A bit of revision

Yesterday I was asked by a good friend and loyal reader to provide a refresher on how I set about my analysis of the market. So here is the first in what I plan to be a series of essays which cover the basic elements that make up my thinking about the market. For those of you who know it all and are only interested in the bottom line, just skip to the end of this post for my latest thoughts.

First let me remind you that I do not claim to be a fount of wisdom. I do what I can and in this blog I describe what I see and how I interpret it.

Playing the stock market is a fascinating occupation and in some ways is unlike any other. In most disciplines you learn your skills and strive for perfection. In playing the markets the important qualification is realising when you have got it wrong and knowing what to do next. Mistakes are inevitable. That is not to say you don’t try to get it right for as much of the time as possible.

There are just two things I am reasonably good at:

• One is picking shares when the time is right
• The other is not being there when the market turns sour.

 In this first refresher I am going to describe how I try to pick my moments for entering and exiting the market. And when I say exiting I mean selling up and going into cash. No half measures. A falling market pulls down all shares including good ones.

So here we go. All basic stuff. No rocket science. The market is made up of buyers and sellers and by watching the way the price moves I try to guess where the market is headed next. I see price action by looking at the graphs of market price movement. Because I want to know how the whole market is moving, I look at the “Index” which measures what the market is doing.

Mostly I look at the daily chart, so that is where I shall focus my attention. I favour candlestick charts because provide lots of information about what has happened during each day's trading. A little imagination allows you to interpret what has been going through the minds of the market participants. Knowing this helps me  guess what is likely to happen tomorrow.

What each candle shows

Each candle on the chart represents one day’s price action. First the colour:

• If the candle is red the day’s closing price is lower than the previous day’s closing price
• If it is green the price closed higher than the day before
• If the colour is solid the price closed lower than the level it opened in the morning
• If there is a white middle to the candle it closed higher than it opened in the morning

The body of the candle (the fat bit) represents the movement between the opening and closing prices for the day.

The two thin “wicks” above and below the body show the highest and lowest prices that the price achieved during the day.

Those wicks give some information that can be used to infer what was going through traders’ minds during the day. A long wick below the body suggests that sellers succeeded in pushing the price down by dumping the stock, but buyers sensed the opportunity to get a bargain and pushed the price all the way back up again.

A bunch of committed buyers in the market makes me think that, other things being equal, there will be a follow through and the market will go up tomorrow. And vise versa.

A column of marching candles

Looking at a column of marching candles tells me where the market is heading. There are only three ways to go: up, down or flat.

The market has a sort of collective mind. With the right sort of skills one can guess what that mind is thinking. Imagine you are reading the expression on your friend’s face to judge if she is happy or sad, angry or calm. Reading the market by looking at the charts is a bit like that.

At any time there will be players in the market who think that shares are cheap and will want to buy more, and those who think shares are too expensive and will want to sell the shares they hold.

The mass of shareholders will be doing nothing, but they don’t count. They will just sit there and pat themselves on the back when the market is going up and say to themselves “how clever I am.” When the market falls they will wet their pants and still do nothing until it's too late.

Collective memory, support and resistance and trends

Traders who are active in the market behave as if they have memories of what has happened before and this recollection is reflected in a shift in the balance of buyers to sellers. It’s a bit like a conditioned reflex. When the price reaches a certain point the balance switches and a market that has been going up will change to go back down and vise versa.

These boundaries are support and resistance lines. They can hold for days, months or years. When price action respects these lines the market is said to be trending. Buying shares in a market that is trending upward is the road to riches. Spotting the end of one of those trends, the break of support, and cashing in profit is the key to fortune.

The market also remembers old highs and lows and when it reaches those points it also encounters resistance or support. These are drawn as horizontal lines on the chart.

At the bottom of the chart a vertical line how many shares were traded each day. Occasionally the volume of shares bought and sold spikes. This means that the market has been more active than usual. I pay special attention to these spikes because it suggests to me that a shadow has passed across the face of my friend and I can expect a change in her mood. 

\That's enough for now. There'll be more another day. I hope this helps to clarify the comments I make each time I post.

Back to Friday's action

Friday's action was not decisive. Monday is Labor Day. It's a holiday in the US and traditionally it signals the end of the summer vacation period and the beginning of the Autumn (Fall) and winter term in the stock market year. What happens next is anybody's guess and Friday's action gave no clues.