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Apprenticed Investor: Tracking Elephants, Part 2

Early Warning Signals

Savvy traders know that charts reveal a wealth of data, including early caution signs of potential underlying problems -- in real time.

To be more precise, charts reveal the behavior of those institutions that have already discerned a problem, long before the crowd has. Good chartists are out of the way before a disaster occurs -- or at least in the very early stages -- and not after.

Why? Because a chart that's rolling over reveals that better-informed, more-connected institutions with deeper fundamental knowledge than you or I have are selling.

There, I've said it ... it's out in the open now: Technicians free ride on the sweat of fundamental buy-side analysts.

The phrase "it's already in the price" means that people with superior knowledge have already bought or sold. It is the same thing with charts -- very often, it's in there.

Sell Signals

It's not just about avoiding disasters. Stocks give several loud and clear signals on charts when an uptrend is over. A new phase of sideways, range-bound trading may not be a debacle, but there are better places for you to put your money.

Breaking a long-term uptrend, as shown in the accompanying chart of Apple Computer (AAPL), falling below a significant moving average, or breaching key support, as evoked in the chart of General Motors (GM). These are all ways an equity reveals to you that it's time to head for the exits.

Why? It shows that fewer and fewer institutions are buying the stock. And as we have seen, this tends to take more than an afternoon to play out. That's why momentum strategies work -- at least for a while.

Bruised Fruit
Apple's chart shows a clear break of its uptrend, a classic sell signal.
Click here for larger image.
Source: Barry Ritholtz

No Brakes
Prior to its recent upturn, GM repeatedly failed to hold at important support levels.
Click here for larger image.
Source: Barry Ritholtz

Risk/Reward Analysis

Charts help savvy traders determine what their possible upside is vs. their probable downside. Finding good risk-reward scenarios (i.e., up $4/down $1) means that even if you are wrong half of the time, you will still be making money.

This is accomplished by figuring out where the likely resistance is, and where likely support is. I avoid stocks where resistance is $1 away (reward) and support is $5 below (risk). For example, with support at $30 and resistance at $39, eBay (EBAY) offers a good risk/reward as it approaches $32.

Hitting the Bid
Technical analysis shows the spots where risk/reward favors eBay's stock.
Click here for larger image.
Source: Barry Ritholtz

Assume that you will hit .500. That means for every winner you pick, you also find a loser. This explains why you want the risk/reward ratio in your favor. I will buy a stock with a 3-to-1 risk/reward ratio -- potential to make $3 for a $1 of risk -- but 5-to-1 is ideal.

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