How to use technical analysis on a stock to help inform buy and sell decisions

Here’s our Club Mailbag email investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. We can’t offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries. This week’s question: Hello Jim, You have talked a lot about the strong fundamentals of Oracle lately. But the chart has a nasty double-top formation. I was wondering if you could help us average investors interpret technical analysis versus fundamentals when they do not align. — Mark in Florida We consider ourselves to be fundamental analysts rather than technicians. The decisions about stocks for the Club focus heavily on the companies’ businesses by studying supply chain dynamics, end market demand, management styles, growth prospects, economic influences, and so on. It’s all in an effort to estimate future earnings and cash flows along with an appropriate valuation for the shares in question. Technical analysts focus on stock charts — looking at momentum, relative strength indicators, volatility, and other indicators that are often referred to as the “technical setup.” We care more about the business than the stock. A technical analyst doesn’t care about the business, instead focusing on the supply and demand of the actual stock. We prefer the fundamentals because it’s our view that technical indicators work until they don’t. The knock on fundamentals, to be fair, is they work until they change. We’d rather be looking forward to changing situations based on companies’ businesses than trying to predict future stock moves based on what they did in the past. For those unfamiliar with the technical analysis term “double top,” it’s pretty straightforward. It happens went a stock reaches a top that it’s unable to hold only to smack right up against that same top for a second time before again moving lower. It kind of looks like two mountain peaks with a valley in the middle. A double top indicates a significant point of resistance or a level the stock just can’t seem to power through. We do, indeed, see such a pattern in the chart of Club name Oracle (ORCL) around $126 per share. Of course, we should note that the second top came as the result of the most recent quarterly earnings release on Sept. 11 so any buying done before that point — were we focused on the technical setup — would have been based on a completely different chart setup; one in which we began to see support around the $113 level and with strength into the print as the stock bounced off a longer-term uptrend (represented by the green line) that acted as support. But instead of support at $126, that level turned into resistance again as the stock fell off completing the double top. Again, technical analysis works until it doesn’t. Now that the double top has formed and the stock has started to break down, we have to consider the new setup. First, however, it is crucial to note that we continue to like the fundamentals of Oracle’s business, if not, we would not be interested in the stock regardless of the technical setup. For that reason, we did opt to pick up shares following the sell-off at around the $114 level as shares bounced slightly. Nonetheless, the sellers came back in — perhaps because the shares failed to recover quickly enough. Given that we still favor the fundamentals, we would approach the chart from a buyer’s perspective, now looking for where support may come into play next. We aren’t going to sell a name due to a bad chart but will be mindful of it as we look to build our position. Unfortunately, that uptrend we saw working into the print was broken in the post-earnings selloff, so that’s out. It also sent shares firmly below the 50-day simple moving average (represented by the rolling marron line), so that’s out. Fortunately, we may be looking at another level of support at around the $103 area. As seen in the chart (represented by the horizontal purple line), the stock previously saw resistance to further downside at around this level. We can also see the 200-day simple moving (SMA) coming into play (represented by the yellow line). It currently stands at around $101.47 but should keep trending upward so long as the stock remains above it. At this point, we should note what technicians refer to as the “Principle of Polarity” — the idea that resistance, once broken, becomes support; while support, once broken, becomes resistance. This principle is generally used for horizontal support and resistance lines. We wouldn’t really use it when a trend line is broken though as we would instead acknowledge that the trend has broken and now look for where the next support level may come into play. Given the magnitude of the selloff, we might also look to the Relative Strength Indicator (RSI), seen by the graph at the bottom of the chart. RSI looks at momentum — both the speed and magnitude of a move — in order to determine if a stock has reached overbought or oversold territory. It does this by comparing the strength of “up days” versus “down days,” generally over a 14-day period. This indicator oscillates between zero and 100. A reading under 30 — where Oracle is about to end up should it move any lower, such as to that $103 level, in the near term — is indicative of a stock being “oversold” and a reading over 70 signals an “overbought” condition. It’s important to remember that an oversold stock can always get more oversold, and an overbought stock can always get more overbought. So, you should not just buy or sell shares based on a breach of 30 or 70. However, as with all technical tools, it is worth being mindful of when considering what to do after a sharp move or trying to determine how much room there is left to go to the downside or upside in the near term. The RSI is similar to the S & P 500 Short Range Oscillator that Jim Cramer has relied on for decades. The Oscillator looks at oversold or overbought conditions in the overall market. We tend to do some buying in oversold markets ( as we did with Oracle on Tuesday ) and some selling in overbought markets. All this leads us to the question of what to do when the technical setup and fundamental setup don’t align. In this case, we would implement what we refer to as “wider scales” — scales being the decline we are looking for in the stock between buys, and wider scales meaning that larger declines on percentage terms between buys are warranted. This allows us to add slowly to a position over time as the setup improves. Indeed that is essentially what we did with Oracle on the post-earnings selloff — picking up shares at around $114 on Sept. 18 in spite of the negative technical setup — as shares were bouncing off a greater than 13% one-day selloff from the earnings release. That left us with plenty of room for additional buys should the stock break down further (as it has) to a level with a better technical setup (which it now has). Hence, Tuesday’s small Oracle add right around the support point noted above. Bottom line When the technical and fundamental setups do not align, investors must proceed with a bit more caution and play a careful balancing act between the two. As noted, we will buy a stock when our positive fundamental view is in contrast with a negative technical setup, but we would never buy a stock on which we have a negative fundamental view regardless of the technical setup. We said it earlier but we’ll say it again — it’s our view that technical indicators work until they don’t and fundamentals work until the change. We like to buy a stock when it’s down because if the fundamentals are intact it means we’re getting a better deal. However, if we only got into a stock because of a technical setup, and then that setup fails, we can’t continue to buy, there is no choice but to exit. It’s for this reason that shorter-term traders might choose to put greater emphasis on the technical analysis — but longer-term investors, like us, looking to build positions over time and buy as prices come down in order to maximize longer-term upside are better off focusing on the fundamentals and leveraging technical analysis to help determine when to gain or increase exposure and not to determine if they should have exposure. When the fundamentals and the technical setup are in agreement, then you could be looking at a very good opportunity to make some money. (See here for a full list of the stocks INJim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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