How to Use Technical Analysis and Other Stock Market Analysis Techniques

A vital part of learning about the stock market is to discover how to use stock analysis to work out if a share is good value.

I suppose the first thing we need to consider if we're going to invest in the stock market is:

Which share, or shares, should I invest in? And how do I know if I'm getting that share at a good price?

One way to decide is to rely on the advice of others… But I do NOT recommend it!

Do yourself a favour and develop the ability to analyse the market yourself, and make your own decisions — rather than rely on “tips”. The tip may well have come from a source with a hidden agenda. Sometime false rumours and misinformation are deliberately spread to create demand for shares that someone else wants to sell.

If you do your own research and make your own decisions, you can be sure you're dealing with facts — not hearsay.

So how do we do our own analysis?

There are two main methods: Fundamental Analysis and Technical Analysis…

What is Fundamental Analysis?

Realise that when you're buying shares, you are investing in a business. Now if you're going to invest your hard-earned into a business, aren't you going to want to know something about it's prospects of success? Like:

• What's the company's financial position?
• Does the management have a good track record?
• How much market share do the company's products have?

…and so on.

Finding the answers to these kind of questions is what's called Fundamental Analysis… where we look at the fundamentals of the company's situation rather than what's happening to its share price on a day-to-day basis.

Fundamental analysis is all about what the company does, and whether it is profitable. It takes into account the state of the economy, the company's balance sheet and its prospects for the future.

The company research page on the Web site of the Australian Stock Exchange (ASX).

Fundamental analysis can be a lot of work — be prepared to trawl through company annual reports, follow the financial press and keep up with ASX announcements.

Usually a “full service” stockbroker can help with fundamental information.

Personally, I think it's important for beginners in the share market to keep things simple. Stick with “blue chip” companies when learning to invest — the larger, well-established companies. Don't make things complicated for the sake of it.

Fortunately, there is another form of analysis that I find much easier to come to grips with…

How about Technical Analysis?

Technical analysis takes an almost opposite approach to that of fundamental analysis. It disregards fundamental factors entirely and focusses on just one thing…

What has the company's share price been doing historically?

In technical analysis we chart the changes in the company's share price over time. This visual picture makes it easy to identify patterns in the behaviour of the price. These patterns then suggest the likely future direction of the price — which at the end of the day, is all we really care about.

Now focussing only on changes in the share price may seem to be dangerously oversimplifying the process of analysing a share. But is it really?…

Sure share prices are affected my fundamental factors, international markets, economic events, company news, interest rates, rumours, market sentiment… all these things have an effect. But when all is said and done, the question of whether the share price will rise of fall depends upon just one thing: Are buyers more enthusiastic than sellers, or vice versa?

If buyers are more enthusiastic, the price will rise. If sellers are more enthusiastic, the price will fall.

Technical analysis assumes that all these many factors, including company fundamentals, just influence the relative enthusiasm of buyers and sellers and are automatically reflected in the price chart.

It boils down to this: a company's share price really has nothing to do with fundamental factors, but with the buyers and sellers perceptions.

The market is driven by fear and greed. Fear of loss, and hope of gain. When fear dominates, prices fall. When greed dominates, prices rise. Simple, huh?

The Trend is Your Friend

This is why prices move in trends.

Take this chart of BHP. Although the price jumps up and down in the short term, we can discern definite underlying trends that go on for months. When the overall market perception of this stock is negative, the trend is down — and that down trend will persist until this market perception changes. Likewise for an up trend — it will remain in effect as long as market perception remains positive, despite short term ups and downs.

So our goal then — if we want the price of our stocks to rise over time — is to only buy shares that are in an up trend.

You can already see how charting the share price gives us valuable information. If this were the current chart for BHP, do you think now would be a good time to buy? Hell, no! The chart suggests that a new down trend has begun.

Only buy shares in up trends

So the first step in the technical analysis of a share is to work out: Is it in an up trend, or a downtrend (or the third possibility, NO trend — just going sideways)?

To work this out we need an up-to-date chart of the price.

We can get basic charts for free off the Internet, for example from Yahoo!…

http://finance.yahoo.com

How to get free share charts from Yahoo!

Here's a chart of Santos Ltd that I made with my commercial share charting software…

We can see that Santos was in a down trend until February and is now in an up trend.

And here's the same chart from the Yahoo! Web site…

Click on the picture above to see a short movie showing you exactly how I created this chart in under two minutes using Yahoo! Finance.

Introducing… Indicators!

The next step in learning to technically analyse a share chart is to learn something about indicators. Indicators are mathematical manipulations of the share price data that are drawn on the chart. They may reveal patterns in the price activity that aren't immediately obvious from looking at the raw price data.

An example should make this clearer…

One of the most common technical indicators is called a moving average. It's a line on the chart created by averaging the price of the share over a certain period of time. The effect of the averaging is to smooth out small fluctuations in the price, making the main trends easier to see.

Here's a chart of Woodside Petroleum Limited (WPL) with a moving average applied. The blue line is the raw price data — the day-to-day price of WPL shares. The red line is an average of these day-to-day prices over the past 100 days. In other words, every point on the red line marks the average price of WPL shares over the previous 100 days. We would call this a “100 day moving average”.

What's the point?

Well, apart from smoothing out small fluctuations, the position of the average with respect to the price helps to make the main trends easier to spot. Notice that when the share price is in a down trend, the blue line is below the red. When the share price is in an up trend, the blue line crosses above the red.

If we were to buy and hold this share only when the blue line was above the red, and sell when the blue line crosses below the red, we would effectively filter out the down trends. That way we would only be holding the share when it's going up in value.

If we expand the WPL chart out to the past five years, you can see we would have bought the share near it's lowest price, and sold it near it's five-year high.

Click on the chart above for a short movie showing how these charts with moving averages were created.

Before investing in a share, you may want to check whether or not it's trading above the 100 day moving average.

Advice on Starting Out…

It's a good idea to try paper trading for a while before plunging into the market with your newly acquired share analysis skills.

Paper trading means monitoring a dummy portfolio for a period of, say, six months to test how successful your investing strategy is going to be.

In the meantime you can be saving more money to invest, while gaining confidence and learning more about technical analysis and other stock market analysis techniques.

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