Before we can dive directly into charting and measuring what the market is saying about itself objectively, we need to lay the foundation for analyzing the markets in analytical or chart form. The most important lesson I can offer at this juncture as we get ever closer to actual decision making is to remember the first rule of analysis. Remain objective! It is very easy at this point in the journey to feel excitement and overconfidence regarding trade patterns and set-ups. This is the point where a little knowledge is very dangerous. The next seven chapters are the heart of the analysis—where objectivity supersedes all opinion. Those who act too quickly and trade on opinion instead of analysis can experience catastrophic financial results.
Like it or not, when you commit your capital to the market, you also commit your emotions. What separates winners from losers is the ability to control emotions. Without this control, there is no difference between trading and gambling.
Gambling is attempting to make decisions about future outcomes based on odds or even just plain luck. Trading requires something more. The goal of this endeavor can be simply stated: minimize and control risk before seeking gain. For example, if someone is playing blackjack for the first time, the odds of consistently profiting, or winning, are low. As the player learns the intricacies of the game, the odds begin to improve. Once the player is very good and can play systematically or even count cards, the player can actually gain an epsilon of an edge or advantage. In terms of risk management, the skilled card player bets small while losing and folds quickly then presses his bets while winning. This is a systematic, unemotional approach that reduces risk and controls emotion while gaining a statistical edge.
There are many myths in the market—perceptions and fallacies that people cling to, but data is not one of them. Market data is what it is, it does not lie, yet it is still prone to subjective interpretation. To reduce the influence of emotion and opinion while trading and investing, we rely on the analysis of data along with the confluence of several indications that confirm the same bias.
Data is a broad term and can mean several things including earnings estimates, economic numbers, company reports, etc. This kind of general market data can be subjected to outside influences. What you, the investor, are looking for is a set of basic building blocks of information that are true pieces of data not prone to manipulation. The most basic of market data is what we call raw data, consisting of price, volume, and time. If a person buys 1000 shares of stock at $20, the price is $20 and the volume is 1000 shares, which is hard data. There is no manipulation because a transaction occurred with a specific size at a certain price, at a certain time. A derivative piece of information, velocity is also considered a building block, but even though velocity is highly important, it is a derivative of price and time. Figure 5-1 illustrates the basic building blocks of market analysis.
FIGURE 5 - 1 The four building blocks of market analysis, whereas velocity is defined as changing price divided by time.
In the earliest days of Wall Street, raw market data was all there was, but now, the evolution of technology has provided many complex ways for viewing this data. There is no question these advancements are improvements, but only if this information is not diluted in value through over-complication. Effective trading methods are timeless, enduring, and historical, and today in the age of technology their simplicity is their greatest disguise. In the earlier days of Wall Street, the data for particular stocks was kept on chalkboards. Traders could track the movement of the market by watching the prices and volume on the board. In fact, one of the world’s most famous traders, Jesse Livermore, got his start as a runner updating stock prices. He later said that he got his feel for the way the market moved from noticing how stock prices changed. The way of viewing the information may have been primitive, but the essential information was still there.
In the 1920s an understanding of electricity and the development of the telegraph made possible the ticker tape machine. The three key building blocks of data—the stock symbol, the price, and size of the transaction—were printed on a streaming piece of paper called the tape.
In today’s electronic society the key elements of price, time, and volume are still available in a tape-like format on most trading systems. The same data that was relevant in the early days of Wall Street is still important today, and this study of raw market data (the three key building blocks) is called technical analysis.
Technical analysis is the study of charts and other objective data to predict future market movement, and a person who studies the technical aspects of the market is called a technician. There are several basic beliefs or foundations of technical analysis. These foundations make up the backbone of all technical analysis in the market. The first foundation is that history repeats itself. History in the market is based on the psychology of the masses. Market psychology is the collective thoughts and emotions of the millions of market participants, and one may assume that these technical charts are a physical form of measuring this psychology. The technician seeks to uncover the deeper psychology behind the movements of price, volume, and time by analyzing charts. While the actions of one person are extremely difficult to predict, the actions of millions of people fall into certain predictable patterns. When market participants are placed in certain situations, they react in a certain way, not unlike the predictable nature of mobs and crowds in emotional situations. For most, participating in the market is an emotional situation. This works to our advantage.
