Understanding Stocks

by Michael Sincere

emotions of the market is helpful in determining future trends. Studying candlesticks helps you to see the psychology of the market. One of the goals of using candlesticks is to exit the market before major market reversals. Figure 13.3 is an example of a candlestick chart.

As you can see, the candlestick is made of two components. There is a unique rectangular portion called the “real body.” There are lines above and below the real body called “shadows,” which indicate the high and low for

the day. If you study the shape of the candlestick and the length of its lines, and whether the real body is empty or filled in, you can see who is winning the battle: bulls or bears. For example, if the bulls are in charge for the day, you will see a tall, white real body. If the bears are in charge, you will see a long, black real body. Also study volume, which helps confirm the move (volume bars are at the bottom of the chart).

technicians look for. Perha...

the doji, which shows indecision (see Figure 13.4). It is characterized by small, thin lines and an equal opening and closing price. Th...

The goal is to participate in uptrends while avoiding downtrends. A saying that technicians use is, “The trend is your friend (until it ends).” The

A stock in a downtrend is moving lower and lower. Sometimes stocks move so low that they begin to plunge. If you are holding stock that is in a downtrend, you are probably losing money. Note: Later in this chapter you will learn about support levels. When your stock is in a downtrend, but hasn’t fallen below support (the price point where buyers previously stepped in to hold up the price), be careful of holding too long. If it does break support, this may be a reason to sell.

bargains. A few years ago, people bought stocks when they were in a downtrend because they assumed that the trend was only temporary. This aggressive strategy does work unless a vicious bear market arrives. No matter what you think of technical analysis, it is a mistake to ignore what you see on a stock chart. Figure 13.5 is a sample screen shot of stock in a downtrend.

stock that is climbing and has been climbing for a while is in an uptrend. For many traders, following an uptrend is the easiest and most profitable strategy. Short-term traders like to buy stocks that

trending higher because they depend on technical analysis for making decisions. (Instead of buying low and selling high, traders might buy high and sell higher.)

Just as in a downtrend, traders will look at volume to help determine whether the stock has enough momentum to keep going up. After all, if a stock is moving higher on increasing volume, it is safe to assume that a lot of people, including institutional investors, are buying it.

During a bull market, many stocks are in an uptrend, which can last for months or years. The challenge, of course, is determining

long the uptrend will continue. Sometimes stocks move up so fast that they “break out” above the current price level and move dramatically higher. Sometimes the uptrend ends abruptly. Do not remain bullish forever...

If the market, or your stock, is in an uptrend, you buy (the “follow the trend” strategy). If the market is in a downtrend, move to cash (or sell short) and wait for the next uptrend. This is easier said than done, but it works remarkably well—that is, if you correctly identify the t...

There is nothing more frustrating than watching stocks (or the overall market) go up and down and then end up almost in the place where

began (unless you are a short-term trader). This is called a sideways pattern. A sideways pattern is hard to detect, but the stock often stays within a narrow range. It is so random that it’s hard to predict which direction a stock is going. Often, the volume in a sideways pattern is very low. A sideways pattern may be a clue that the current trend is ending.

Trend Reversal One of the challenges of technical analysis is determining when the current stock trend has run out of steam and may reverse direction. In fact, technicians are

the lookout for the “breaking” of the trend line, which signifies a trend reversal. Figure 13.7 illustrates an example of a stock index that has reversed direction.

A short-term trader isn’t especially concerned about why the stock reversed direction—only that it did. Identifying this trend reversal and buying into it during the early stages could be very profitable for a trader. In this scenario, holding the stock until the trend ends may bring the greatest profits—that is, assuming you can identify the...

It’s extremely difficult to identify a trend reversal before it happens, but sometimes there are clues. For example, a stock in an uptrend may appear to run out of gas, and drop below its moving averages, which you’ll learn about in Chapter 14. If

trend reversal, use other technical indicators (in addition to moving averages) to confirm that your analysis is correct and that it is not just a temporary reversal. Also, just because a trend has continued for a long time doesn’t mean that it will reverse. Long trend lines are common.

Unfortunately, it’s not always obvious that a trend has ended. It takes the courage of your convictions (and the ability to read charts) to exit a winning position. If you truly cannot decide, consider selling half the position. If you see n...

You do not have t...

at the top to make money in the stock mar...

When a trend ends, most people, and especially the media, don’t believe it (at first). For e...

these people do not understand charts and have no clue the trend has ended), declaring that the bull market is still intact. It takes courage to move to cash when an uptrend...

also takes courage to stay with the uptrend while everyone else is warning about a market correction or crash. Either way, you have to do what you think is right and not be influenced by the media or opinionated acquaintances.

In addition, don’t be stubborn. There will be times when the charts do not give a clear message. During these times, it is acceptable to take the conservative route by hedging, or taking the profits and getting out.

Here’s how it works: When

down where enough buyers step

the shares, thereby “supporting” the price and preventing it from falling further. Support is the price level at which a stock price found support the last time it traded down to this level. The theory is that the same price will pr...

Support is often at whole dollar numbers because people tend to buy at whole numbers. When looking at a chart, you can often find support levels by studying how the stock reacted in the past. Let’s use the three-month chart shown in Figure 13.8 to demonstrate support, which is at $60 per share.

If the stock did drop below $60 per share and continued to fall, technicians say that

“broke through s...

When this happens, it is not a good sign for the bulls. It means that the...

support the stock at that price level. When support is broken, it is a si...

In the figure, however, the stock did hold support, and did not break through. According to technicians, no matter how good the fundamentals are or how much you love the stock, when the stock breaks through it...

When a stock price is rising, there will be certain prices on the way up where sellers step in and prevent the stock from rising further.

Resistance is the price level at which a stock has stopped rising and sellers take temporary control.

There isn’t enough demand for the stock to cause it to rise any higher. An example of resistance is shown in Figure 13.9. In this example, the stock tried to break through resistance at $75 per share four times. Once again, sellers prevented the stock from going higher. It then retreated until it reached support at $60. How do sellers “prevent” the stock from moving higher? They cannot prevent it. However, those who believe that resistance will hold continue to sell the stock. On the other hand, there must be a suffi...

However, when the sellers give up or run out of shares to sell, that is when th...

In Figure 13.9, if the stock had been able to break above $75 per share, technicians would have said that the s...

that to be a significant buy signal. This indicates that a stock is strong and can be bought as it moves higher. It is common for stocks to brea...

the way, many professional traders wait until a stock breaks through support or resistan...

Warning: Although it is possible to find fantastic stock plays using technical analysis, it isn’t easy to master this skill. It is very common for a novi...

is easy after making a couple of wi...

One reason the same stock patterns occur again and again is that people tend to make the same mistakes—for example, selling in a panic at the end of a bear market or buying

just before a bull market has run out of steam. It’s human nature to follow the crowd, and investors tend to get greedy at the end of a bull market and fearful at the bottom. These emotions show up regularly as patterns on charts. Stock patterns

Head and Shoulders Top Reversal (Bearish) The head and shoulders is a bearish reversal pattern that shows up often on charts. It indicates that buying has stopped at the top of the uptrend and is about to reverse

see that the pattern really does look like a head and shoulders. The stock moves higher but pulls back to form the left shoulder. It then moves higher to form the head, which seems bullish. It then falls back to its support level or neckline, which is the alignment of the two support levels.