Understanding the technical analysis of stock trends is a key to making money in the stock market even if you are using fundamental analysis by looking at earnings and valuation metrics when picking out the stocks you want to trade, because it is critical to making good entry and exit points in them.
I know it because I’ve used trend analysis for years to understand what is happening in the stock market. I ran a hedge fund over a decade ago and now operate a private high level investment mastermind group that includes accredited investor and big institution traders. We talk about these methods and share ideas with each other all of the time and I write about them on this website.
These things are second nature to me, and that’s why I believe if you understand some of the basics you can apply them yourself.
To explain technical analysis to you in simple terms isn’t hard.
It basically means making decisions based on the price history and price trend of a stock and knowing a few simple patterns made on stock charts that tend to repeat.
What you need to understand is that stocks are traded by people and people respond to price and that will never change.
No matter how great a company you invest in may be if you own its stock and it crashes you are going to feel emotional pain and if it goes up you will feel euphoric.
Those emotions impact everyone who is in a stock or is simply watching a stock and thinking of buying it. That means price movements impact what a stock is going to do; and that all shows up on patterns that tend to repeat on a chart.
How does this work?
The classic book Technical Analysis of Stock Trends by Edwards and Magee lays out the foundation concept that all is built upon.
Their book talked about support and resistance in a stock. Support is an area in which people come in to buy and resistance is an area they come in to sell. It’s all driven by emotions.
Ok so let’s figure out how support works. Let’s say you are watching a stock that you want to buy and it’s trading at five dollars a share. You hesitate to buy, because you are not sure. Then suddenly the stock shoots up to ten dollars a share. You hit yourself in the forehead with regret.
“If only I bought,” you tell yourself. Well you wish the stock would go down. You see it pullback a little to seven dollars a share now think it’s a steal. The move to ten convinces you that’s it’s real and you don’t want to make the mistake of missing out again. So you buy. Thousands of others are thinking just like you too and all of your combined buying creates a support zone in the stock.
At the same time there is some buyer who bought at the high price of ten dollars a share who is scared because he saw the stock fall to seven. He is in emotional distress, because he’s thinking he lost money on the move down. He wants to get out so when it goes back up to his break-even point he dumps.
People like him are creating resistance in the stock and as long as they are in it they will prevent it from going higher than ten.
A powerful zone of support and resistance has now formed in the stock. You can sit there and watch it go up and down with buyers coming in again and again where you came in and sellers at ten. At some point though the stock is going to run out of potential buyers once the last guy on the sidelines gets in or is going to run out of potential sellers at ten. If that happens the price resistance holding the stock down will vanish and it will takeoff.
You’ll then make money because the price will go up and form a new resistance level at a higher price. Many who are still on the sidelines will then be buyers at a higher level than they are now. It is the price movements of the stock that people react to and their reactions and emotion that create the overall trends that define the up and down lines you see on a price chart.
These are the free market forces of simple supply and demand that drive all financial markets and cannot be stopped. Let’s apply these concepts to a simple technical analysis of gold as an example.
Gold made a top in 2011 and went into a bear market. It bottomed in 2013 and at the moment is going sideways. It’s long-term moving averages turned down during the bear market, which told us all we need to know.
Now the rate of their decline is decelerating, which is telling us that the bear market is pretty much over. Once the moving averages flatten out and gold goes back above them then we’ll know a new bull market is on.
Stocks in that sectors are doing the same thing. You just need to be able to read the trends to know what to do.
You make money in the financial markets by understanding them and then harnessing to your own benefit. You ride the trends until they end. Then you identify a new one and ride that one out.
Putting It all Together
There are many books about technical analysis that you can buy. I have written one myself that has been a best seller since I released it in 2008 called Strategic Stock Trading.
People also use various technical indicators on their charts to better understand price trends and try to detect changes in the trend ahead of time so they can buy near bottoms and book their gains near important tops.
I want to tell you though if you use them don’t get so caught up in them that you make things too complicated for yourself. People new to this game try to find some perfect combination of indicators to figure everything out for them, when that doesn’t really work.
Instead indicators should just be used to help you understand the overall price trends better. I only use a few of them myself, with the simple moving averages being the most important one I use.
There is no need to get lose yourself in a deluge of information and get lost. You just need to keep things simple. I’ve found one simple chart pattern to be my most consistent money maker when it comes to picking out individual stocks and written a technical analysis pdf all about it for you. It’s called The Two Fold Formula.