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  • Chart use is widespread by professionals.
  • It's important to match your chart to your time horizon.
  • Keeping charts simple can increase your odds of success.

Most professional investors use charts. They may not admit to it, but trust me, they do.

Over two decades of working with managers at the biggest money managers in the world, I've found non-chart users to be the exception rather than the rule (and those who don't use them are likely getting buy and sell ideas from internal and external research sources that do use charts!)

Of course, money managers use charts in different ways. The minority use complex software that overlays key technical formations, indicators, and oscillators. However, just about all of them know where a company's share price is relative to its 200-day moving average.

Since institutional money flow dictates the direction of stocks over time, and charts are incorporated into many managers' workflow, understanding how to best use technical analysis can be profit friendly.

Match charts to time horizon

One mistake many investors make is including moving averages on their charts that conflict with their time horizon.

Indeed, you can use multiple moving averages to see where short- intermediate, and long-term resistance and support exist if you have a lot of charting experience. However, I've seen long-term investors make short-term decisions (and vice versa) based on charts and moving averages that don't match their time horizons.

For this reason, if you're a long-term investor, include a 200-day moving average on your chart, but don't include a 21-day moving average. Alternatively, if you're a short-term trader, focus on the 21-day moving average like Real Money Pro's Bob Byrne.

If you're a swing trader, focus on the 21-day moving average and 50-day moving average when you're shrinking your holding period (ex. during uncertain times), and swap to the 50-day and 200-day moving average when up or downtrends are more established and your holding period expands.

Similarly, if you're a buy-and-hold investor, focus your attention on weekly and monthly price charts rather than daily price charts, which show a much shorter time period. Conversely, if you're time horizon is a couple of years or less, focus more on daily price charts.

The goal of matching charts and moving averages to the time horizon is to minimize making investment decisions based on information that runs contrary to your over-arching investment style. This will reduce the risk of long-term traders over trading accounts and short-term traders holding stocks for longer than initially intended.

Take formations with a grain of salt

You'll often hear technical analysis talk about specific price patterns that can lead to moves in a particular direction. A few examples are the cup-and-handle, W, pennants, flags, and head-and-shoulders formations.

While it's true some formations offer better than coin-flip results, they often fail. When that happens, it can inflict significant damage, especially when an investor relied solely on the formation to enter the position and failed to set a specific stop loss to contain their loss. 

As a result, investors can wind up with portfolios full of failed formations, prompting them to conclude that technical analysis is hogwash.

In reality, it's not the formation that was the problem but the investor's unwillingness to control risk. Again, most of these formations only have a slightly better than 50/50 win rate. As a result, spotting a cup-and-handle may tip the odds in favor of buying, but it's up to you to control your risk with a stop loss.

There's also the problem that once you learn what these formations look like, you start 'seeing' them where they aren't.

For this reason, it may be best to leave the formation-reading business to others. That's not simply my opinion, either. Real Money has two technical analysis pioneers – Helene Meisler and Bruce Kamich – who help investors understand technical analysis, and each boasts over forty years of experience. 

In an email to me recently, Meisler explained why she doesn't spend a lot of time on formations in her columns, writing "I can see a cup and handle. I see triangles, bull flags, bear flags, etc. I always see head and shoulders patterns--tops and bottoms--everywhere!"

Kamich replied similarly, writing, "Win rates on patterns depend on the user's experience - when I taught patterns at Baruch, some students saw them and others said ugh? The worst results were the students who started to see a head and shoulders pattern everywhere and on every time frame."

Keep it simple

So, what do Meisler and Kamich primarily use when discussing technical analysis with readers? 

Meisler writes, "I think resistance and support are important on charts. I often draw in down and up trend lines because that tells us the general direction but flat lines tell the real story to me."

What she's talking about is drawing a line connecting a series of highs over a period (for downtrends) or a series of lows over a period (for uptrends). For horizontal lines, connect areas where stocks stopped falling (support) or rising (resistance) in the past.

Back to Meisler: 

"Also, I have a view that bad charts can turn good and good charts can turn bad so I prefer to let the indicators guide me. They tell the story of the market with no bias at all. Chart reading is an art, not a science so bias creeps in. With indicators, if I get it wrong, it is not because the indicators were wrong but rather my interpretation of them that was wrong."

Meisler often shares with Top Stocks members various indicators, including the 10-day moving average of net advancers/decliners. She calculates them herself, so she understands the math behind them, and that allows her to better calculate potential outcomes. She says if she didn't do that work, then she'd be "just guessing."

When Kamich shares insight with Real Money members, he uses a variety of tools. For example, he writes, "I use the On-Balance-Volume (OBV) line because it is simple math and is easier to "read" than the volume histogram. I favor indicators that are easily explained to the average person."

OBV is essentially a running total of up-day and down-day volume. If it's trending higher, buyers are in control, and vice versa.

Kamich writes:

"I use moving-average-convergence/divergence (MACD) or a momentum study to round out the techniques... I use the point and figure (P&F) charts for price targets but also will use a chart pattern too when appropriate. Also, I like P&F charts because they can clearly show breakouts and breakdowns."

MACD subtracts the 26-day Exponential Moving Average (EMA) from the 12-day EMA. A bullish or bearish signal triggers when that result crosses over or below zero, or the 9-day EMA.

Point-and-figure charts tally up and down closing prices using Xs and Os, without any interest in the passage of time. It's a 'pure' price chart that traces all the way back to Charles Henry Dow late in the 19th century.

Smart Play

As Meisler suggests, there's a lot of 'art' to reading charts, and as Kamich suggests, success rates vary with experience. The more you use them, the more they'll help you.

Personally, I've been using charts to assist with entry and exit points since my first sell-side job in the late 1990s. In addition to fetching coffee, I was tasked with transposing data from every one of the blue and green Daily Graphs charts our firm received in the mail every week. 

I've bought stocks simply because I liked the chart, but mostly, they help me time entry and exit points for stocks I like fundamentally. For example, in bull markets, once I've added a stock to my watch list, I'll look for a pullback to the 21-DMA, 50-DMA, or 200-DMA to start my position. In a bear market, I'll do the opposite. Typically, I avoid being long stocks if they're trading more than 5% below the 200-DMA, unless it's a "forever" mindset idea or we're at an inflection point (ex. Sentiment indicators support a market relief rally).

Charting is also useful because it helps you find stocks that move up out of bases (Stan Weinstein's Stage 2 stocks). This can be particularly profit-friendly with stocks that are trading near multi-year highs because there aren't many sellers trapped at higher prices who might want to sell.

Charts can also help you spot turning points (ie. vertical moves up or down) in both individual stocks and the market itself. If you track volume on up days and down days, it can add conviction to your thesis too.

Overall, charts are a useful tool in the toolkit. You can make technical analysis complex, but keeping charts simple will reduce portfolio churn by reducing false signals. Therefore, keep your charts relatively "clean", rather than packed with lines, and, as always, know what you own (have a thesis) and manage your risk.

  • Chart use is widespread by professionals.
  • It's important to match your chart to your time horizon.
  • Keeping charts simple can increase your odds of success.

Most professional investors use charts. They may not admit to it, but trust me, they do.

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