lost money in the past. A gift of cash is more readily forgotten and levels where profit was taken in the past have less impact than levels where losses were realized.
The strength of these memories and the number of people who have similar memories help to establish the probability of price behavior. Our purpose here is to understand how to recognize this strength and how to use the probability to our advantage.
The way price behaved in the past, and in the future, is a function of fear and greed. Fear paralyses while greed galvanizes. Fear makes us hold on while prices fall, and greed encourages us to chase rising prices. Fear and greed ‘load’ the dice, and when the trader develops tools for understanding where and when the loading takes place he can make sure the balance of probability is very much in his favor.
Price action is recorded as a database of numbers and the newspaper stock report pages list the results. In elementary school, students sometimes cut up these pages and use them to make cityscapes of skyscrapers. This is as close as many people get to making a picture from printed market information – unless, like accountants and other number crunchers, they are at home with figures.
The mathematician uses numbers to calculate the odds, and the probability. Fund managers use post-modern portfolio theory to hedge against market risk. The private trader finds its difficult to calculate these intensely mathematical solutions. A page full of numbers is difficult to understand.
Mere mortals, traders included, find it easier to see the probability – the bulge – in graphic form. The price chart draws the picture and outlines the cluster of prices in the same way as Figure 1.1 shows the bulge. Deciding when the balance of probabilities is in your favor is made easier on a chart, but only if you can put aside some preconceptions and learn to read the language of the chart.
PICTURE PERFECT
The Antarctic has weird snow shapes sculpted by the wind, the desert sun-blasted rocks. Our landscape resembles that of a little known Disney educational cartoon on maths. It did little to improve arithmetic skills, but its enduring image is of a man in a landscape of distorted numbers, towering 7s and 5s, rather like a Sesame street nightmare. The market jungle replaces vegetation with elegant price bars, thickets of candlesticks and clumps of moving averages against bluffs of charting.
Charts affront many traditional market players, from company directors, to brokerages and brokers, to moms and pops. They appear to devalue their hard-won research and knowledge by suggesting prices can be understood independently from the fundamentals of the underlying company or economy.
Some chartists confirm this divide by relying almost exclusively on obscure number relationships, often expressed as cycles and recurrent angles. Some fundamental traders add their bit to the division by emphasizing that only detailed financial understanding of the company’s books, with a dash of informed knowledge about company secrets, can allow the trader to take profitable positions in the market.
The truth lies somewhere in between. I rely primarily on charting and technical analysis as the basis of my trading decisions. This horrifies one of my brokers, but he has learnt to live with it. I use these methods to identify my trading opportunities. You may use other methods, but when it comes to assessing the trade we need information that only the chart can provide. It is beyond question that an ability to read a price chart will improve your trading.
A judicious mix of both disciplines makes for better trading. A price chart conveys very specific information in the same way a balance sheet reveals very specific financial information. Both displays – graphic and numerical – sometimes reveal more than their authors intended. Both displays are easily misunderstood.
No matter how you research, and finally reach, a trading decision you must eventually analyze and assess the trade financially. When the trade is entered, the open position must be managed to achieve financial objectives. The price chart, not the newspaper, gives you the basic information needed to undertake this planning process. Later we will look in detail at these procedures.
For now it is sufficient to understand that neither the entry nor the exit from a trade is determined by changing price-earnings (PE) ratios, by management structures, by product litigation, profit forecasts or food poisoning scares. These certainly are events that trigger a decision to buy or sell, but they do not set the price the trader receives. Better traders make an exit based on the most recent price activity. Except in apocalyptic events, such as October 1987, few market professionals unload stock at any price. Instead they use current price activity to make an informed decision about the best possible exit price. Private traders emulate this and the chart, as a record of prices, is an indispensable trading tool.
Please remember, when a chart is used as some type of computerized ouija board it is just as accurate, and useful, as ouija board forecasts.
Let us very briefly consider the types of information conveyed in a price chart and what it does, and does not, tell us about the security we are considering. We need to decide if the bulge is fat profit, or dangerous flab.
HERE’S HEALTH
When we check our financial health we reach for our wallet. Many market participants check the price chart in the same basic way.
‘What causes a stock price to go up or down?’ asks a self-confessed rookie trader in any one of the trading chat rooms. Another passenger in the same boat ‘SS StockRookie’ suggests that price might be linked to demand for products the company makes. Either they are purchased or they sit on the shelf and this affects the price of the company in the market, he suggests. This thinking implies a link between the line on a price chart and the financial health of the company. In this understanding the price chart morphs into a balance sheet in graphic form. The daily cash value of our wallet is put into a graph.
This unsophisticated explanation is usually dressed up more attractively by brokerage analysts. Takeover deals are sometimes described in glowing terms – a marriage made in heaven. Other analysts tell us the deal creates a synergy of size and market share, and analysts include figures to prove it. All too often the result is a slide in share price.
Attractive in its simplicity as this line of reasoning may be, when stripped to the basics the picture is less pleasing. Ashton Mining shows the unattractive side of this simple explanation. It is a diamond producer and explorer working in the Kimberley region of north-west of Australia. Figure 1.2 shows a price chart of Ashton Mining in a standard bar chart format. In this five-month chart period the price of Ashton Mining varies dramatically. In 12 days from point A to point B, Ashton Mining adds 23 percent to its market value. The price increases from $1.74 to $2.15.
Figure 1.2 Financial health? Ashton Mining, Australia Daily bar chart
What does this tell us about the health of the company, about the strength of its management, the size of its inferred diamond resources or the state of the cartel market for its products? We can speculate a great deal on this, but it is very difficult to establish a precise relationship between changes in any of these fundamental factors and the share price.
Perhaps they did add significantly to their inferred resource estimates. Perhaps, in this instance, we can accept an increase of 23 percent in the underlying value of the company over 12 days, no matter how improbable it seems.
However, five weeks later this prosperous company loses 19 percent of its value in six days, plunging from point C to point D – $2.11 to $1.71. We are justified in asking if the diamonds added to inventory in December were found to be paste in February? What does this price action tells us about the health of the company, its management and its markets?
To add more confusion to contradiction, the price rockets back to beyond its old level and after nine weeks has grown 37 percent, rising from $1.71 to $2.34 as shown by the rise from point E to point F. Perhaps improved security procedures meant diamonds were no longer being smuggled out the front gate, or that reserve estimates had been upgraded again.
These wild swings in a basically sound company confirm our suspicions that the price chart tells us little about the health