Every week Jim Cramer works with technicians in "Mad Money's" Off The Charts segment to look for chart patterns that can predict the next big stock moves. While Cramer is certainly not a chartist, he understands technicals play a vital role in understanding if a big move is the real deal.
"Why do charts work? First, you must consider them as if they are footprints at a scene of a crime. These footprints trace out what big money managers might be doing with their buying and selling of stocks," the "Mad Money" host said.
The second reason to care about charts is that Cramer finds there is a remarkable self-fulfilling nature of charting stocks. Some of the best investment ideas can come from chart inspired brainstorming sessions — though Cramer thinks that the best way to produce results is with a careful melding of both fundamentals and technicals.
Sometimes technicians start by comparing the chart of an individual company to the chart of an average to determine the legitimacy of a move. This is what is known as confirmation.
For instance if the Dow Jones industrial average hit a new high, historically it is not sustainable unless the Dow Jones transportation average also hits a high, or confirms the breakout status of the Dow itself. So, if both the industrials and the transports hit a new high, Cramer considers the move to be one he can bless as being legitimate.
"I like to see all of these indices move up in sync before I truly bless a market move. You get all of these indices rolling higher, and you have to put the maximum amount of chips on the table," Cramer said.
Part of looking at the charts is being able to spot the bottom for the best entry points and ceilings for the best places to exit from a stock. When an investor buys a stock, they are betting from the start that the stock will go up. That means understanding the historical patterns of the charts and where it might be headed.
"As long as sellers overwhelm buyers with their dumping, no base can form. A climax is a sign that those potential sellers who had been holding on for some time are finally giving up en masse," Cramer said.
Additionally when a chartist sees that the volume has grown or expands but the stock doesn't go down, that means the stock has finally found its floor and is now safe to buy. That is when the number of buyers is finally equal to the sellers in their power to determine the direction of a stock.
Investors can determine if a stock is overbought or oversold by charting the ratio of higher closes, also known as the relative strength index, or RSI. This is a momentum oscillator that measures the direction that a stock is going, and the velocity of the move.
Cramer also likes to match the RSI of an individual stock to something else, maybe the relative strength of its sector or a larger index, and then measure the price action historically. He looks for anomalies where strength stands out, because that is a sign that there is a pending move, or a change in momentum.
"Typically, when a stock gets overbought it is ripe for a pullback because overbought stocks, ones with many buyers reaching to take in supply, tend to snap back after they have gotten too far away from their longer term trend line," the "Mad Money" host said.
Sometimes stocks can even break through all of the ceilings of traditional significant measurement periods, and then stay overbought for weeks at a time. These stocks defy the notion of the inevitable gravitational pull of the old equilibrium line, and can't be contained.
"When you spot these highly unusual moves you may be able to strap yourself into a real moon shot," Cramer said. (Tweet this)
The most simple and reliable pattern out there is the dreaded head-and-shoulders pattern. Cramer learned not to ignore this pattern when his charitable trust bought Alcoa in the low teens in 2010, and ultimately took a blood bath because it was a really early buy.
Alcoa's stock had a healthy run from winter of 2010 until February 2011, rising to $17 from $13. The stock ran to $18 on the eve of its quarterly earnings report, and Cramer thought it was a fine quarter when it reported.
Yet, what worried him was that even after an initial positive reaction, the stock dropped. So a few days later, Cramer assumed it would take out its $18 level and went back to buy more.
Cramer was wrong — extremely wrong.
What Cramer didn't realize is that the fluctuation in price had traced a perfect head-and-shoulders pattern. And no, this isn't referring to the brand of a shampoo.
"Yes, just like a human's head. That is the most frightening pattern in the chart book," the "Mad Money" host said.
In situations when a stock's fundamentals give little insight into the direction it is headed, the technicals could light the way. Another chart type that Cramer relies on is called the cup-and-handle pattern. In fact, he has used the reliance of this pattern to stay in stocks that he might have otherwise sold.
A cup and handle pattern is one that resembles a cup with a handle. The cup creates a 'U' shape with a downward drifting handle.
Cramer learned the lesson of the beautiful cup-and-handle opportunity in the stock of Domino's. He was thinking about selling the stock, when chartist Ed Ponsi set him straight and told him not to.
Ponsi pointed out that Domino's had reached a pivotal moment and was getting ready to launch into a bigger move. Sure enough, Ponsi nailed it—and Domino's proceeded to double and then some. It turned out that while Cramer was nervous about the stock, it was actually consolidating and getting ready to power higher.
"Technicians and fundamentalists can co-exist. Make peace with them both, and I bet you will make a heck of a lot more money than if you are blind to one or the other and certainly to both," Cramer said.