By now you should feel yourself moving through the process of thinking like an analyst. We have a long road ahead of us, but you’re doing well. An understanding of basic charting, as well as the important psychology behind it, is vital to good trading and investing. Already in this process you are separating yourself as smart money from dumb money. Most people jump into the financial markets and don’t know what they are jumping in to. They simply don’t know what they don’t know. They don’t have the knowledge base needed to understand the nuances of supply, demand, price, time, volume, and velocity—all of which will be discussed in this chapter. Without a solid foundation of knowledge, many people make decisions based on emotions like hope, greed, fear, and even anger, which is a sure path to lost money when engaging in the financial markets.
When a stock price starts to fall, for example, most participants that are long the stock hope the price will begin to move higher. The truth is, however, that hope is skewing the decision-making process. Most participants are on the wrong side of the trade and if they had a knowledge base to work from, they would know to exit the position.
Greed rushes the trading process and is the basis of most poor decision making. Even when positions are profitable, greed can turn even winners into losers. Amateur market participants hold on to profitable positions even after market trends indicate they should exit the trade.
Fear may cause people not to trade at all, or trade too much. Fear can influence people to jump into trades because they are afraid of missing a move or exit a position prematurely because they are afraid to lose money. Fear can also lead to misplaced faith as they convince themselves they are in the right trade while the trade moves against them. These amateurs may not even realize that they are being ruled by their emotions, and in this case, ignorance is not bliss. It costs money.
Anger manifests itself as well among amateurs, blaming others for poor advice they should never have consumed. Anger also shows up in other ways such as trying to “get even” in a stock they lost money on. As if the stock itself had something to do with it. This revenge syndrome shows up often among amateurs.
Emotions or combinations of them, although they usually travel together, are the seeds of failure. Once we can reduce their impact, we can improve the edge we seek. Professional traders look to hard data, math, statistics, and experience to influence their trading decisions. History provides another tool of objective analysis to the professional still used extensively today called normal distribution. The theory of normal distribution was first published by Abraham de Moivre in the mid-1700s. A bell curve is illustrated in Figure 6-1. If a person measured the heights of a large group of people, they would find the most common heights clustered around the average height. As the height range gets further away from this average, there are less people with that height.
The distribution of heights of many people, when plotted on a chart, looks much like Figure 6-1. Many things that appear to be random occurrences actually take the form of a bell curve when plotted. A good example is rolling a pair of dice. Plotting the number that comes up after rolling a pair of dice again and again looks much like Figure 6-1. The mean value is 7 since there are so many ways to arrive at this number: 1 + 6, 2 + 5, 3 + 4, 4 + 3, 5 + 2, and 6 + 1. In fact, the odds are six times better that you will throw a 7 than other numbers. This is why the game of craps is based on this number and why casinos can build million dollar pyramids in the desert!
FIGURE 6 - 1 This is the normal distribution or “bell curve.” The number of occurrences is on the vertical axis and the data is on the horizontal axis.
Market participants using technical analysis apply probabilities to market movement not unlike those described above. Technicians apply this probability theory to the psychology behind market movements. The probabilities found through technical analysis allow a statistical edge to be traded upon, instead of relying on emotions, fate, or advice from others. The fact is that mutual funds and other money management services need to index to the market in order to manage large sums of money and compete with other funds. Therefore, they miss the benefits afforded to the small investor who can trade and invest around the wake they leave behind. While we no longer build bell curves to plot averages and deviations from the average as seen in Figure 6-1, we apply the same principles. Having the benefit of managing relatively small sums of money by comparison to funds, we gain the value of the data they create to find an edge and reduce emotions.
The concept of supply and demand is a key concept upon which traders base their decisions. Supply and demand fuels both our economy and the world’s economy. It is pure capitalism. For example, trade is based on getting goods from where they are built, grown, or mined, to a place where there is a need (or a demand) for those goods. Goods are taken to a place where they are less abundant and consequently sold for a premium. In theory both the buyer and the seller are better off for having traded. This is the basic premise of arbitrage—acquiring or building an asset in one market and selling it in another.
The balance of supply and demand is actually an equation. This equation equals itself at a center point where it balances out. To truly understand how this equation works, it is necessary to understand what supply and demand is and how to use it as a technical trader. Demand is defined simply as the willingness to buy a particular item, good, or service. The key word is willingness. There has to be a desire for the product. In addition to willingness, people must also have the ability to buy the product. For example, if someone wants to buy a black hole, there is a desire for a black hole but there is no supply since a black hole is not for sale. Supply is the amount of goods or services that people are willing and able to sell. There has to be both willingness and the ability to sell a product in order to have a true supply.
