Investors are different. Some prefer the excitement and pain of high risk investments, others prefer a steadier, surer approach with preservation of capital as the first priority. Those in the first group have likely responded to the recent market fall, buying shares. Those in the second group are probably still on the sidelines. What would give more cautious investors the green light to start buying?
Waiting for an unambiguous improvement in the fundamental conditions may mean missing the opportunity to buy shares at lower prices. The share market prices the future, not the present, meaning by the time the numbers are good the market may already reflect the improvement.
This is where investors can employ charts. There are still some pockets of investors who believe charts are a form of voodoo, but the view is outmoded. An increasing number of investors, and almost all frequent traders, use charts in some way to inform their buying and selling.
Investors don’t need to be efficient market theorists to use charts effectively, nor is a mathematical university degree required. Two simple concepts can improve any investor’s performance. Identifying share price trends and support and resistance levels can help investors buy their intended investments cheaper and/or more safely.
As an example, here’s the current composite chart of the Australia 200 index:
The composite chart includes both the daily movement in the Australia 200 index and the overnight moves implied by futures markets. This is a daily chart, so each “candle” represents one day’s price movement.
Technical Analysis – Principles
The theory underpinning charts is that the available information about a stock (or index, currency, commodity, bond etc) is reflected in the current price. Further, despite being described with numbers, markets are essentially organic in nature – a form of crowd behaviour. This means that there are patterns of behaviour that may be discerned on a chart.
There is an element of art to technical analysis, as well as science. It’s important to remember that a pattern on the chart points to a higher probability of a particular share price move, but does not guarantee it. There are no 100% accurate indicators in either fundamental or technical analysis.
This art aspect means investors should not get hung up on an exact price point for a share, but rather be aware of the “behaviour” of the price as it approaches important levels. Skills in technical analysis are rapidly improved by practical application.
With these principles in mind, let’s turn to the current index chart to illustrate the building blocks of charting – identifying trends, and support and resistance levels.
The random walk theory of markets says all price action is unpredictable. However, study after study shows price trends can persist for far longer than the random walk theory allows. This is important to investors, and is the same principle that underlies momentum investing. There are three possibilities – the price is trending up, trending down, or is moving sideways.
Down trends are characterised by lower highs and lower lows for each candle. A down trend line is drawn above the prices, as shown by the black lines on the chart above, and should touch at least three highs. Investors are particularly interested when the price approaches the trend line. Will the price break through the trend line and end the downtrend, or will it respect the trend line and continue to fall?
An uptrend observes the same conditions in the opposite direction. Daily highs and lows must be moving higher. The trend line is drawn under the prices. A fall through the uptrend line signals the end of the uptrend. As many investors are painfully aware, there are no uptrends available for illustration purposes from the last six months.
The third possibility is neither an up or down trend. This is known as sideways trading, and is the current state of the market. In breaking the down trend (black) line, there is a clear signal that the down trend is over. However, while there may be an uptrend emerging, a third higher low is required to confirm.
Support and resistance
Price levels where the market has repeatedly bought or sold form what is known as support (buying) and resistance (selling) . The idea is that investors made decisions at these price levels in the past, and may take the same action again if there is a return to the price level.
Support is identified by a series of lows, or repeated lows around the same price level, indicating there is widespread interest in buying at that level.
The index on the chart is at key resistance. The initial bounce off the lows of the down trend ended at 5310. If the index now trades above that point it will “break” resistance. This would signal a new uptrend, and would therefore likely trigger buying from cautious investors waiting for a surer sign the correction is over.