Use charts to assess risk and reward

By Jim Jubak

Risk and reward.

Investors want to minimize the first and maximize the second. But how do you get a handle on the potential reward in any investment and the risk you might be taking on?

Technical analysis -- what's popularly called charting -- can help investors evaluate both risk and reward. Let me walk you through the tools on MSN Money that can help you balance risk and reward whether you're considering a market segment or an individual stock. I'll start with the simpler tools and gradually add complexity to the picture that technical analysis can draw.

In the Stocks section of the site, click on Charts in the left bar. Using the pull-down menu under Find, go to Common Indexes and select Nasdaq Composite. Within the gray shaded box under Chart, click on Price History, and under Period, select One Year. In the pull-down menu under Analysis, select the last term, No Technical Indicator. These choices give you the simplest kind of picture you can get of a stock's performance -- a record of its closing price over time.

One-year price history

Even this very simple chart can tell you a lot about a market or a stock. For example, if you pulled up a one-year chart for the Nasdaq on Jan. 17, 2003, you'd notice this pattern:

• First, a very steady, almost relentless decline from January 2002 to a low in October 2002;

• Second, a rapid recovery from October until a peak in December 2002, and third, what looks like a plateau that stretches from December into January.

It's the first real plateau of any duration that you can find on the one-year chart.

Three-year price history

So what does this plateau mean for the future direction of the Nasdaq market? To add perspective, change the period from one year to three while keeping everything else exactly the same. This chart tells you two things:

• First, that this is indeed the longest plateau that you can see on the chart -- that raises the possibility that the Nasdaq is stabilizing at this level after almost three years of decline…

• Second, that the high point on this plateau corresponds to the low at 1,423 that the Nasdaq market hit after the Sept. 11, 2001, terrorist attacks in New York and Washington.

To see why this is important, let's add some moving averages to this chart.

Two-hundred-day moving average

To put a moving average on this chart, go to Analysis, Moving Averages, and select 200-day. A moving average is simply a way to turn sometimes confusing near-term volatility into a smoother trend. (It's calculated by averaging a stock or index's closing price on each day of the period in question -- such as 200 days. The next day you do the same calculation all over again but with a 200 period that have moved ahead one day.)

Moving averages are a good shorthand for the average price that investors have paid for a stock over the period in question. So when a stock price climbs to near an average from below the average, the stock is approaching a level where a lot of investors who own the stock -- and who have been holding it at a loss -- can sell and break even. That level represents resistance, a ceiling, since selling at the moving average is likely to send the stock lower.

When a stock falls to near a moving average from above, the price approaches the level where a lot of investors bought and that price is likely to bring out strong buying from investors who are adding to existing positions or rebuilding positions that they sold when the stock was higher. When a stock moves down from above a moving average, the average represents support, a floor, under the stock.

On the three-year chart, it's easy to see that the 200-day moving average acted as resistance in January 2002 and March 2002: the Nasdaq moved up to the average, attempted to penetrate that ceiling, and, then moved lower. Right now the Nasdaq seems to be setting itself up for another test of that 200-day moving average at a level that approximates the October 2001 low. A clear break above the 200-day average would give investors faith that the rally has more strength. A clean break below that level would set up the index for a move lower.

Fifty- and 10-day moving averages

Go back to Analysis and the Moving Averages pull-down menu and add the 50-day and 10-day moving averages to your chart. The three averages all sat within 22 points of each other (from 1404 to 1426) on Jan. 17. That's confirmation of the importance of the recent consolidation in the Nasdaq market and the importance of what was the floor until the index closed at 1,376 on Jan. 17. How important is it that the index closed below support on the 17th?

Let's add Bollinger Bands to the chart to see.

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