5. Trading patterns. Remember, technical ana- lysts look for specific patterns to reveal and anticipate future price movement, often as quickly as a matter of days or even hours.
These patterns have been given names.
These include gaps (patterns showing space between one day’s close and another day’s open); spikes (an unusually exaggerated price movement well above or below previously established trading levels); triangles (trading patterns establishing either a broadening of the price range over a series of days, or a nar- rowing); flags (short-term price congestion with trading range running parallel); pen- nants (short-term price congestion in which the trading lines converge); V formations (sudden price reversals, such as a new price high, followed by an immediate downward movement, or a sudden and sharp decline followed by a sharp price reversal); and head and shoulders (a popular three-part price trend in which three stages are experienced:
stage numbers one and three establish a trad- ing top or resistance level, and the middle stage sets a resistance at a higher level; a re- verse head and shoulders has the same pat- tern, but involves support levels and establishment of bottom price levels).
The Value of a
fundamental changes. Trading ranges (and thus, price volatility) are related not only to short-term market news and gossip, but also to fundamental changes.
Rather than making the decision to use one method or another exclusively, it makes more sense to take useful intelligence from both sides and use them to confirm trends, to anticipate short-term changes, or to judge a stock based on various features.
triangles trading patterns in which the range of high-to- low prices broad- ens or narrows within a short period of time.
flags short-term trad- ing patterns in a specific direction in which the gap between high and low remains constant.
pennants short-term trad- ing patterns in a specific direction in which the gap between high and low converges over time.
V formations a price pattern typified by a sharp increase or de- crease in price to a new high or low level, followed immediately by a sharp reversal and price movement in the opposite direction.
Even though fundamental and technical philoso- phies don’t agree, both are valuable. You gain important information by reviewing financial and price information, and using both to make decisions.
Key Point
You are thinking about buying one of three stocks that are comparable on several fundamental measurements. These tests include dividend yield, P/E ratio, working capital, and operating trends (sales growth and net profits). You cannot decide which of these stocks would be lower risk based on the consistency in the fundamental indicators.
However, when you begin to view the
technical side, you discover that one stock has reasonably low price volatility and a long- established trading range. That range has been moving in a gradual but consistent upward trend for several years. However, the other two stocks show far higher volatility. One has had considerable change in its trading range over the past year, in both directions at
different times. The other is so volatile that no trading range is discernable at all.
Example
From this simplified study of the technical in- dicators, you may conclude that the first of the three stocks is the lowest risk of all. Of course, fun- damental analysts will remind you that short-term trends are unreliable and, additionally, looking to historical price movement does not indicate what the future will hold. In other words, there are no guarantees that the assumptions you make about safety of an investment are always best guesses.
In the market, your best guess—based on using information from both fundamental and technical indicators—is far better than a mere guess. You will not be right 100 percent of the time, either in stock selection or in the timing of decisions to buy or sell.
The purpose to analysis is to improve your averages.
If you can be right more often than wrong, you are ahead of the average, and that is the real goal.
Because short-term price movements are ran- dom and chaotic (as you will see in the following sections of this chapter), you cannot use technical analysis exclusively to pick long-term investments.
In fact, that idea is contradictory and irrational. The nature of short-term movement has nothing to do with what may be called “value-based in- vesting.” This is a reference to the ideal of picking stocks likely to grow over the long term. A stock’s price, whether today, yesterday, or in the fu- ture, has nothing to do with the value of the company as a long-term in- vestment. This critical reality is so often overlooked by investors, but it is the key to understanding the value of each method, as well as to avoiding the common error of assuming that both methods provide equal infor- mation but in different ways.
For example, a study of price trends may reveal trading range pat- terns and give you an advance signal of price movements that are going
T h e Va l u e o f a C o m b i n e d M e t h o d 41
head and shoulders a price trend pat- tern involving three stages. In an upward head and shoulders pattern, stages one and three show prices reaching a resis- tance level before retreating, and the middle stage tracking the same movements but with a higher resistance level. In a downward head and shoulders pattern, the same stages exist, but they involve sup- port levels rather than resistance.
A stock’s price has no direct connection to a company’s financial results. The test methods are based on different assumptions, and provide entirely different types of market intelligence.
Key Point
to occur over the next few days or even months. But what is that based on? Price reflects the market’s level of supply and demand, and may have no relevance whatsoever to value itself. For example, if a large mutual fund decides to sell off its holdings of a company, thousands of shares are dumped on the market. That will cause a price decline because, unex- pectedly, there is a large excess supply of shares. In the opposite scenario, that big mutual fund may decide to acquire a large block of shares, creat- ing less supply. The basic economic reality kicks in at that point: more supply causes a decline in price, and less supply causes an increase in price. But now consider the underlying reality: The decision by an insti- tutional investor (like a mutual fund) to buy or to sell a large number of shares of a company may have little or nothing to do with that com- pany’s fundamental strength or weakness. The decision may be a matter of portfolio balance, investment objective, or other reason that is not based on profit and loss or capitalization of the company.
A realistic combination of fundamental and technical analysis should be undertaken with the full realization that the two methods are not merely aspects of the same process. They are entirely separate and based on dissimilar assumptions. The fundamental approach relies on fi- nancial results and status; the technical approach is price-based.