Fundamental and long-term investors often dismiss stock charts as useless voodoo. They argue that past price action has no impact on future performance, and that some of the more simplistic technical-analysis patterns are nothing more than self-fulfilling prophecies.
Now, you can argue that historical price patterns do have impact on the future, because there's always an emotional reaction in the market as a stock's gains, losses and entry points shift. But you don't really have to believe in charting's predictive power for it to be very a useful tool for you.
That's because charting's greatest value might be in simply be providing you with a framework for your trading strategy. To me, charts offer a great way to cut your losses and let your winners run (which everyone knows is the key to producing superior returns). You'll view charts differently if you start to think of them not as fortune-telling devices, but merely as tools to help you decide where to enter and exit your positions.
Now, I believe that prediction in general is overrated as a trading strategy, as I discussed in a column last week. Instead, optimizing your gains requires you to constantly evaluate and reevaluate a stock's situation. You press your bets when the odds look good, but decrease exposure when the risk is high.
So, I believe that it's still important to understand the basic concepts of technical analysis, but to the use charts with a more reactive rather than anticipatory approach. Consider the case of Global Blood Therapeutics (GBT) , a stock where I've used charting to manage my trade.
GBT will be releasing some important data on a key drug in mid-June, and I'm looking to trade the stock heading into that event. I have no idea if the news will be good or bad, and I don't want to just roll the dice. So, I'm looking for entry and exit points based on the stock's chart action:
As you can see, the chart above shows that GBT has perked up in the past couple of weeks and is showing some signs that it wants to run higher into the upcoming drug announcement. The stock is trading above its 50-day simple moving average, while GBT's recent lows are serving as obvious support level.
I have a position in GBT, but the question is: "When do I add to it?" The most obvious point would be over $50, but then I'd want to keep a fairly tight stop while waiting to see if some momentum builds.
The key here is that I've developed an investment thesis on my own, but am using a stock's chart to help me enter and exit the trade. I can't predict what will happen in the future, but I can manage my trade so that I keep risk contained and have the opportunity to benefit if conditions develop in a favorable way.
So, I believe that charts are actually the best tool in a trader's arsenal -- not because they tell you what's going to happen, but because they tell you what you should be doing right now.