As stated earlier, the supply and demand equation is self-equaling, with price as the center point. For example, if there is a demand for llamas, but there are not many llamas available, then llamas are strongly desired and people will pay more for the llamas. High demand combined with low supply drives the price higher. As a llama seller, why would you sell llamas at a lower price when there are people lining up to buy your llamas at a higher price? Consider also the reverse scenario. Why would you buy llamas at a high price when there are 10 different people selling llamas at a lower price? As supply outpaces demand, the price of the product falls. Here is another example. Most people would like to own an expensive high-end sports car. The demand is there, but the supply is small because high-end sports cars are hand-made from expensive materials. This small supply means a very high price. There is also only a small number of people that can afford to purchase the car, so the equation equals itself out. The supply and demand equation is a fundamental principle of capitalism, and the center point, or price, is one of the variables to pay attention to in foundational analysis. We will soon apply this cornerstone of capitalism directly to market analysis to find specific trading and investing opportunities. See Figures 6-2 and 6-3 for an example of how the supply and demand equation works.
FIGURE 6 - 2 As demand increases, supply decreases and prices move higher.
FIGURE 6 - 3 As supply increases, demand decreases and prices move lower.
Capitalism, in its purest form, is the buying and selling of securities. Price is the center point of the supply and demand equation, and it plays a very important role in the movement of a stock. Price is the very measuring device used to gauge the movement. Price is the consensus of all market participants as the fair value of a security at a certain time. If buyers are more aggressive than sellers, demand is greater than supply, and the price goes higher. This is seen when the demand becomes so great that there is no more stock for sale at a certain price, and the buyers in essence take up all the supply at a particular price. In this case, buyers would then have to pay up for the stock, which would drive the price higher, regardless of fundamentals. If there are more people trying to sell stock than trying to buy stock, the price decreases. If supply increases to a point where the demand has been filled at a particular level, in order for participants to sell their securities, they have to lower the selling price. This is capitalism in its purest form. There are no premiums on either end; just supply and demand. As the supply and demand equation levels itself, the price moves. On shorter timeframes there are many small movements in price that are smoothed out on longer-term timeframes. These small movements are called volatility.
There is always volatility or a “choppiness” to stock movement, depending on what timeframe you are observing. On shorter time-frames, volatility is very important. A small change in the volatility could have a significant impact on when you enter or exit a trade. On longer-term timeframes, the overall trend of the market is more important than the volatility of stock movement. A consensus range is where the price a security is trading at may seem fair to some but undervalued or overvalued to others. This is why securities trade in ranges. On longer-term timeframes the range can appear smooth on charts. When looking at charts on a small timeframe, the volatility becomes more apparent. Some people are willing to pay a little more for stock or sell their stock a little lower than an average price. In fact, very active traders attempt to trade some of the intraday volatility (volatility that occurs within the trading day). See Figure 6-4.
FIGURE 6 - 4 Both charts show the trading information for the same day. One is a daily chart and the other is a two-minute chart. Notice that the wide range elasticity is more simply viewed on the daily candle as opposed to the “noise” that can be overanalyzed on the two-minute chart. Traders and investors will do best by seeing the bigger picture, and this picture hedges out some of the volatility that can feed the two-headed monster of volatility and “whip-saw” risk (being shaken out of positions too quickly).
Referring to Figure 6-4, notice that by looking at the daily candle it looks like a day where the sellers were aggressive and the stock moved lower in price. By looking at the second chart, which is a two-minute chart, notice that there was choppy or volatile intraday. A daily chart shows only one candle with the high, low, open, and close displayed on it. The same day can be charted on a two-minute chart that breaks up the day into 195 two-minute segments. The daily chart shows the high, low, open, and close, but it doesn’t show how the security traded throughout the day. This is an example of how consensus should be seen as an average, but keep in mind consensus varies with time.
When taking the foundational variable of price into account, the psychology of the crowd, meaning all market participants, is seen in the movement of price. Professionals see both the actual price movement as well as the psychology of what is causing the movement.
Time can mean many things in the market. Time can make the market look volatile (short term), or make it look smooth (longer term). Time can be the seeds of rationalization, whereby a short-term trade is turned into a long-term investment. These trades are generally losers. In the most basic sense of the word, it reveals what time a trade happened. Time is also the length you stay in the market per trade or investment. Time means many things and needs to be defined in terms of analysis and risk.
