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Technical Stock-Picking: How to Trade Off of a Stock Chart

Stockpickr Staff

Instead of trying to outsmart the large institutional "elephants," why not join them?

If the big hedge funds , mutual funds , institutional investors and players such as Warren Buffett, Carl Icahn and George Soros (who have billions of dollars to invest, huge research budgets) are buying and selling a stock, then that activity will be reflected in the stock chart -- the graph of the stock's historical price over time.

If a stock's chart is showing that an institutional feeding frenzy is taking place, we might want to join the feast. So instead of buying and holding, we can enjoy the ride up until the chart tells us that the party is over, at which point we would sell.

The key to tracking the elephants: Understanding how to read a chart. A stock chart has three components: price, volume and time frame. Let's look at each of them.

Price. Price is the obvious starting point. Stock prices essentially follow the law of supply and demand. When more investors want to buy than sell, the price rises. When the opposite is true -- there are more sellers than buyers -- the price falls.

Volume. The real key to chart reading is a stock's volume . Typically, only a fraction of a company's stock trades on any given day. Breaking news, such as an earnings surprise , a new product announcement or a pending merger , usually causes the volume to spike, indicating increased investor interest. (The news itself can be either positive or negative.)

Here's a one-year (2007) chart of Google (GOOG - Cramer's Take - Stockpickr), showing both price and volume fluctuations:

Google 1-Year Chart

Click here for larger image.

Source: Yahoo! Finance

Notice that the daily volume trended in a range of 5 million to 6 million shares (for a recent range, check out the box labeled "Avg Vol (3m)" on Yahoo! Finance's GOOG quote page), but that significant spikes did occur during the year -- at one point, increasing to almost 18 million shares.

Spikes are typically due to breaking news. For example, Google's daily volume increased to nearly 16.5 million shares in early November, thanks in large part to the Alibaba.com IPO in Hong Kong. Why? Google competitor Yahoo! (YHOO - Cramer's Take - Stockpickr) is a big investor in Alibaba.com, and that caused some Google investors to sell, causing a drop of over 100 points, from around $741 to $626, in mid-November. Volume confirms the price movement.

Savvy technical investors, seeing a move down on strong volume, would have probably sold before the big down move. A price move on light volume, on the other hand, is usually interpreted as a "lack of conviction," which means that the trend might not continue.

Time frame. When reading stock charts, time frame is also important. A chart can be drawn for a period as long 10 years or more, or as short as a few hours in the trading day -- the so-called intraday chart. The longer the trend endures, especially if confirmed by heavy volume, the more likely it is to be sustained in the future. Google's move from the mid-$400s to over $740 over the year was certainly impressive. Has its momentum run out of steam? To find out, look at a chart over a shorter time period. Here's a recent one-month bar chart of Google:

Google 1-Month Chart

Click here for larger image.

Source: BigCharts

The one-month bar chart (the height of the bar is the difference between the highest and lowest price of the day, the left tick indicates the open price , and the right tick indicates the closing price ) seems to confirm the upward momentum of the one-year chart. Google's price moved about from around $630 to $730, during the month, with strong buying volume on the price dips. So look at a chart over different time frames. A great indicator of strength is if the stock keeps making higher highs no matter what time frame you choose.

Even fundamental -based investors should look at a stock's chart, because the chart will show when buying opportunities present themselves. In Google's case, the stock seems to bounce back consistently from these temporary lows.

Some daytraders use the intraday chart to trade in and out of a stock. For example, here's an intraday candlestick chart of Google for Dec. 18, 2007:

Google 1-Day Chart

Click here for larger image.

Source: Yahoo! Finance

According to Japanese tradition, candlestick charts were invented by the 18th century Japanese rice trader Homma Munehisa, who allegedly could execute 100 out of 100 profitable trades. Each candle in this chart represents five minutes of trading during the day. The height of the rectangle within the candle is the difference between the opening price and the closing price during each five minutes.

If the opening price is lower than the closing price, the rectangle is not filled in, signifying a trend to a higher price. If the opening price is higher than the closing price, the rectangle is filled in, signifying a trend to a lower price. The line beyond the rectangle, either above or below the rectangle, extends to the highest and lowest price in the five-minute period.

On the morning of Dec. 18, 2007, Google sold off about 20 points, from $675 to $655 between the trading day's opening (9:30 a.m. Eastern standard time) to about 10:45 a.m., possibly on short -covering. Buyers came in until a little after 11 a.m., pushing the stock above $660.

The stock traded without a clear trend until about 1:15 p.m., at which point the buyers came in again, pushing the stock up again. At the end of the trading day, Google stock recovered all its losses to close near its opening price. A careful reading of the chart would have provided daytraders with profit opportunities on quick moves.

Your Chart-Reading Assignment

Every week on TheStreet.com and Stockpickr, James Altucher picks his "rocket stocks" for the week -- those stocks he thinks will increase the most in price -- and one of the most important tools in Altucher's stock-picking toolbox is chart-reading.

To learn more about chart-reading, check out RealMoney's Dan Fitzpatrick's Web video segment on TheStreet.com TV, 3 Stocks I Saw On TV.

So here is your technical stock-picking assignment: Find the next rocket stocks on the basis of chart-reading -- these are stocks you think will increase the most in price this week, on a technical basis.

Step 1. On Stockpickr, create a portfolio called "Rocket Stocks Research: [Your Stockpickr Username]." (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register at www.stockpickr.com/register.)

Step 2. Research the Stockpickr portfolio database to find five companies that you think will increase the most in price this week, on a technical basis. Don't do any fundamental research, just focus on the chart as well as the immediate cause of the price rise. Analyze the stock's price and volume changes over different time periods, including one year, six months, one month and one day.

In addition to Altucher's rocket stocks for the week, look at the following portfolios:

• Stocks Rising on Unusual Volume: This portfolio captures the philosophy behind technical trading. Look at the stock charts over various time periods to see whether this is just a temporary rise or whether it has occurred in the past. Check out news about the stock to find the immediate cause of the rise.
• 52 Week Highs: Certainly achieving a new high is a reason to look further. However, if the high is on relatively weak volume, you may be looking at a "bear trap," in which case the price will drop.
• Stocks With Unusual Options Activity: If investors are buying a lot of call options , this could signal an imminent price spike upwards. Confirm by looking at the chart.
• Unusual Volume System: This is one of Altucher's System Trades of the Day, based on monitoring stocks that have risen on larger than usual volume.

Find stocks that you think will rocket. Document your reasoning in the "Reason?" box. Enter the stock high, low, close and volume for that day as well.

Step 3. After the close of the next trading day, enter the high, low, close and volume in the "Reason?" box. Is the high price on high volume trend continuing, or is it time to sell?

Step 4. Repeat Step 3 for the next four trading days, developing a weekly history of the stock's price and volume performance.

Step 5. At the end of the week, compare your results with Altucher's rocket stock portfolio for that week (example: "Rocket Stocks for the Week of Dec. 31"). Did your picks match any of his, or did you find better ones?

A company's can have great fundamentals and have a lousy chart. The reverse is also possible -- a company on the verge of bankruptcy with a chart that indicates short term profit potential. Ideally, the fundamentals and technical characteristics of a stock reinforce each other. They're both important weapons in your fight for stock market profits.