Nowadays, short-term traders believe that price is driven primarily by what people are saying and how they are saying it. That’s why they’re also interested in the technical analysis of charts. Why do they invest money in a stock today when everyone else is skeptical? That’s a good question, and one we had to look into in depth.
When people say a “good chart” shows a stock about to make a move up, they mean it shows an upwards/leftward trend line and a higher high. It’s a pretty standard thing to do. But if you notice, most charts show moving averages too. As it turns out, only a small fraction of the time do you need to look at moving averages to determine where a stock is going. That doesn’t mean you can ignore them, but the degree to which they’re relevant for determining future prices is much lower.
Most investors don’t have the luxury of waiting for a pattern to develop; they need to act right away. And when that means that they have to bet on a bullish trend at a price point that’s significantly higher than other people have to, most investors will ignore the moving averages and move the stock in their own way.
But since moving averages are part of a bull trend, they actually represent a floor of sorts for a stock, as well. When you see a bullish market developing, that’s when you want to buy a stock for the long-term. Just like a forex trader, that’s when you want to buy a trade. As we’ve explained before, investors have to take some of their subjective risk into account, and buying something with a high correlation to a bullish trend — even if there are better places to make money — is the right way to go.
What about “support”? It’s a more complicated story.
Past is not always prologue. Every time you see a chart with moving averages, do you know how many of those moves were significantly higher than what the stock was trading at at the time? We don’t know the answer to this question, and we may never know, but we can get a good estimate by using a tool called closing prices on the NYSE. This formula tells us the percentage of all closing prices between the end of the previous day and the next day that were higher than the actual price, which we can use to determine how likely it is that an upward move on a stock’s chart is going to result in more gains for the stock.
In practice, that number is not going to be as high as it was a couple of weeks ago or a couple of months ago. And you probably don’t want to put in a lot of money when that number is less than the price at which you’re actually buying the stock. That’s why we’re telling you not to jump in and buy a stock just because it shows a pattern of higher highs and lower lows. And yet, we’re also telling you to pay attention to the stock for the long term, as we told you to do in the first place.
It’s easy to be seduced by a trend line and to look at the chart to determine the value of your portfolio right now. But if you wait for a pattern to form before you buy, you’re going to miss out. And that’s going to be a bad decision for you.
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