ranges
Another general classification of price patterns is the trading range. A trading range occurs when the price of the instrument remains between a clearly established high and low value. The upper boundary is known as resistance while the lower is termed support. A resistance level is established when there are more investors willing to sell, rather than buy, at a given price because they believe the security is overvalued at that level. A support level will occur when investors feel the stock is cheap or undervalued at a given price and they can't afford not to own it. From a chartist's point of view, that is the area where it is most advantageous to initiate new positions.
Trading ranges can also occur as part of an uptrend or downtrend. These patterns are often called "continuations" since the general direction of the overall trend is not changed. Another type of buying signal can occur in the transition or "reversal" from an uptrend to a downtrend. A key reversal occurs when the daily price range has a high that is above the previous day's high and a low that is below the previous day's low. It is often referred to as an "outside trading-range" day and most analysts agree that this short-term pattern (a close above previous day's final price) is a bullish signal. If the key reversal occurs near a bottom in the long-term price cycle, a trend reversal is likely in progress and the opportunity can be used to initiate long stock positions with relatively low downside risk.
In all cases, the goal of the technical analyst is to use the past price activity, trends, and chart patterns of a particular stock to predict its future direction and possible changes in character. Once you can do this accurately, on a regular basis, you are well on your way to becoming a successful options trader.