Jim Cramer isn't a chartist, but he understands why charts are so important for predicting the next big stock moves.
"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, Cramer said, is that there is a remarkable self-fulfilling nature of charting stocks. Some of the best investment ideas can come from chart-inspired brainstorming sessions. However, Cramer has found that the best way to produce results is with a careful melding of both fundamentals and technicals.
Additionally when a chartist sees that the volume has grown or expanded 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.
Chartists also look at the advance of a stock, which happens when the stock takes out its resistance overhead. Technicians don't just look at the closing price and a graph against the previous day, because it won't actually paint a clear picture of the trajectory.
Instead, technicians use what is known as a moving average to better represent a stock's movement. They figure out the moving average by taking the closing price of a stock over a period of time, add them up, and then divide by the number of days in that measured period.
"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," Cramer said.
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 matches 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.
The most simple and reliable chart pattern out there is one that Cramer dreads.
Unfortunately, Cramer learned not to ignore the head-and-shoulders pattern the hard way when his charitable trust bought Alcoa, now known as Arconic, in the low teens in 2010, and ultimately took a loss because it was too early to buy.
"Yes, just like a human's head. That is the most frightening pattern in the chart book," Cramer said.
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.