The ABCs of Charts, Part II

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Editor's note: Welcome back to TSC's two-part series on using charts. If you missed yesterday's piece, in which columnist Andrew Greta detailed the basics of using BigCharts, click here. Also, to take a look at Greta's recent three-part series on stock picking, click here. As always, we welcome your feedback.

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Moving Averages

We kick off the second part of

TSC's

chart primer with a look at moving averages -- over on the top right of the

BigCharts page

under "More Options." Moving averages are the hearty dinner roll of technical analysis. They come in several flavors, with BigCharts giving you the option of the "simple" or "exponential" variety. Both of these choices smooth the jagged stock graph like a slice of Velveeta on a bumpy head of broccoli.

A moving average accomplishes this feat by plotting the average price for a specified number of previous days on the chart (you choose -- the longer the time period, the smoother the line). In other words, any given point on, say, a 90-day MA line indicates the average stock price over the last three months. The only difference between the two types of averages is that the exponential calculation places a heavier numerical weight on the most recent data.

Legend has it that the moving average was popularized during World War II when British radar operators used the mathematical construct to predict the intended target of German bombers during their evasive maneuvers over the English countryside. You can use the same technique to see through daily market fibrillations and visualize general stock trends.

Another technique is to use the moving average line in conjunction with the stock price to give buy and sell signals for a particular security. Following this method, if the price crosses the MA line to the upside, you should go long. When it crosses to the downside, sell, on the theory that the tide is turning against you. Put another way, as long as your current price is higher than the average price in the past, your stock is generally continuing its upward trend and you're happy to hang on for the ride. When your current price dips below average, however, watch out for a selloff.

For the long-term investor, you can use these techniques to better time your purchases, confirm a good buy, or indicate an imminent trend reversal.

Be careful here, though. The number of days you choose for the average is a critical variable. Too short, and you can end up getting bandied about like a White House intern in a room full of lawyers. Too long, and you could miss critical signals. The right length depends on the volatility of each stock. Play around with different figures until you get a good fit (i.e., historical signals that would have kept you in during big upside moves and kept you out of trouble when things turned as nasty as a grand jury investigation).

Some of you more sophisticated types that know your salad fork from you dinner fork might try using two moving averages of different lengths and trade when these lines cross. I've found that 60 and 120 days give pretty good signals on most one-year charts (To get this effect on BigCharts, set your choice to SMA - 2 Line at 60 days).

Dressing It Up

The next box down, called "Upper Indicator," gives you even more choices to dress up your price chart. For the long-term investor, useful options include showing the history of stock splits for a particular issue or displaying past earnings performance. A stock with a record of regular splits along with consistently positive earnings could be a real powerhouse worth considering.

Volume

The bottom indicator, while normally relegated to the menial task of showing volume, has the most choices of any function at the BigCharts dinner table. But before you discard this dumpy pot-scrubber in favor of more glamorous alternatives, you should understand the value that volume can provide.

One application that I've found helpful is using this information to judge the soundness of a trend. An uptrend with high volume on good days and low volume during brief corrections is usually considered a clean bill of health from the chartist's standpoint. Conversely, high volume on down days can indicate that a disease is incubating even if the patient looks fine outwardly.

Relative Strength Index

Another indicator that I've used almost as much as volume is the Relative Strength Index (or RSI). The RSI gives a numerical score indicating the internal strength of a particular issue (basically a ratio between the magnitude of upside moves versus downside moves for the past few weeks). Because it relates its information in a range from 1 to 100, the RSI is considered an "oscillator" (along with several other of the multitudinous choices on BigCharts).

One way to use the RSI is to look for divergence. If the indicator is trending upward while the underlying stock price is going down or basing, it's considered a bullish indicator, and vice versa.

Additionally, you can use the RSI just like all the other oscillators (including the "Stochastic," "McClellan" and "William's %R"). Each of these uses a different set of calculations to create its score, but all are designed to flag "overbought" and "oversold" conditions for an individual stock or the entire market. When the oscillator breaks out of a mid-range band (say 30-70, for example), it's considered a buy or sell signal for the underlying security.

Homework

Naturally, if you're interested in technical analysis, I've merely whetted your appetite with this brief charting primer. When you really want to dig in up to your elbows and get a little dirty, consider the following books for greater detail on the technician's process:

The Technical Analysis of Stocks, Options and Futures: Advanced Trading Systems and Techniques

, by Willaim F. Eng. (Considered an industry classic).

Technical Analysis from A to Z: Covers Every Trading Tool ... from the Absolute Breadth Index to the Zig Zag

, by Steven B. Achelis. (A comprehensive dictionary of terms written by the president of EQUIS International, maker of Metastock software).

Technical Analysis Explained: The Successful Investor's Guide to Spotting Investment Trends and Turning Points

, by Martin J. Pring. (Another solid overview).

Andrew Greta, an occasional contributor to TheStreet.com

, is a business student and onetime stockbroker who lives in West Lafayette, Ind.