The Virtues of Charting

Recently I was taken to task by a fellow trader for applying price patterns on charts to Fannie Mae (FNM), the mortgage giant that was taken over by the government after it, along with the rest of capitalist finance, underwent an utter collapse.

"Math has nothing to do with it," he wrote with the passion that only a compulsive message-board poster can muster.

I've got to confess, I, too, have a compulsion when it comes to trading -- to explain and to educate. So, here's my Q&A on the Virtues of Charting as Applied to Divers Equities Including Those Under Ownership of the Government.

Q. What are charts for? A. Charts are a way of visualizing support and resistance levels in the movement of prices. Q. Why are such levels significant? A. Often it is because they represent prices where shares were left on the table. Price movements pause because there are more shares offered for trade than can be absorbed immediately at a price. In charting, as in everything else in the markets, it comes back to supply and demand. Charts are a way of visualizing levels of excess supply and demand.

"The best textbook ever on technical analysis." --Tim Bovee

Q. Why else might they be significant?

A. Often results from charting are based on belief. If enough people believe that prices will go up at the apex of an ascending triangle, then they will trade on that belief and it will happen. The markets are a phenomenon of mass psychology.

Q. So the charts are always right, yes?

A. No. Like any trading tool, the charts are right some of the time and wrong some of the time. In my market work stretching back decades, I've found charting to be more useful than not.

Q. But charts are all you need, right?

A. Not at all. There are many tools out there. I grab the ones that seem to fit my needs of the moment. I've known people who obsess about the rightness and wrongness of any particular approach to trading. In my experience, a flexible and eclective approach works best. I trade based on facts, not theology.

Q. Well, OK. Maybe charts and your technical analysis are fine for normal stocks. But Fannie Mae (FNM) is anything but normal.

A. Right. Because FNM is controlled by a federal conservator, it's much more prone to news surprises, policy surprises and rumor surprises. It's a very political stock. And because the price is so low, it is a fine vehicle for untrammeled speculation, which gives it more velocity than most stocks. But FNM still has price pauses. It has support and resistance levels. Shares are still left on the table when the price moves off, and they come back into the market when the price returns.

Q. So FNM trading is based on supply and demand like any other stock?

A. That's correct.

Q. And so charting can be applied profitably to its price movements.

A. Right you are.

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Here are principal analytical tools that I use on my charts, along with the abbreviations I'll snap out when I'm writing in a hurry:

adx - Average Directional Index, a measure of the degree to which a stock is trending directionally rather than moving sideways. See Stockcharts, Wikipedia and Investopedia.

bb - Bollinger Bands, a measure of volatility using lines that are two standard deviations from a moving average. See John Bollinger's website, Stockcharts, Wikipedia and Investopedia.

fibs - Fibonacci Retracements, levels based on Fibonacci ratios at which stock prices tend to pause. See Stockcharts and Investopedia.

ma, sma -  Moving Average, often followed by a number indicating the period, such as ma20, sma50, ma200 and so forth. An average of closing prices over a certain period of time that shows trends more clearly by smoothing short-term fluctuations. When I use ma, I mean the simple moving average (sma), which gives equal rate to each closing price used in the calculation. See Stockcharts, Wikipedia and Investopedia.

macd - Moving Average Convergence Divergence, subtracts a longer moving average from a shorter moving average to calculate momentum. See Stockcharts, Wikipedia and Investopedia.

mfi - Money Flow Index, a volume-weighted measure of money flowing into and out of an issue. See Stockcharts, Wikipedia and Investopedia.

pps - Person's Proprietary Signal, a buy/sell signal designed by John Person. It's inner workings have not made public.

rsi - Relative Strength Index, also a measure of money flowing into and out of an issue, but without the volume component. See Stockcharts, Wikipedia and Investopedia.

sto, stochastic - Stochastic Oscillator, calculates the relationship between the current close to the high-low range over a period of time. See Stockcharts, Wikipedia and Investopedia.

Here are some of the price patterns I look for:

Ascending Triangle - See StockCharts, Wikipedia and Investopedia.

Descending Triangle - See StockCharts, Wikipedia and Investopedia.

Head and Shoulders - See StockCharts, Wikipedia and Investopedia.

Pennant - See StockCharts, Wikipedia and Investopedia.

Symmetrical Triangle - See StockCharts, Wikipedia and Investopedia.


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