Question: I often hear the terms “resistance” and “support” from my broker whenever I ask for advice on when to buy or sell a stock. Sometimes, I also hear funny names like “hammer” and “morning star.” Do I need to know this to make money in stocks? — Keith Alison, by e-mail
Stock prices are a reflection of market emotions as determined by demand and supply. When there is more demand than supply for a particular stock, share price tends to increase just as they tend to fall when there are more sellers than buyers.
The factors influencing the demand and supply can be rational and irrational. The market may be buying or selling a particular stock based on a rational belief that it is fundamentally cheap or expensive, but it can also be irrational sometimes when it is motivated by extreme greed or fear.
When irrationality happens, this is where stock market prices present trading opportunities. Some stocks may be sold too low out of fear that share prices may fall further. Or stocks may go up too fast as investors expect higher prices. But as soon as market players recognize this, share prices will start to correct and revert to the normal price.
Analyzing price patterns in stock charts assume that what happened in the past can happen again in the future. The price patterns reflect how the market feels about the future of a stock. By reading stock charts, you can time the buying and selling of stocks to maximize your profits.
Here are five ways you can use stock charts to trade profitably in the stock market:
1. Identify shifts in price trends
In charting, trend lines are essential in identifying whether a stock is on upward or downward trend. Trend lines are drawn by connecting two or more historical price points and extending that into the future. For as long as the stock moves along the line, the trend remains intact.
These trend lines also serve as support and resistance. If a stock is on an uptrend, the line holding the price points is called “support” while if the stock is on downtrend, the trend line above it is called “resistance.”
When a stock breaks resistance or support, a shift in trend can be expected. The change in trend signals a change in demand and supply for a stock. Such a change can be a minor or major correction.
The PSE Index has broken an important support recently at 8,400. The shift in trend to downward bias has another support target at 7,400. If the PSE index bounced back after hitting this support, the resistance that it will need to break is 8,400, which was its previous support.
2. Identify changes in trading volumes
Trading volume can reveal significant information about a price movement. A rising stock that is not supported by rising volume may mean that the uptrend may not last.
In the same way, when a declining stock is not supported by rising volume, it may mean that the decline is weak and the stock should be able to recover soon.
When the stock market was in a bull run last year, the PSE Index was going up on rising volume. This means that the strength of the uptrend was supported by increasing demand for stocks in the market.
There were periods when the market corrected but it was not supported by higher volume. The correction was weak which further supported continued rise in the PSE Index up to early this year.
But when the market started to correct two months ago, trading volume was rising as the PSE index fell, which showed strong selling pressure. The momentum created by rising and falling volume can indicate the future direction of the price of a stock.
3. Identify market overreactions through price gaps
Market psychology suggests that investors tend to overreact to unexpected news or announcements that affect movement of the stock. One sign of market overreaction is when a stock creates a sharp move at market opening resulting to a price gap. Gaps happen where there is a newsworthy event overnight affecting the stock that has not yet been discounted by the market.
Last February, speculative trading on stock of MRC Allied (MRC) pushed the share price to open at Php0.65 from its previous close at Php0.58 after rumors circulated overnight that the stock would hit another ceiling price.
The stock did go up to as high as Php0.94 in the next few days after a price gap, indicating strong demand for the stock. But when the stock started to correct in mid-March, share price fell to a gap from previous close of Php0.68 to open at Php0.67, which represented strong selling pressure. True enough, the stock went down to as low as Php0.47.
4. Identify oversold and overbought conditions
Price charts can also be used to identify whether a stock is already oversold or overbought. When a stock is oversold, there is a very good chance that it will recover soon, so you can anticipate this by buying it at a good support price to make quick profit.
When a stock is overbought, it means that the price has gone too high relative to its level several days ago and it may soon correct. If you know that a stock is about to correct, you may start selling to take profit or position your buying at support price to buy it at a lower price.
You can identify the overbought and oversold condition of a stock by looking at the stock price indicator. These indicators are calculated using the historical prices of a stock, which come in different formats.
For example, the most common indicator is the Relative Strength Index, which is used to identify overbought oversold levels of a stock. Others you can consider include Stochastics, MACD and Momentum. You can easily access these indicators when you use a stock chart software.
5. Identify timely trading decisions
There is no holy grail in stock market trading. Success in using price charting needs discipline and commitment. You need to monitor price action daily to spot potential price patterns for trading opportunities. Timely trading that captures early buying or selling signals is key to succeed in price charting.
You don’t need to trade at all time. Trade only when there is a good opportunity. Always consider your time horizon when you invest. If you intend to trade for short-term gain and your strategy failed, try to have the discipline to cut your losses unless you really intend to make it your long-term investment.
Trading can be a source of excitement for some people. But be aware that frequent trading in general can lead to losses. This is because of the trading costs that can accumulate over time.
There are hundreds of patterns and charting techniques that are available in the market but you only need to master a handful of them that can fit your investing style. If you feel that you find your techniques no longer effective or need to improve your skills, you can always research and learn from experienced traders.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice email@example.com or follow him on Twitter @henryong888