“Fundamentals are the focus of my successful approach to investing in small-cap stocks. Ultimately, it is the fundamentals that determine the long-term direction of a stock. But long-term growth and strong fundamentals alone don’t assure successful investments. As with most things in life, timing is everything when it comes to investing. Fundamental research must be complimented by technical analysis, a useful tool for determining the ideal time for buying or selling a stock.”
That introduction paved the way for Ian Wyatt’s exploration of technical analysis in chapter six of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks.” He titled it “Taking the mystery out of technical analysis and trading for quick profits.”
He also wrote, “Technical analysis focuses on the chart of a stock and the movements in share price. A technician looks for market strength or weakness based on current trends in the stock, chart patterns, and breakout signals.”
Essentially, technical analysts, also known as “technicians," believe price and volume tell the “whole story.” Wyatt wrote, “There is a degree of truth to this belief and I urge everyone to employ technical indicators.” But, as noted above, he calls for a combination of fundamental and technical tests.
Wyatt’s essential technical indicators and tools include trading ranges, accumulation and distribution and relative prices.
Trading ranges
He called this “the space between the highest and lowest price that a stock typically reaches within a period of time.” This illustration from StockCharts shows a trading range (between the red and green horizontal lines):
The red line across the top of the chart is called the resistance line and showed the highest prices per share that buyers had paid in the period covered by the chart. The green line across the bottom is called the support line, and showed the lowest prices paid over the same period.
If a new price goes above the resistance line, there is a good possibility a “breakout” is underway and the share price may dramatically rise. Similarly, if a new price goes below the support line (a “breakdown”), the stock may decline significantly.
This range between resistance and support also defines a stock’s volatility over the period. The narrower the range between the two, the lower the volatility. Since volatility is often used as a proxy for risk, technicians would measure risk by the breadth of the “channel.”
Within the trading range, and with the resistance and support lines as references, technicians search for six important patterns:
- Double tops or bottoms.
- Head and shoulders.
- Triangles.
- Flags and pennants.
- Wedges.
- Gaps.
Trading ranges also provide entry and exit signals:
- Three or more periods of uptrend or downtrend movement indicates a trend.
- A narrow-range day refers to a day within which the price range is unusually small or possibly flat. This signals the possibility a trend (as indicated in 1 above) is ending.
- Very high volume – if volume spikes at the same time (or within one session) as indicators 1 and 2, there is a high likelihood a trend is ending, and prices will soon move in the other direction.
Accumulation and distributionÂ
As the name suggests, this indicator uses buying (accumulation) and selling (distribution) data, and is tracked over a number of days. It shows the supply and demand status of a company’s shares. With increasing accumulation, demand pushes the share price higher, and vice versa. An emerging trend should be confirmed with other indicators.
Moving averages fall within the same general category. A moving average charts average prices over specified periods; there are several commonly used averages and they look back 20 days, 50 days or 200 days (averages for almost any number of days can be calculated). Normally two averages—one longer and one shorter—and technicians look for crossings between the two, since these can signal changes in direction.
The following GuruFocus chart shows a 200-day moving average in blue and a 50-day moving average in red:
Note how the crossovers generally correspond with changes in direction, but provide no indication how long the change in trend will last. Normally, though, the longer the averaging period, the longer the trend should hold. The trade-off for this is a fewer or slower crossovers.
Relative prices
This indicator measures the price of a stock in relative rather than absolute terms. For example, the relative strength indicator measures the magnitude of gains and losses to assess whether a stock is overbought or oversold.
The bottom section of the following chart shows the RSI for Tesla (TSLA, Financial):Â
Source:Â stockcharts.com
The conventional view is that RSI values above 70 indicate a stock is overbought, while a value below 30 indicates a stock is oversold. Individual technicians may set other upper and lower values.
Wyatt emphasized that all technical indicators are generalizations. Individually, they cannot be used reliably, but when used in groupings, “they are effective tools for timing of entry and exit.” They can also confirm or disconfirm an emerging fundamental trend for a specific company. Finally, “The best approach to studying a company is utilizing a wise combination of fundamental and technical indicators, and tracking both types over a period of time.”
Summing up, in chapter six of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” Wyatt wrote that he uses a combination of fundamental research and technical analysis. Fundamentals to choose which stocks to buy or sell, and technical to time buying and selling decisions. Broadly speaking, technical analysis is about stock prices and volume; its tools include trading ranges, accumulation/distribution and relative strength.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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