A Basic Introduction to Stocks: Part 2

In part 1, a brief background on fundamental analysis as a basis for making good investments was discussed. Part 2 explores the other core technique used to make investment decisions, namely technical analysis.

 

The human genome has not changed substantially since stock trading first began in 1611. Behavioural economics indicates that human’s psychological, cognitive and emotional attitude to risk/reward hasn’t changed, over this period, either. Technical analysis involves the identification of previous stock trends that indicate how the market, as a whole, feels about a stock: if the market feels bullish towards a stock, its price will be driven up by investor greed, if it feels bearish, its price will be driven down by fear.

 

The two main indicators examined are price and volume, where volume is the number of shares traded over a given time period, as shown in Figure 1. Volume can be analogised to force: high volume is suggestive of a large force driving the stock up/down, where low volume is suggestive of a lesser force driving stock movements.

 

Figure 1: Graph showing Amazon’s stock chart over the past month. The blue line represents Amazon’s stock price over the period. The bar chart on the bottom depicts the daily volume. Yahoo Finance.

 

Lines of support and resistance reflect the market’s perception of the range that a stock should reside within. Lines of support/resistance can be horizontal or inclined/declined depending on the stock as shown in Figure 2. Technical investors often favour stocks with ascending lines of support/resistance and will tend to buy at a stocks line of support and sell at its line of resistance, for maximum gains.

 

Bases are typical platforms of which a stock tends to have a bullish breakout. For example, stock price breaks out of its previous support-resistance regime in a bullish manner. Such trends indicate strong short to mid-term gains. There are many different types of bases; some common bases include a cup with handle (Figure 3) and a double bottom (Figure 4). Note the moderate to large green volume as we come out of the base in each of the examples below.

 

Figure 2: Graphs showing stock trends with horizontal and ascending lines of support/resistance respectively. Fidelity and mytradingskills.com.

 

Figure 3: Graph showing William Sonoma’s stock chart over the past year. Lines of support and resistance are displayed in green and red respectively. A typical cup with handle base is highlighted in black. Yahoo Finance

 

Figure 4: Graph showing United technologies stock chart 1998- 1999. Lines of support resistance are displayed in green and red respectively. A typical double bottom base is highlighted in black. These are commonly associated with a reversal general in stock trend. Stock Charts

 

The question as to whether fundamental or technical analysis is ‘better’ is futile: they are both useful. Technical analysis helps to determine short to mid-term price movements (days to a few years), providing an efficient mode of generating capital. However, investors should be aware trends can be misread, especially by investors with little experience. Fundamental analysis provides an arguably more reliable basis for long term investment (months to decades) but may not be the most efficient way of generating capital as quickly as possible. Therefore, wise investors will adapt and evolve their portfolios with time, based on technicals and fundamentals in order to achieve efficient and reliable gains over time.

 

By Charlie Gregg

Sector Head: Aaron Hobb

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