- "Mad Money" host Jim Cramer goes over the key chart patterns all investors should keep in mind.
- Knowing when stocks are overbought or oversold is key to understanding how to play them, Cramer says.
- The "Mad Money" host also shares the lessons he learned from two reliable, albeit scary, stock patterns.
Jim Cramer may not be a chartist, but he understands why charts are so important for predicting the market's major 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.
Cramer's second reason for caring about charts 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, he said.
But for Cramer, the best way to produce results is by carefully analyzing both a stock's fundamentals and its technicals for more comprehensive results.
Additionally, when a chartist sees that trading volume has grown but the stock has not gone down, it often means that the stock has finally found its floor and is now safe to buy. In other words, the buyers' power to determine the direction of a stock is finally equal to the sellers'.
Chartists also look at the advance of a stock, which happens when the stock takes out its resistance overhead.
Rather than simply looking at a stock's closing price and graphing it against the previous day's close, technicians use what is known as a moving average to better represent a stock's movement. They calculate the moving average by taking a stock's closing prices over a period of time, adding them up, and then dividing by the number of days in that 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 whether 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 of a given stock and the velocity of its move.
To find moments in an individual stock's trajectory where its strength stands out — a potential sign of a pending move or change in momentum — Cramer matches the stock's RSI to something else, such as the relative strength of its sector or a wider index, and then measures the past price action.
But 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 — which spun off its aluminum business in November 2016 under the name Alcoa and is now known as Arconic — in 2010, when the stock price was in the low teens, 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," the "Mad Money" host said.
Another chart type that Cramer uses is called the cup-and-handle pattern. In fact, he has relied on 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 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 as the company embraced new technology and broke into digital ordering.
"Technicians and fundamentalists can co-exist," Cramer concluded. "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."