How to Read a Stock Chart in Just Five Seconds

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Whenever I tune into CNBC, I’m usually blown away with the raw amount of data thrown at me. For the average person, there’s no way to separate what’s useful from what isn’t, so people often rely on the pundits to tell them. I’d prefer not to do that – I know from my experiences in following politics obsessively that pundits rarely are telling the whole truth and are often not all that well informed. So I’ve taken to trying to understand the basics of this data myself, and I’ve figured out one big truth: most of what you actually need to know, you can figure out pretty quickly.

Let me show you what I mean. Quite often on those television shows and stock analysis magazines and websites, you’ll see complex graphs showing the ups and downs of a particular stock price or stock index. You’ll see something that looks sort of like this:

goog

What’s pictured above is a screen capture from Yahoo! Finance’s chart of Google’s stock price over its history. It’s a nice little picture that shows it going steadily up until about the start of 2008, then dropping a little.

Stock pundits love these kinds of graphs. Not only do they look pretty cool, there’s a lot of data compressed in there. Even more important, many stock pundits believe that you can use this history to predict where the stock is going to go.

That predictive process is known as technical analysis, and people have debated for years over whether it actually works. Technical analysis basically says that you can look at patterns in the past behavior of a stock – combined with basic tenets of human behavior – and predict where the stock is going.

Here’s an example of one tenet of technical analysis (if you’re really interested, the Wikipedia article on technical analysis is a killer read). According to technicians, over short periods of time, a stock often has a “level of support” and a “level of resistance.” A “level of support” is a price that a stock simply can’t seem to drop below, while a “level of resistance” is a price that a stock simply can’t seem to break through. This will usually hold true for some period of time until an exceptional piece of information comes along pushing the stock over the resistance or under the support, at which point new lines form.

Here’s an example on the Google stock graph from above:

tech

Line A represents a line of resistance, Google’s first one. It had a hard time bursting through that line from the IPO in August 2004 to roughly April 2005, when Google kept pumping out unbelievable growth numbers. At that point, it broke through that resistance line and hit another resistance line (line B) until roughly November 2005, at which continued amazing numbers caused that line to give way. Interestingly, after that crossing, line B became the “level of support” for Google and still holds until today. The new level of resistance seems to be line C – around 725.

Seems simple and reasonable, right? And you can obviously see how people could make money from this. If you can identify a level of resistance, just put in a long-standing order to buy that company’s stock if it crosses that level, because you’re likely buying it at a new level of resistance, meaning you’re going to profit. If the price was floating around A, for example, as it was in early 2005, if you had put in a buy order to buy at about 210, you would have made money when it crossed that level of resistance. Similarly, if you put in a buy order for when it crosses line B at about 330, you would have again made money.

It makes sense if you look at a clear-cut example like that, but let’s throw in a line D to show why this isn’t all cut and dried:

D

That D line (with a Google stock value of about 570 or so) makes sense as a level of resistance up through October 2007, at which it bursts through. If you had set up a buy order – telling your broker to buy Google if it crosses 570 – you would have been very happy up until about February, when Google peaked at somewhere over 700.

But then everything goes to disaster. It quickly drops back below that supposed level of resistance, stays roughly there for a while, then begins to drop even more in July, finishing this chart just below 400.

So, why did that happen? Obviously, the late drop was due to the ongoing economic crisis of 2008, but that itself shows a problem with technical analysis: major events often cause such analysis to go haywire.

Also, past performance is never a guarantee of future results. Just because a person is able to identify some sort of pattern in the historical data doesn’t mean any of it’s going to hold tomorrow.

Take, for example, the recent debacle with Apple. A false rumor about Steve Jobs having a heart attack caused the stock price to drop to a 17 month low (a 5.4% drop) very suddenly. Imagine, if you will, if Jobs actually had passed away. It’s an event that no technical analysis could predict – it only deals well with long-term patterns in very stable companies.

In short, technical analysis is a great thing for a stock pundit to show off, but in many ways it’s a lot like reading tea leaves. You can see patterns in there, but identifying the meaning of those patterns and what they portend to the future is much more of an art than a science.

So, how can I read a stock chart in five seconds?
one upNow that it’s pretty clear why pundits like those stock charts, what can you get out of such charts in the five seconds they’re up on the screen on CNBC? This is, of course, assuming you’re following the basic idea of only owning stocks in companies you know and believe in and have a specific reason for owning that has nothing to do with the stock price – which is a very good way to invest. It’s the way Peter Lynch suggests in his excellent book One Up on Wall Street, for starters, and is also described in many other stock investing books.

