Apprenticed Investor: Tracking Elephants, Part 2

In the last installment of the Apprenticed Investor series, we discussed how charts reveal the elephantine footprints of institutions and shared the golden rule of technical analysis: Don't buy stocks when they are in a downtrend.

But the charts have many other uses -- even for nontechnicians. Fundamentalists can use technicals to help with their risk management, as well as their decision-making process.

This can be accomplished without using complex pattern recognition to predict where a stock might go, or tracking volume for confirmation of a move.

Charts are far less squishy than fundamentals. They are not based on someone's estimate of what future earnings might be, nor do they require you to guesstimate management's skill set or presume the desirability of a new product.

My biggest complaint about Wall Street's fundamental analysts is their disconcerting tendency to downgrade stocks after all the bad news is out. Hey, once the problems are publicized, it's too late for the investor to avoid the bloodshed and tears.

One difference between technicians and fundamentalists is that we never listen to what management has to say: Never.

Quite bluntly, I'm too trusting of an individual and don't have the insight to know when a CEO or CFO is lying to me. So listening to their sales pitches offers me little in the way of trading advantages. And as we have seen over the years, the fundies who believe management often get caught with their pants down.

With that in mind, let's go over some of the less technical uses of technical analysis, focusing today on more defensive vs. offensive maneuvers:

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.

Relative Sector Strength

A company's performance is determined in large part by the sector it is in. (The health of the overall market is just as important.)

Sector charts clearly reveal whether an entire sector -- or the overall market -- is in an uptrend, a downtrend or merely going sideways.

Good advice: Even the best company in a sector trending downward has a tough time rallying.

I believe a bad stock in a good sector can go higher and do so more easily than a good stock in a bad sector. The PC business was awful after the Y2K upgrade. Even Dell ( DELL) got killed in 2000.

Consider also the online colleges in 2003. It wasn't just Corinthian Colleges ( COCO) -- they all screamed higher, even the lousy ones. That's sector strength at work.

Knowing this can help you decide whether to avoid a stock --or jump on board.

Charting History

A weekly three- or five-year chart gives you a broad historical overview of a stock or a sector. It provides an immediate snapshot of a firm's earnings history, both good and bad. Sure, you could read five years of 10-Ks and analyst reports, but why waste all that time? The picture is worth many thousands of words.

You can easily see how volatile a stock is with a quick glance. A chart showing wild intraday swings and sharp reversals might raise suitability issues for more conservative investors. A more measured, gradual chart might not fit the goals of short-term, more active traders. Either way, the chart provides some insight as to whether this stock is for you.

Reality Check

How often has a piece of fundamental data or a tidbit of "unknown" or hot information induced you to buy a stock? The chart lets you know whether that data point is baked "in the cake" already.

If someone tries to convince you to buy a stock because of the hot news he has, a quick glance tells you how warm or cool the news really is. A stock up significantly over the past three months implies that the hot tip you just got ain't so hot -- lukewarm is probably more like it. As my head trader is fond of saying, "Last man in pays for the beer."

Buying a stock based on an analysis that is not fresh or advantageous is a recipe for losing money.

Charts have more to offer than patterns and predictions. Savvy investors learn how to use them for recognizing warning signs, managing risk and selecting stocks. Over time, you will too.

1. Expect to Be Wrong 2. Your Fault, Reader
3. The Wrong Crowd 4. Bull or Bear? Neither
5. Know Thyself 6. Prepare for Battle
7. Bite Your Tongue 8. Don't Speak, Pt 2
9. The Zen of Trading 10. The Folly of Forecasting
11. Lose the News 12. Tracking Elephants, Pt 1
Check back for more of Barry Ritholtz's
Apprenticed Investor series

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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