Tom Dorsey's Trading Tips
Why You Need Technical Analysis
No matter how terrific your stock, it won't rise in price unless someone wants it badly enough to pay more for it than you did. That's the law of supply and demand, and it controls prices on every open market.
Quality, the basis of value investment strategies, is one of the factors in whether or not anyone wants your stock. That's why you need to create a list of sound stocks. To do this, you use fundamental analysis. Fundamental factors entail everything that affects a company's business prospects, including its assets, earnings, products, markets, competition and management.
For fundamental analysis, you should rely on professional analysts. No one person could possibly do all the necessary research, but many sources can provide you with the information you need. The resources you will want to use depend on many factors, including the amount of your own time you have to spend, whether you use a conventional or online brokerage service, how much you are willing to pay for help and which new Internet resources are available.
However, to determine whether your high-quality stock is going to make you any money, you need to add technical analysis. Technical analysis is the study of stock price and volume movements. Simply stated, are prices rising or falling? Technical analysis is much more simple than fundamental analysis; knowing how to do it yourself can put you ahead of the pack.
Popular Charting Methods
Technical analysts use a variety of charting methodologies. All of them can be used to plot prices over a period of time, but they differ in visual format and in which price points are represented. The four most common chart types are line, bar, candlestick and point and figure charts.
- Line charts are simple, formed by plotting one price point of a stock -- usually the closing price -- each day, and connecting these dots, or price points, with lines.
- Bar charts contain more information. They show high, low and closing prices, on a daily or weekly basis. A vertical bar is drawn between the high price and the low price, and a short horizontal line going through the bar represents the closing price.
- Candlestick charts use four daily or weekly price points -- opening, closing, high and low. As in bar charts, a vertical bar is drawn between the high and low points. A box or "candle" is drawn between the opening and closing prices. If the closing price is higher than the opening price, the candle is white. If the closing price is lower than the opening price, the candle is black.
- Point and figure charting is the only one of these formats that isn't time-dependent. Price points are not plotted at regular intervals, but rather whenever they move significantly. Xs are used to represent upticks, and Os are used to represent declines.
Tom Dorsey recommends point and figure charting because the dominance of price movement over time makes trends easier to see and interpret. Small, insignificant moves are ignored, but all significant moves are recorded, no matter how quickly they occur. This prevents chart users from getting bogged down in short-term minutiae, while enabling them to catch any substantial movements that occur within the space of a single day -- and these can be important in today's fast-paced market.
Basic Charting Skills
In a point and figure chart, a price scale is located on the vertical axis. The range of your price scale will obviously reflect the range of prices your stock tends to move through. The intervals represented in your scale will also depend on this price range. Tom Dorsey recommends the following intervals:
- 1/4 point per box from $0 to $5
- 1/2 point per box from $5 to $20
- 1 point per box from $20 to $100
- 2 points per box from $100 to $200
- 4 points per box above $200
These scale adjustments help you show the larger price movements found in higher-priced stocks without running out of paper!
Placing Xs and Os in the boxes on the chart plots the price movements. Xs represent upward movement, while Os are always moving downward. When a stock's price rises one interval of your scale, you represent this by placing an X in the appropriate box. But you don't plot this upward movement unless or until the stock has risen at least three scale intervals. In other words, no column can show fewer than three Xs (or Os). You continue plotting Xs in this same column until the stock begins to drop (at least three scale intervals). Then move to the next column and begin plotting Os to show the downward movement. You continue plotting Os in this column until the trend turns around again and you move to the next column to plot your rising Xs.
In point and figure charts:
- Columns of Xs and Os alternate.
- Xs and Os can never mix in the same column. (Each column is either a price rise or a price fall, not both!)
- There must be at least three Xs or Os per column (eliminating insignificant movement).
The numbers within such a chart are used to identify the months of the year. For instance, 1 stands for January, 2 for February, 3 for March and so forth through September. October, November and December are represented by A, B and C respectively. This is the method Tom Dorsey and his analysts use to indicate time. Other analysts using the point and figure method may place the months along the horizontal axis -- not at regular intervals, but wherever they fall as the chart is constructed.
That's all there is to plotting a point and figure chart. Simple? Yes. But charting doesn't begin to get really interesting until you've been covering your stock (or sector or market) for a while, and patterns begin to emerge.
Charting the High Flyers
Be aware that as you get more sophisticated in plotting point and figure charts, you may want to adjust the price scale for stocks that experience wild price swings. In 2000, some Internet stocks showed intra-day swings of as much as 10 points! When this occurs, increasing the price interval can eliminate excessive ups and downs that muddy the overall pattern. It's easier to see what's really going on.
Pattern Recognition: Buy Signals
Technical analysts use past price movements to predict future price movements. They do this by recognizing certain patterns that recur again and again. When you've done this type of charting for a while and have seen these patterns over and over, you'll begin to recognize them quickly. They are the basis for your buy and sell decisions.
Bullish chart patterns signal that a stock is in demand. The price is on the rise and it's a good time to buy. Tom Dorsey and his analysts have identified six bullish chart patterns:
- Double Top: This simple signal occurs when an X, or up, column exceeds the previous X column.
- Triple Top: An X column exceeds two previous columns.
- Shakeout: The stock makes two tops then breaks a double bottom (when an O column exceeds the previous O column). It is completed when a triple top is broken.
- Bullish Triangle: Five columns are required to make this buy signal pattern, identified by a series of lower highs and higher lows.
- Bullish Catapult: This buy signal pattern is a combination of a triple top breakout followed by a double top breakout.
- Bearish Signal Reversed: This signal features a series of lower highs and lower lows that abruptly "reverses" that pattern and breaks out.
In addition to patterns that signal buying opportunities, there are also patterns that alert you when it's time to sell.
Pattern Recognition: Sell Signals
You must make two major decisions for every stock in your portfolio -- when to buy and when to sell. Too many investors spend more effort on the first decision than on the second. To avoid this mistake, keep in mind that you realize your profits only at sale time!
Bearish chart patterns signal a time to sell. Here are the five bearish chart patterns that Tom Dorsey and his analysts identify:
- Double Bottom: In this simple sell signal pattern, an O, or down, column exceeds the previous O column.
- Triple Bottom: An O column here exceeds two previous columns.
- Bearish Triangle: Five columns are required to make this sell signal pattern, characterized by a series of lower highs and higher lows that form what looks like a triangle.
- Bearish Catapult: A triple bottom sell signal followed by a double bottom sell signal.
- Bullish Signal Reversed: A seven-column-minimum sell signal featuring a series of higher highs and higher lows.
Notice that the bearish patterns are essentially upside-down versions of bullish patterns. The same principles apply.
You've now seen the basic patterns that analysts look for. In later lessons, we'll refine your understanding of them a little more so you can maximize your benefits.
Versatility: Price Isn't Everything
Point and figure charts are very versatile and can be used to plot information other than individual stock prices. You can use the charting you've learned to follow the pricing patterns of NASDAQ, the Dow, the Standard & Poor 500 or industry indices. Price trends are critical in technical analysis, but they aren't everything. In a strong market, for example, it isn't enough to know that your chosen sector is going up. If it's rising more slowly than other sectors, this may not be your best opportunity. Fortunately, in addition to tracking prices, you can use point and figure charts to plot the relative strength of a stock or sector.
You can also use this type of charting to ensure that you're getting into the market or a sector when it's not only headed up, but when there is also plenty of room left for growth. If you bought technology stocks near the end of their run, you didn't have the same profit opportunity you would have had if you'd bought near the beginning. A concept known as "bullish percent" can help you determine if demand is just beginning or has nearly run its course.
Thomas J. dorsey.