Another foundation of technical analysis is that price discounts everything. This means that the price at which a stock is currently trading takes everything known to all market participants, both current and anticipated, into account. The psychology and motivations of all participants is reflected in the current price of where the stock is trading. If some market participants obtain information prior to the public and act upon it before the general public, the technician will observe these actions as they happen through price, volume, time, and velocity, not by word of mouth or through the media. This raw market data accounts for all manipulations, fundamentals, and news through its consensus of value, called price. Hence, the discounting characteristic.
In an ideal bullish example of market pricing, both the economy and the stock market move higher in unison. As the economy shows the smallest signs of improving, professional traders anticipate good news about the economy. These economic reports are then released from the Government (unemployment rate, GDP) and by independent sources such as the Institute for Supply Management (ISM) or from companies themselves (earnings). It is important to realize that most economic data is reverse looking and indicates how the economy has done, not how it is doing at the present time (lagging indicator). Professional traders anticipate how the market is doing at the present time by reading the subtle signs that the market posts. By the time the good economic numbers are released, no one is surprised except the amateur. Upon hearing the news, the amateur tends to react, precisely what the professionals hope they will do. In most cases, the amateur misses the boat because economic news is most often anticipated by professionals, and these participants are more inclined to trade ahead of news, creating the price action prior to its release. In the case of upward price action for example, the average investor then wants to participate in the market and jumps in and buys stock upon the release of positive forecasts. For this reason more than any other, amateurs consistently lose. This phenomenon of price discounting can be summed up in an age-old market cliché, “buy rumor, sell fact.”
Consider once again the food chain of market information. If certain market participants get relevant market information before other people and act upon this information, then this is reflected in the price of the security. For example, people at the top of the food chain receive positive information about a company and buy a particular stock before the news gets to the public. As the news trickles through the food chain, other participants receive this same positive information as well as having the benefit of seeing the price starting to move. They too act on this news. The technician views this market activity through data and therefore, though not privy to the information at the top of the food chain, they can view the actions of those at the top through price and avoid being caught up in the often manipulative information within the food chain.
The final premise of technical analysis is that price moves in trends. The price of a security is much like that of an object in motion. Sir Isaac Newton’s first law states that every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it. The same theory applies to stock price. A stock that is moving higher continues to do so until it moves to a level that motivates sellers, (the external force) to offer out enough stock to overwhelm the buyers and halt the advance. If a stock is moving lower, it will continue to do so until enough motivated buyers begin to overwhelm the sellers and change the direction of price. The psychology behind trend is based on the fact that as information becomes more known, amateurs will begin to react. The media reports the price action, the charts have already shown the move, and the trend gains strength as the amateurs join in. The important point here is they represent the last contributors to trend, and once the trend comes into question, professionals are the first to leave—leaving the amateur holding the bag. With these concepts in mind, we begin with the most basic form of charting. You may ask why it is that seemingly dated techniques are covered when modern tools exist. The answer once again lies within the belief that history is our greatest teacher, and the basics to follow will force you to understand the foundation of all modern-day charts, price, volume, time, and velocity.
A chart can be created in many ways, including a point and figure chart, a line chart, a bar chart, or a candlestick chart. Each chart has its own advantages and disadvantages, but most charting methods are just slightly different ways of viewing the same thing. As you become more educated, you automatically move up the food chain. Understanding charting is the first ingredient in this recipe. We will review each charting method as well as the pros and cons of each.
A point and figure chart is a tool that plots price movement only and doesn’t reflect the passage of time. It is a system that only displays larger moves and filters out the small movements or noise of the market. Time is automatically mitigated by only populating the chart with extensions of range (high or lows). In theory, many days could go by where a given security trades within a tight range, making no new highs or lows. In this case, the chart would not reflect any activity, hence mitigating time. The point and figure chart is typically updated daily using end-of-the-day data and consists of a series of Xs and Os, where the Xs represent demand and the Os represent supply. The easiest way to learn point and figure charting is to actually build a chart. The reversal box represents a condition when a trend is being called into question by trading opposite the trend by a standard three-box minimum. Using the three-box standard, this means that if the stock fails to trade lower by three price increments (user defined), in the case of a rally, it will not be reflected on the chart. By having no reflection or populated box, market noise is automatically filtered out. If the stock reverses direction from the previous trend by more than three boxes, another column of populated boxes is drawn to signify a change in trend.
This can be a bit confusing without the aid of an example. To begin with, if XYZ has been trading higher, say in a $23 to $25 range, the initial point and figure chart that represents this action is shown in Figure 5-2.