Although there are no definite timelines of market engagement, for the purpose of this book, the types will be defined as follows:
• Investor—One to six months is the typical timeframe for our purposes.
• Swing Trader—One who takes trades from one day to a couple of weeks.
• Active Trader—One who takes several trades per day and also carries position overnight when risk is acceptable.
• Day Trader—One who takes many trades per day, typically in and out of the market several times in one day.
These time horizons bring up the subject of position sizing. Sizing a position to time, which is how many shares or contracts are bought or sold, compared to the time spent in the market, is paramount to risk management. The only things that can be controlled in the market are the securities you plan to trade, the amount of shares or contracts you buy or sell, and the length of time you spend in the market.
The two items of risk that can be actively managed are the size and the time you spend in the market. Just by being engaged in the market you are taking on systemic risk—the risk of events happening that you cannot control. Systemic risk is the risk of time. The longer a position is held, the higher the chances are of an event occurring. An event is anything that could move the market—world news, national news, or company-specific news. If you are planning on being in the market for a lengthy amount of time, then your share size should be adjusted for the risk of time. In the era of the highly active day trader, we enter and exit trades within minutes if not even seconds, but would enter trades with large size. Time risk was small but position size risk was high. The longer-term trader has to be able to tolerate the volatile swings on the shorter-term charts. The position size to timeframe equation has to be balanced. As you are planning your trade or investment, this must be calculated.
In terms of analysis, the timeframe you observe and study when looking for patterns of the market form another basis of time. When looking for trades you need to know what timeframe you plan on trading on—such as minutes, hours, daily, weekly, or even months. So it becomes clear the value of measuring time and adjusting risk according to your method of engagement. Clearly the investor should look at long-term trends and evaluate the direction of the market or stock, while the active trader pays more attention to short-term patterns. Both methods work well, but neither works when mixing styles. Active trades that don’t work out should never become investments, and investments that are influenced too greatly by short-term patterns can destroy conviction.
As stated earlier, volume is the amount of transactions that take place in a certain instrument in a certain amount of time. If you are charting a stock on a daily timeframe, then the amount of transactions that take place during that particular day is the daily volume. If 300,000 shares of stock change hands over the course of a day, the daily volume is 300,000. Volume varies from stock to stock. It is usually dependant on the number of shares available for trading and the particular interest level in the stock at a certain time.
Volume is best viewed as fuel for the fire. It shows the excitement of participants as the security moves either higher or lower. If buyers are excited, the stock will move higher in price, causing the volume to increase. This increase in volume reveals the emotional state of participants. If many shares change hands and the stock moves higher, then the bulls are in control. Volume acts as a confirmation to the movement of a stock. As a security moves higher in a typical, expected way, it increases in volume each time it pushes higher.
The reverse is also true. As a security moves lower on higher volume, the sellers of the security are excited. As a stock moves lower in an expected way, price moves lower and volume increases; each time the stock rises in price, the volume will be lower. In this way, the strength of the bears can be seen.
If a stock moves either higher or lower on light volume, the strength of the move is suspect. It lacks the fuel to get the fire started. The emotional strength of the crowd is not enough to confirm that they are really aggressive. It signals a lack of consensus. If a stock moves higher on light volume it shows that there are no aggressive buyers jumping in. If a stock moves lower on light volume, it shows that sellers are not being aggressive. When larger players jump in to participate in an emerging trend, then they will typically get in with large positions. These are not your average investors that buy a couple of thousand shares; the large player can buy hundreds of thousands of shares. These large players can be mutual funds, hedge funds, or pension funds, and are referred to as institutions. This institutional buying would show up as volume on a chart. See Figure 6-5.
FIGURE 6 - 5 When the stock moves higher there is an increase in volume, illustrating the aggressiveness of the buyers. Volume therefore confirms trends.
Notice in Figure 6-5 how each time the stock moves higher, there is a surge in volume. This surge in volume reveals the aggressive sentiment of participants trading this stock. In other words, when stock is aggressively bought at a high volume, the bulls are in control. When stock is aggressively sold at a high volume, the bears are in control as demonstrated by an increase in volume as the stock price moves lower. Each time a stock moves lower, we look for confirmation in the volume. The surge in volume as the stock price moves lower shows that the bears are in control and they are aggressive.
Figure 6-6 demonstrates how as the stock is pushed lower, the volume rises. Each time the stock rises, it shows a decrease in volume. Then as it moves lower again, the volume increases. This is how volume is supposed to look as a stock trends lower.
