Introduction
To learn how to trade stocks and understand what happens in the stock market at large, and the way individual stocks and stock indexes perform, it helps to become familiar with a few somewhat unscientific guidelines that traders find useful in forecasting possible future outcomes. The guidelines are based mainly on patterns of stock movement that can best be recognized with the aid of stock charts. These patterns of stock movement have occurred repeatedly in the history of the stock markets and can be confidently expected to occur again in the future.
By recognizing certain chart patterns as they are evolving, the reader can anticipate the several possible outcomes that might follow and recognize them if and when they do materialize. Perhaps the “guidelines” referred to are a matter more of psychological importance than reality but it is assumed that the patterns of stock action and movement are likely to duplicate the similar action previously observed in the past, events in history do tend to be repeated.
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March 21, 2010.
In the last post we showed a chart of the S&P 500 covering the period from March 2008 to February 2010 in which, as pointed out, it clearly showed, starting from the left, how the trend of the market was down until reaching a bottom in March of 2009 and after that has trended up until January 2010 when it began to show a correction, meaning a reversal of the trend. To know how extensive that reversal would be requires watching the market’s activities for the following days, weeks, and perhaps months, depending how severe it would be.
I want to return to the original chart that was posted here on February 12, 2010 to continue our process of showing what can be learned by the examination of stock charts but first let us look at the S&P 500 now, five weels later, to see what happened to the correction that was then still in progress since it started in January 2010.
To do that we go to Stockcharts.com and when the home page appears type in the symbol for the S&P 500, which is $SPX (not case sensitive for spx). That will bring up the chart, something like the one shown below.
Today’s chart, showing activity until the close of trading on Friday, March 19, 2010, covers the prior six month period, making it a little easier to read than the two-year chart we looked at previously where the two years of data had to be squeezed into the same amount of horizontal width.
Methods of showing trading price ranges for a trading period
Opening price refers to the price of the first trading transaction of the official opening time for trading for the period and closing price refers to the price of the last transaction up to the official last closing time for the period. Some trading usually occurs before the opening and after the close, especially if significant news becomes public, but these are not recognized in reporting opening and closing prices.
The trading data, prices, volumes, etc., that is depicted on the charts can be shown in several other ways that differ from what I am choosing to use here. The chart reader has the option to alter them to other methods such as solid line, broken or dashed line, straight vertical line with ticks to left and right to indicate total price range for the period and the opening and closing prices, and there are other methods to choose from.
But let’s keep it simple and stick with the method I’m using now that is called Candlestick Charting, derived from its appearance of representing the period’s activities in a way that looks a little like a candle.
The candlestick method does have a graphic advantage I believe because it shows at a glance the full trading price range for the period as well as the opening and closing prices and also whether the stock, or other issue represented, closed up or down from the opening price for that period, whether that period be day, week, month, or whatever. It is conventional that for the periods when the price closed above the opening price, the candle shaped rectangle will be left plain, unfilled whereas the losing periods they are shown solid, usually either black or red.
But it is not the specific prices the candlesticks provide that is important, it is more a matter being able to easily recognize patterns and relationships of stock price as they changes compared to previous trading activity and to other “reference points” such as support and resistance levels, lines of moving averages, and others.
What the charts show (in part)
We can see that the earlier chart, made February 12, just happened to be at the bottom of the correction, something we would not have known at the time. This has not been reconstructed by the way, what is shown is the actual chart that appeared at the time, as is the new chart we publish today. Anyway, we can see the market recovered and has been in an uptrend since then for an S&P 500 gain from about 1060 up to Friday’s close at just under 1160, a gain of 100 points, about 9%.
But from the time that the reversal began, in February, we could not be certain that it would continue until it reached and continued past certain price levels, defined as resistance levels with regard to a stock rising in price, or support levels for stocks falling in price. Any interpretation of what constitutes a resistance or support level is somewhat arbitrary but they are just variable reference points that become fairly obvious to the chart reader after a while, although everyone does not necessarily use the same price point as the reference value, it’s a matter of individual interpretation.