FIGURE 5 - 2 Since on Day one the stock was initially moving higher and in a range between $23 and $25, there are three Xs between $23 and $25. On Day two the stock had a high of $26, so an X was placed next to $26.
If on the second day the stock stayed within the same range as Day one, you would do nothing to the chart and it would look exactly the same as Day one’s chart. If the stock didn’t break Day one’s three-point range to the downside, the movement would not be charted since this would be considered an “inside range,” meaning prices remained inside the Day one price range. By not charting the inside price action, the chart remains clean and free of noise.
Continuing with the example, if on Day two the stock opened at $25, traded up to $26, and had a low of $24, the chart would get an X next to $26 and would look like the chart labeled Day two in Figure 5-2. The box achieves an “X” at $26 since a new high was achieved and the current trend remains intact. Note that the high and low price of the day is all that matters. Opening and closing prices are ignored. This condition is important to understand since we only seek to measure the elasticity of the market’s emotion (bullish or bearish). The highs represent the extent of bullishness and the lows the extent of bearishness.
Now suppose that on the third day the stock trades in the range from $24 to $26. Again the chart would not change; since it is trading within the range (inside range) and the lack of range extension is considered market noise. On the other hand if the stock continued its trend higher and traded up to $27, you would put an X in the $27 box.
To trigger a reversal box, the stock must trade below the highest box by three boxes (points in this example). In Figure 5-2 the level to watch to the downside is $23 since this qualifies as a three-box reversal. Within the low of $23, a column of Os is drawn on the chart to indicate a three-box (point) change in trend. The Os are used to show supply or downward movement. Note, when the three-box reversal occurs, the successive two boxes above the $23 also get populated with Os to identify the trend reversal. See Figure 5-3.
FIGURE 5 - 3 The stock has a three-point reversal on day three and trades down to $23 from the last X at $26.
This charting method may seem confusing at first, but it provides a unique view of the stock since it only shows high and low range price movements, while filtering out fluctuations (noise) less than three boxes (points). Though still a fairly popular method for charting, the point and figure chart excludes time, and without time, velocity cannot be determined—so you only have two of the four foundational variables. For more information on point and figure charting and another iteration that introduces time and puts a different twist on this type of charting called market profile, refer to Steidlmayer on Markets by Peter Steidlmayer. This book offers an excellent lesson on the intricacies of the method while also including the other foundational variables and is still widely held today.
The line chart is one of the most basic forms of charting. In this type of chart, the closing prices of a specified period of time are connected to form a line. For example, if looking at a daily timeframe for a certain stock, the closing price for each day is connected, thereby creating a line that shows the movement of that stock price. See Figure 5-4.
FIGURE 5 - 4 Notice how the closing price of each day is connected and makes a line that illustrates the movement of the stock price.
Figure 5-5 is an example of an actual chart of stock XYZ tracking the closing price of the stock for the last 200 days. Note that we use the fictitious symbol of XYZ since the method is timeless and applies to all issues. Price is on the vertical axis and time is on the horizontal axis. What is missing from the line chart is “elasticity” within the day. While price may rise and fall throughout the day, the line chart only reflects the closing prices as presented and can only reflect day to day volatility, missing an important component of intraday volatility (elasticity).
FIGURE 5 - 5 A line chart of XYZ on a daily interval.
The bar chart shows the closing price as well as several other pieces of information. This additional information illustrates how the stock traded during a specified period (intraday range). Included in the bar chart is the high price of the period, the low price of the period, the opening price, and the closing price. See Figure 5-6.
FIGURE 5 - 6 A single bar that illustrates the high, low, open, and closing price.
In Figure 5-6 there are four pieces of data for each period being measured. The highest price the stock reaches during the specified period is at the highest point of the bar. The lowest price the stock trades at is displayed at the lowest vertical extension of the bar. The bar that sticks out to the left is the opening price, and the bar that extends to the right is the closing price of the period. Figure 5-7 is a daily bar chart of the same stock over the same period as Figure 5-5.
FIGURE 5 - 7 A bar chart of XYZ stock on a daily timeframe of 100 days.
Notice how the bar chart in Figure 5-7 is similar to the line chart in Figure 5-5. The general pattern of the charts is the same but the bar chart includes data on the range of each period. These periods can be measures in months, weeks, days, hours, or minutes. This range can be important in many situations, which will be discussed later in this chapter.