FIGURE 6 - 6 The stock moves sharply lower amid a surge in volume.
Since volume is a measure of how many shares exchange hands in a certain timeframe, it is a direct measure of how easily a buyer is found for each seller or vice versa. This is called liquidity. Volume is a good measurement of how liquid a stock is. If you had 5000 shares of a particular stock and decided you wanted to sell the shares, if many shares of stock trade hands each day, then you would have no trouble selling that stock.
Figure 6-7 illustrates a stock that trades over 20 million shares each day. This stock allows easy entries and exits into positions. The large number of shares exchanging hands makes buying a large amount of that stock easy.
FIGURE 6 - 7 This is the chart of a heavy volume stock.
However, if you owned 5000 shares of a stock that doesn’t trade very many shares each day, you would be hard pressed to find a buyer for your stock.
Figure 6-8 shows a stock that trades under 10,000 shares on some days. If you owned 5000 shares of this stock, it could be difficult to find a buyer for your stock at a reasonable price. You would have a lot of stock for sale but not very many participants interested in buying that stock. It might force you into a situation where the only way to sell your stock is to sell it below the market, adding to your losses or cutting into your profits. The only participant active in the market at this time may be a bargain hunter who will buy your stock, but at a low price.
FIGURE 6 - 8 The stock illustrated below is a low volume stock.
The definition of velocity as it applies to the financial markets is the change in price divided by time. If a stock moves $2 in two minutes, it has a high velocity. If a stock moves $0.20 in two days it has a low velocity. Velocity determines whether the stock is moving aggressively or just drifting. Figure 6-9 shows a stock that has a low velocity for several days then increases in velocity toward the last several days. In just a couple of days the stock moved lower by seven points.
The high velocity shown in Figure 6-9 is caused by people aggressively selling their shares of the stock. High velocity can either hurt you or help you in a hurry, so be prepared to react. People who own the stock see the selling pressure start to increase. This produces fear, and they start to exit their long positions aggressively. In this case, it happens so aggressively that the supply they bring to the market, by selling aggressively, completely overwhelms demand. This causes an imbalance and the price quickly falls. Velocity can be thrilling, especially when the stock goes in your favor. When you are on the wrong end of a trade, conversely, velocity can cause fear. The fear can manifest disbelief and can cause paralysis, which is the worst possible thing at this point.
FIGURE 6 - 9 This is an intraday 60-minute chart that shows a stock that has low velocity suddenly turn into a high velocity downward move.
Often stocks will exhibit low velocity where they don’t do anything at all and their price stays within a small range. When actively trading and investing, you don’t want to be in a stock that does nothing for an extended period of time. See Figure 6-10.
Taking a position in a stock that is trading in a small range simply ties up your trading or investing capital in a market that is essentially flat. The ultimate goal of entering a trade is to take a position just before it makes a large move. Instead of keeping capital tied up in a stock like the one shown in Figure 6-10, wait until the stock starts to make a move. Going back to elasticity, by breaking the elastic range you can then jump into the position. This saves you the aggravation of having a position in a stock that is static.
FIGURE 6 - 10 This chart shows a stock that is trading in a relatively narrow range, making small movements for days on end.
Understanding the basic concepts of supply, demand, and emotions is a solid start to your journey of learning what you don’t know. What we don’t know is what fundamental factors are driving the current price condition of the stock (driven by supply and demand). The fact is, the reason we don’t know is because the markets see to it that you, the investor, exist at the end of the food chain, meaning that any fundamental information having nutritional value is either extremely rare or illegal to have! The irony is you don’t know what you don’t know. Therefore, we as technicians rely on market food that is available through the foundational variables of price, volume, time, and velocity, as represented on the charts. These variables tell more about the stock’s condition and the next likely move than the news and media ever could. Only after these moves occur will the reasons for the moves be told through the media. Remember that the charts tell the story before the media does. The information leaks and anticipation of the leaked news shows up on the charts and illustrates the supply/demand state of affairs before the information becomes widely held. Therefore, the nature of markets is that we don’t know what we are not supposed to know, except we can gain a statistical edge ahead of others by anticipating what is soon to be known by the way a stock “acts” on the chart ahead of its fundamentals or news. These basic concepts apply to every security, every entry, every exit, and every decision you make while trading and on any timeframe. From this understanding, we can see this psychology on the charts beyond the lines they draw. We can understand what draws those lines on the chart. We can learn to see the data behind the lines, and this defines the instincts that cultivate with experience.