First, look at the general trend over the last six months or so. This is usually a clue as to the general health of the company – no major news, just little signs of good health or poor health. If it’s a stock you own or might be interested in, you may want to take note of a steady rise or a steady fall and find out why it’s happening.

Second, look for recent spikes. A big spike upwards or downwards means something significant has happened to the company. These are usually game changers and are definitely worth noting.

Third, see if they throw up charts for similar companies. See if the general pattern of the stock in question matches the general patterns of the competitors. If they do, then it’s probably a broad market effect or a sector effect and not quite as worrisome as something drastically different than a competitor, which you should look into.

What these three things point you towards are signs that something has changed in the company – something that might violate the reasons you own the stock. As I’ve said many times, you should only own an individual stock if you have a specific reason for doing so. You trust the CEO. They deliver a stellar product. Their product has some sort of inherent advantage over the competition. Each of those changes, which you can quickly pull out of a chart, is simply a sign that you need to investigate the stock you hold in more detail to make sure the reason you have for owning the stock is still intact.

Unless you’re investing professionally or doing it as a serious and focused hobby, there’s not much else you can really get out of a glance at a graph, so don’t let yourself get overloaded with data. Just look for the important events, the ones that would change your opinion of the company or how it does business. Leave the rest to the people who do this eighty hours a week.

Or, better yet, do what I do: follow individual stocks for fun and learning and keep your real investments in index funds. That’s the route suggested by an army of experts, including Warren Buffett, and it’s the route I’m following.

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28 thoughts on “How to Read a Stock Chart in Just Five Seconds

  1. Hi Trent,
    I strongly agree with your opinions for the most part. It is a certainty that the average person should shy away from technical analysis as a means of selecting stocks.
    However, you left out one vital piece of the puzzle in your charts.
    Most technical analysts make decisions based on the relationship between price AND volume. Your charts show only half of the story (price).
    If the stock price shoots up on smaller than average volume (read: demand) there is no reason to believe that the price is sustainable and would form a new price floor. However, if the price escalates on significantly higher than average volume (increased demand), then the price is more likely to be sustainable and/or to form a new floor.
    Of course the opposite is also true. Selling on higher than average volume indicates less demand and thus a sharp drop in the stock price.
    Of course this subject demands a lengthier explanantion, but the major points have been made.
    - Tyler

  2. Trent, this is a great for getting a quick overview. You provide us with some simple and effective tools. If a stock looks compelling, people can do their own intense research. I’m like you, I never could put much faith in technical analysis. I am really looking forward to your reviews of Benjamin Graham and your perspective on his premise of value investing.

  3. Haha! Maybe you would be good at Political Science! I had to look at graphs like that all the time in getting my polisci degree and found it completely mind-numbing. You’d probably find the mathmatics much more interesting than I ever did!!!

  4. I’m going to take the other side of the argument from Trent. Technical analysis is the astrology of stock trading: instead of the stars, it gazes at the charts to infer actions in the real world.

  5. technical analysis also uses patterns.
    there is so much about it but i think if a person has the will to go for it it’s not too complicated.

    nothing is 100% so don’t expect results all the time. Speaking of that I made 10% profit on GE by using technical analysis. although i don;t show my indicators on the link below. I show just the price.. I did use technical indicators and they work mighty fine.

    http://investingfreak.com/2008/10/07/10-gain-in-a-day-when-people-panicked/

    -K

  6. Tyler: if I had gone down that road and added another dimension, it would have made the bit about technical analysis way too complicated and lost a lot of people along the way. Better to introduce one concept and make it comprehensible for many than introduce two or three at once and have it lose people.

  7. Trent,
    As previously mentioned, I agree with you. And, of course, you know your audience.

    With such a diverse readership, I apprecaite your thought process and ability to articulate the understanding of complex theories in “bite sized chunks”.

  8. Thank you, Trent. I never knew about looking at financial charts this way. It makes so much sense. I’ll look for the levels of resistance and support from now on. My husband watches CNBC in the morning before heading off to work; he’s only interested in the entertainment value, but I’ve been trying to learn stuff by watching the charts and listening to Warren Buffett when he’s on there.

  9. Basically, technical analysis is attempting to analyze mob psychology.

    I believe there’s a difference between being able to do technical analysis profitably and having to spend eighty hours a week at it. Yeah, a lot of the really big-time fund managers do this, and they make some really incredible (in the literal sense of the word), consistent returns – and they are obsessive – but there are a growing number of “second-string” traders out there pulling consistent but more down-to-earth results doing the same thing on a part-time basis.