Perhaps a little difficult to explain in writing, it becomes a clearer when examining the chart. The strength of any breakthrough is also subject to other accompanying factors too, one of which is the amount of trading volume that took the price through the level, a big price breakthrough on more than average volume would be viewed much more favorably than on small volume when a continued wait-and-see attitude might prevail. There are no certainties.
It is a little easier to see those levels on today’s chart, above, the reader can mark them with a line or in some way to emphasize and draw attention to them.
You can ask yourself, what might happen now? . Friday’s down-day was accompanied by a slightly more than average volume. Does it mean anything? Is this a minor correction after about 2 weeks of uninterrupted rising closing prices? This is a time to wait and see what the following direction will be, continue down, resume the upward trend, or just trade sideways? Will the passing of the Healthcare bill that took place today have any bearing on market action? Perhaps, again, let us wait and see.
More about support and resistance levels
It is import to point out that the low of 1060, or thereabouts becomes a Support Level, (another term for to add to the Glossary).
Without going into detail right now, it will soon become apparent after looking at charts that there are a number of different price levels (and they are different for every stock or chart subject) that in the past have been the lowest and highest trading prices for that time period, referred to as support levels and resistance levels, at which that particular stock traded on previous occasions until significantly changing direction again or pausing and trading sideways for a while. These become important references at a later date when the stock is trading towards and closing in on them and they provide an alert that the stock should be watched to see whether it will be stopped at the level and change direction or break through and continue on its trend, down or up, until it encounters the next support or resistance level.
The StockCharts site provides the definitions:
Support is the price level at which demand is thought to be strong enough to prevent the price from declining further.
Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further.
Moving Averages
The reason I want to return to the February chart covering a 2-year-period, is because the chart also shows 2 colored lines, one blue, one red and I did nor refer to these in the earlier post. These lines show individual prices averaged over a time period, called Moving Averages, the blue line is the 50-day and the red is the 100-day moving average. Just as the closing prices change each day so too do the value of the moving average change each day. Any number of days can be used to calculate moving averages, we will certainly look at the 20-day, the 10-day, and 5-day in the future.
I can explain moving averages more fully another time elsewhere but for now it is just the blue line on the chart that we need to examine in relation to the stock price or, in the case of the S&P, the price of the general market. For now, note that when the prices shown on the chart are below the blue line, as they are starting at top left until they cross over the blue line in late March 2009, the market is falling, the trend is down. When they move above the blue line, the prices are moving up, the trend continues up from late March to mid-January when the blue line was again crossed. That makes a 300 point advance over the 10 month period.
Conclusion for this chart
The blue 50-day line becomes a reference, an indicator of great value
Following the frequently voiced market saying “Don’t trade against the trend”, we can use the 50-day moving average as a general guide in which way to trade. Be mainly a seller or hold short positions in the down market and be a buyer and hold on to positions from when the cross over points are confirmed, a short while after to clearly confirm the trend had changed. There would be no certainty as to how long it would continue of course, that is why it is watched each day. Small dips below or above the blue line would be ignored but would be acted upon when a certain level is reached, that might be when support and resistance values would be taken into account. Or it could be the implementation of a certain percentage of loss guideline to sell if that should happen, a loss of 8 percent is a commonly followed exit point.
So, to summarize, the “general” guideline is to use the 50-day moving average (50 dma) of a stock or index as a reference to decide whether to continue to hold or enter or exit a position. It can be seen in the 2-year chart how the stock frequently pulled back to but bounced back up off the 50 dma on its upward trend, until in January 2010 it penetrated below the 50 dma enough to indicate an exit. Individual stocks will not necessarily conform to the major trend of course, that’s why following the trend is referred to as a “general” guideline.
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I am grateful that the StockCharts are available for our review and I encourage anyone reading this who wishes to learn how to trade stocks to frequently consult this free source, which is backed up by an immense amount of well organized and catalogued educational material. In doing so, it will help in becoming become familiar with, and learn to recognize, the many patterns that can be easily identified when you know what to look for.
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