The candlestick chart is similar to a bar chart in that it gives data on the high, low, open, and close of the period being measured. The information is given in the form of a candle that is white if the close is above the open, and shaded dark if the close is below the open. See Figure 5-8.
FIGURE 5 - 8 A white candle occurs when the closing price is higher than the opening price. A shaded candle occurs when the closing price is lower than the opening price.
The candlestick chart contains the same information as the bar chart, but when using a candlestick chart, it is easier to tell whether the stock finished up or down for the period being measured since it is color-coded. Figure 5-9 is an example of a candlestick chart on a daily timeframe for the same stock used in Figures 5-5 and 5-7.
Compare Figure 5-9 to Figures 5-5 and 5-7. The same pattern of price is revealed. The candlestick chart displays more information than the line chart but the same information as the bar chart. When examining the bar chart and the candlestick chart more closely, it is apparent on the candlestick chart whether the closing price was above or below the opening price as denoted by the color of the candle. Refer to Chapter 10 for more information on basic candlestick formations.
FIGURE 5 - 9 A daily candlestick chart of XYZ stock over 100 days.
Most of the hard market data discussed earlier is included in the charts; however, the one missing variable is volume. Whether it is a line, bar, or candlestick chart, volume is typically represented by a vertical bar beneath the period that is measured. This vertical bar indicates how many transactions took place over the course of the entire period. A transaction is the amount of securities that have changed hands. For every transaction there is both a buyer and a seller so volume has no direction. Figure 5-10 illustrates a graphical depiction of how volume is viewed on a chart over a specific period of time.
FIGURE 5 - 10 Volume is the amount of transactions that have taken place over a specified period. It is represented as a vertical bar at the bottom of the chart.
The volume bar shown in Figure 5-10 displays a bar representing all the transactions that took place over a specified period. The height of the bar indicates the number of transactions that occurred in the period, thus the more transactions, the higher the bar will be. Figure 5-11 demonstrates the three different charting methods discussed earlier with the addition of volume bars. The most important thing to look at when noting volume is the relative change. It is not as important what the actual volume is, but note what volume is relative to what it was in the past; a moving average on volume is one way of measuring this.
Of the three charting methods, the bar chart and the candlestick charts contain the most information. Throughout the rest of the book, the candlestick chart will be used to illustrate selected concepts, however, it is important to note that the candlestick chart is not superior to other charting methods. Refer to Figure 5-11 for reassurance that each method is measuring the same data. The same information is included in both candlestick and bar charts and it is a personal preference as to which you decide to use. Those who are visual will prefer candles, while those who prefer reading each bar will be inclined to the bar chart.
FIGURE 5 - 11 A daily chart of a stock using three charting methods, including volume.
Charting the time period is highly customizable. Long-term timeframes, such as monthly and weekly periods, can give you a general idea of the larger picture. Looking at a long-term timeframe is like standing on a cliff and overseeing a vast forest spread out below you. As you shorten the period on the chart, it is like zooming in on the same forest with a pair of binoculars. As the forest is magnified, each tree begins to distinguish itself. The individual branches appear and demonstrate unique features of their own. The vista has now changed so you see the individual trees instead of the forest. Figure 5-12 illustrates a weekly chart for a particular stock. Note the general shape of the price movement.
Now by switching to a smaller period, the magnification is increased. Figure 5-13 shows a daily chart of the same stock that appeared in Figure 5-12.
Take a close look at Figures 5-12 and 5-13. Notice that the extreme right side of Figure 5-12 has a similar shape to Figure 5-13. The effect of decreasing the period length is akin to zooming in on the right side of Figure 5-13. Taking the magnification one step further, examine Figure 5-14.
FIGURE 5 - 12 This is a 300-week chart that shows the long-term price movement of the stock. Each candle represents one week of trading activity, with price on the vertical axis and time plotted on the horizontal axis.
FIGURE 5 - 13 This is a daily chart of the same stock used in Figure 5-9, looking at 200 days of data.
FIGURE 5 - 14 This is an hourly chart of the same stock, taking into account the last 60 days of trading activity. On this hourly chart each candle represents one hour worth of trading data.
By comparing Figures 5-13 to 5-14, it is now obvious that decreasing the period is in effect looking at a magnified view of the far right side of Figure 5-13.
