We are going to start a series on chart reading to help our readers to better use this tool. In investments and trading, charts are often used to help make analysis of an investment and aid in the decision-making process. I cannot imagine how one will not rely on using charts before making the investment as charts are so fundamental in any investment analysis. This is akin to a captain of a ship who does not rely on his maps for navigation in the oceans to his destination.
The biggest mistake any investor or trader would commit is to rely on one type of chart to make his or her decision to buy or sell.
Here are two examples. A trader who actively trades in securities will rely solely on charts using technical analysis or the study of price and volume charts along with repeatable patterns to help chart the course of a stock movement. The chart below shows the formation of an ascending triangle in which the price of GLD (ETF of gold commodity) failed to go higher and in fact, broke the lower support. The technical trader would have sold the GLD at $120, then only to regret in the following year, the ETF went all the way up to near the $200 mark.
While a value investor will be reluctant to buy into a stock like NFLX (Netflix) back in 2016 when it broke to new highs at $125 because the PE ratio was simply too rich at 350x its forward earnings. Today this stock is trading close to $500. The opposite is also true when we hear investors who tout a stock that is undervalued (say based on some fundamental valuation like low Price to Earnings or book value or by its discounted cash flow (DCF) method) and then to get into a value trap as the stock falls further lower.
In both these cases, charts are being used with too much ignorance. This is clearly a failure of a chart reader. A professional will acknowledge that chart reading is just part of a holistic investment or trading process. It must be used in conjunction with other charts or data to help build the conviction of the trade.
To sum up on this new series on chart reading, the goal of understanding charts it to achieve the following goals:
Using charts to look for trends or cycles that our eyes are not able easily discern or see. Sure, some charts will show a stock that is in a clear uptrend or cycles up and down every season. But in most cases, our eyes will fail us to see the hidden patterns. In other times and more dangerously, our eyes will see what we want to see which leads us to severe investment losses. In this series, we will show to find stocks that will uncover these trends with ease.
Looking for meaning in a stock price or chart when there is so much noise coming from news, rumors and fundamental data on a daily basis. We have all been through this when a stock is down 25% after a great earnings report but later to see your investments get wiped out by a quarter. Now will you continue to hold on to your positions or sell it? An investor with experience in chart reading will be able to help guide through these turbulent times.
Providing a relativistic view of a security. One thing I have learned in my 2 decades of trading is a stock, a commodity and an asset class does not exist in a vacuum. Securities are constantly fighting for money and money is always looking for a better asset to invest into.
Using charts as a valuation tool. It might be surprising to hear this since most finance books will always talk about the common valuation methodologies like PE or price-to-cashflow. But the true way of valuing a security must and should be in respect with other securities or competing asset classes.
Building confidence and conviction of an investment or a trade. What good will a stock investment be when you have a “weak hand” when you sell out your position to only see it becoming a multi-bagger (a stock that goes up a few hundred percent). Or when your great investment turns out to be a seating duck going nowhere.
Chart as a timing tool. Once we understand the above concepts then we will be able to use charts as a timing mechanism to alert us when to buy or sell a security.
Back to our analogy of a captain of a ship, the world’s seas and oceans are constantly moving. How confident are you able to navigate your shipment from one destination to another in the face of storms and uncertainties. There must be a way and there is.