    And I think most technicians would agree it is as much art as science. I was reading one interview with a fund manager recently who said his best analyst is only right about 65% of the time. So it can give you a leg up, but it’s definitely not as cut-and-dried as some would have you believe. So I feel it works, but it’s not a crystal ball. More like a meteorologist trying to predict the weather 20 days ahead.

    If you are investing for the long term, I really like the combination of using fundamentals mixed with some basic technical indicators like those promoted by Phil Town in his book, “Rule #1.” The fundamentals tell you what stocks to buy (the ones that are both underpriced by a wide margin and growing solidly with good management and a strong competitive advantage), and when to buy them – and when to sell them.

  10. Also, as I understand, support lines don’t have to be flat. For instance, I would see the support line B to actually be sloping upwards from about October 2006 to about July 2007. Then, when it broke through that support at about Janurary 2008, that meant real problems for the stock.

    Long on GOOG

  11. Trent,

    Please explain the current financial crisis to all the economic neophytes out there!

    You’d be great for the task.

  12. To my knowledge Warren Buffet does not invest in index funds although he does suggest that the average Joe invest in them. To really find out how Warren picks stocks (and other investments) read the best investment book ever written “Buffet, The Making of an American Capitalist”. Trust me, you won’t read this in a weekend. It is all about finding value like finding a $100,000 house built with $50,000 worth of material and labor that you can buy for $30,000. Charts mean absolutely nothing except history.

    Trent, you quite often write about passive investments but rarely if ever on active investments. Active investments can bring in 50 to 100 times more return on your money. I think that this obsession with passive income is one of the reasons this society has gotten itself into trouble. Everyone is looking for a free ride or at least an easy ride.

    David T.

  13. Perhaps interesting to point out this is the complete opposite of Warren Buffett’s philosophy. TA only works when enough people believe it and even then it is more voodoo than science.
    I’d recommend “Paul Wilmott Introduces Quantitative Finance” (corny title but step past that,) specifically chapter 3.

  14. I like that you mentioned technical analysis without bashing it but without claiming it will reveal certain truths about a stock. It is what it is: just another thing to look at when considering an investment.

  15. I think it was Warren Buffet who said that he realized TA did not work when he flipped a chart upside down and still showed the same results.

  16. Another solid post, Trent, and I particularly agree with your closing: follow stocks & learn, but in the end, invest primarily (or exclusively) in index funds. If you simply try to *match* the market, you’ll outperform the vast majority of funds & investors over the long haul.

  17. Nice post and good example.

    Below is how I would act situation on graph.

    Let’s assume I bought stocks after passing ressistance D (or could be A or B as well). Then I would set simple stop loss (sell order when stocks reach certain price level). I would keep moving this stop loss few percent behind price, setting for example on last minimum. Then, as we can see on the graph, price can’t break C, trying almost three times to do so. This is a good sign to close your position.

  18. I agree with the way you are explaining how to understand stocks but one particulary indicator I read is the Beta.
    If you go to google finance and type in a stock you will see a spot that says Beta. Beta is telling you how risky a stock is. For example if the S&P is a 1 and the stock is a .5 your stock is half as risky as the S&P 500. The same is true if it goes the other way. If it was a 1.5 Beta then the stock would be 50% more risky than the S&P500. I hope this helps.

  19. Wwwwwwwwwooooooooooooowwwwwwwwwww this stuff is confusing!!!! you need to dumb it down a little like seriously man. Aaaaaaaaaaaaaaaaaaahhhhhhhhhhh I swear my hair is falling out!

  20. I know this is an old article, but I had to leave a comment.

    I’m one of those people who do this 80 hrs a week (I’m a trader) however, I must say that you did an excellent job of explaining it in simple terms.

    Good Job!

  21. Re David T: “I think that this obsession with passive income is one of the reasons this society has gotten itself into trouble. Everyone is looking for a free ride or at least an easy ride.”

    Uh, I thought it was all the idiots who made the overly aggressive and uninformed decisions who caused all the problems. Actively buying stocks because other people said they should, buying houses they couldn’t afford b/c the banks said they could, wanting a big bang for the buck NOW rather than having the patience to wait for small profits to accrue over time. I think passive income generation, and the patience it requires, is actually the solution to many of our societal problems right now.

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