Charting stocks to become a better investor

Nation's Business,  Jan, 1998  

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Looking for a simple way to become a better stock market investor?

By charting.

Stock charts show you at a glance how a stock has performed. According to charting aficionados also known as technical analysts), these snapshots can yield important clues to how a stock will perform in the future.

"Over the years, charting has protected me from a lot of disasters," says Richard McDermott, a veteran stock broker and editor of Analyzing Bar Charts for Profit a book by John Magee. "Charts protect you from big losses and help you further your gains," McDermott says.

Although some fundamentalists dismiss charting as investment voodoo -- and, when carried to an extreme, it may be just that -- simple charting techniques are proven tools that stand up to the test of logic. A basic stock chart does nothing more than reveal buying and selling patterns that would be hard to discern by reading stock quotes in the daily newspaper; charting shows heavy selling that develops whenever a stock reaches a certain price, for example, or repeated heavy buying at another price.

A simple chart consists of a vertical axis, scaled to represent a stock's price, and a horizontal axis, scaled to represent time. The time axis generally spans many months or even years, broken into segments representing days or weeks.

Traditionally, chartists have plotted their information by hand on graph paper. In each time segment, both the high and the low price of the stock are marked and connected with a vertical line.

Many chartists also include a companion chart -- indicating the stock's trading volume -- below the one representing the stock's prices.

Why? Because volume is a key indicator of supply and demand. A stock moving higher on heavy volume is much more likely to continue climbing than one that is moving higher on light volume.

"You like to see volume expanding when the stock is going up and contracting when the stock is going down," says Ralph Acampora, head of technical analysis for Prudential Securities in New York City.

Although you can produce charts by hand, you may prefer to buy them from charting-service companies by subscription or to create them in seconds using a personal computer and any of a dozen or so software programs designed for the job. (Two popular and inexpensive programs are Wall Street Analyst, by Omega Research, and Personal Investor, by Window on Wall Street.)

Three Core Patterns

Although dedicated chartists sleuth out esoteric patterns such as "island reversals" and "rising wedges" in their stock charts, novices can focus on three simple things:

* The correlation between a stock's price and volume activity (as shown by the price and trading-volume charts).

* The stock's price trend line (up or down).

* The stock's support and resistance levels (the prices at which a stock typically reverses course).

To create a price trend line for stocks that are moving higher, chartists draw a line that connects the ascending low points of the bars that show daily high and low prices. For stocks that are heading lower, the trend line connects the descending y price high points.

The more times the stock hits and bounces off the trend line, the greater the significance of any subsequent price move that violates the line.

If a climbing stock's price falls decisively (3 percent or more) below its rising trend line, it means that the stock's likely to be over, particularly if the trend line is broken on heavy volume. Similarly, a declining stock that decisively pierces a descending trend line might be poised to reverse course and start rising in price.

The Outer Limits

Sometimes, stocks move neither up nor down consistently but instead bounce back and forth in what Wall Street calls a trading range. When that happens, it's helpful to identify the stock's support and resistance levels for clues to its future direction.

A support level is a price at which buyers repeatedly appear, preventing the stock from falling lower. A resistance level is the opposite: a price at which sellers repeatedly rear their heads and bail out of the stock, preventing it from moving higher.

If a stock breaks decisively below a support level, it is likely to continue falling until a new level of support is established. That's your cue to sell. If it breaks through a resistance level, it is likely to push on to new highs. This could be a good time to buy.

If you'd like to give charting a try, bear in mind that it is as much art as science. If trading patterns could always be deciphered easily, with no exceptions to the rules, all chartists would be rich. They're not.

Still, technical analysis can be a wonderful tool for even novice chartists. At the very least, it can help you decide whether other investors concur with your fundamental analysis of a company's business prospects.

If you like a company but its stock chart suggests that other investors don't, for example, you may want to postpone buying until the chart looks more favorable. Similarly, you can monitor unfavorable developments through a stock chart to help you make selling decisions.