By now the basics of charting should be clear and the question that has most likely entered your head is “How will this information help me?” The next section will help answer that question. For now though, the most important thing to understand is that everything that we have charted is raw, hard data. The high, low, open, close, and the volume are firm pieces of data that truly happened. The data has not been manipulated and you can receive this information at the same time as everyone else, leveling the playing field. With other forms of news, this is simply not the case, and herein lies where the edge begins to emerge. Once you learn how to evaluate this raw market data effectively, the edge is obtained since most amateur participants won’t put forth the effort to become marketwise.
As stated earlier, when comparing the line chart to the candlestick or bar charts, there are several differences. The line chart connects the close of the period while the bar and candlestick charts display the open, high, and low for the period in addition to the close. There is an important psychological feature we receive by using candles and bars—range.
The theory of elasticity is based on the psychology of price range. The high and low of a particular timeframe represents the extent of bullish or bearish sentiment. As a securities price trades up near an elastic high, a battle of emotions (fear and greed) takes place. The maximum strength of the participants who are buying the security is shown by the high of the day. The maximum strength of the sellers is shown by the low of the period. These “tails” as they are called represent the truest forms of support and resistance for the period measured. There is no subjectivity. With this small dose of reality and some common sense, support (lows) and resistance (highs) are best read with the brain, not the computer. See Figure 5-15.
FIGURE 5 - 15 The elastic range of a particular period is the range between the elastic high of the period and the elastic low of the period.
If the general movement of a stock is sideways, meaning little change in price with the passage of time, the stock is in a range oscillating back and forth. The average price of the range is called the true level of value within the time being measured. More volume tends to occur within this range since supply and demand are close to equilibrium. Buyers essentially agree with sellers and therefore shares turn over more. It is only when demand exceeds supply that the stock starts to move higher (vise versa for declines). As the rally unfolds, at some point the selling pressure increases until it equals the buying pressure. It is at this point that the high is marked. As sellers add pressure to the rally, price tends to get pulled back to equilibrium like a rubber band. Elasticity theory describes the condition in which price gets pulled back to a “true level of value.” See Figure 5-16.
FIGURE 5 - 16 Day two has trouble breaking out of the elastic range set by Day one.
When a stock trades within a range and ultimately breaks the range with high volume the event is considered significant. This shows a new level of market consensus that is now outside the prior range. Picture the rubber band being stretched tight near the high of the range. If the rubber band is capable of breaking through the prior highs, we can then expect follow-through motion in the direction of the trend. Figure 5-17 illustrates an upside break-out example.
FIGURE 5 - 17 As the second day’s price breaks the range that the first day set, the rubber band is broken and the price is no longer pulled within the first day’s range.
Figure 5-17 demonstrates that the bulls are firmly in control for the day because the second day breaks the range of the first day. The stock price passes right through the point where the selling pressure is equal to the buying pressure (Day one’s elastic high). This shows that the psychology of the people trading the stock is bullish and the price at which the bears exert their influence on Day one is no match for the power of the bulls on Day two.
The examples of elasticity that have been given were of bullish examples. Elasticity works exactly the same when dealing with a bearish example. The theory runs true as well when looking at multiple days of data. See Figure 5-18.
FIGURE 5 - 18 As the three-day elastic low gets broken the stock continues to lower.
In Figure 5-18, the first segment displays the stock trading within a range where the elastically of the price remains within the range. The second segment displays a breaking of the previous range to the downside. Once the elastic range is broken, there is nothing to pull the stock back into the range, so the stock continues lower (Segment three). This is an example of bearish elasticity. This kind of market action will be discussed in more detail, but to satisfy your curiosity now, know that when a range of elasticity is broken, any subsequent rallies should not equal the prior level of support broken. For example, shares that breakdown below prior lows may rally somewhat, but not to the extent of the prior low. If they do, the breakdown is considered a false breakdown. Notice in Figure 5-18, on the fifth day, that the elastic high never penetrated the closing price on Day four. This suggests that bears are in control and the breakdown is real. Selling longs or opening shorts would be where the statistical edge lies. The opposite is true on new elastic highs. If shares break out above prior elastic highs and then pull back or retrace, they can only pull back to a higher low above the prior high in order to be defined as a true breakout. Figure 5-17 illustrates that longs should not be affected until shares trade higher than the Day one elastic high (mid-body of the candle).
Now that you know how to display the essential market data, the next step is to understand what influences the data. Everything in the market is based upon this set of essential market data. Analyzing this market data is called foundational analysis.
