Technical analysis

Is technical analysis useful for a long term investor?

Technical analysis is mainly used by traders and short-term investors as an aid to determining the next direction of movement in a security, but on rare occasions can be of use to the long-term investor.

When looking at the chart of a company, it is best viewed in candlestick form.  Although some technical analysts still use the bar chart (I was still using it as recently as the late 1980s), the japanese candlesticks do a better job of showing the direction of prices.

Some basic understanding is required of a typical cadlestick.  The filled in part of the candlestick is called the body and represents the open and close price in the period; the colour will indicate whether it closed above the open (green) or closed below the open (red).  The thin lines, called shadows or wicks are the high and low price in the period.

Just because a candle is coloured green, it does not mean that the close of the period is above the previous period's close, but just above the current period's open.  This can be caused by a stock gapping down at the open of trading.  The reverse can happen when stocks gap up at the open.



Click on picture to enlarge.

Technical analysis is at its best when used to determine areas of support or resistance for a stock.  For support think of demand and for resistance think of supply.  Support on a chart looks like a floor that price has difficulty pushing down through, demonstrating there is demand for the stock at that price ie. buyers.  Resistance on a chart looks like a ceiling that price has difficulty pushing up through, demonstrating that there is supply for the stock at that price ie. sellers.

The weekly chart  below (the higher the period the more reliable the signal) of Bhp Billiton (BLT) demonstrates the use of lines of support and resistance to determine demand & supply.  An area of resistance or support is where price has reacted on a number of occassions on approching that area.

   
Click on picture to enlarge.

If you have ever wondered where institutions are buying or selling stocks or where they think a stock is overvalued or good value, then areas of support and resistance can be a good indicator, so long as it is supported by volume.

So how would a long term investor use this?  A reasonably useful rule is don't sell into an area of support and don't buy into an area of resistance.  I recently purchased BLT at prices between 1775 and 1779 as it fell through 2068 (previous resistance that could have become support).  As it hit the area of previous support around 1744 the candles were demonstrating that there was still good demand (green candles with longish lower wicks) and buyers with a reasonable level of volume.

So why does this work?  Well first off it doesn't always work.  Although, if we take the example above, a hedge fund may well have borrowed stock in BLT from an investment fund at say 2230p in February (paying interest to the fund), targeting this price as it has struggled to break this resistance level in the past and fundamentals were negative for the mining sector.  They then sold the borrowed stock at around that price and then looked to buy it back at around a good level of historic support, where they know funds have been buyers in the past.  So buying back at around 1750 - 1800p.

As a long term investor you can ignore all this noise and just concentrate on fundamentals, but it can just add a little edge as to where to buy or sell investments, or where to place your stop loss.