In our last lesson, “There are so many stocks to invest in, where do I even start? Part 1”, we learned the first part of our due diligence is doing some fundamental research on a company. Remember our 5 key questions to ask.
- How does this company make money?
- What industry is this company in?
- What are the companies I know the most about?
- What’s going on in the stock market today?
- Where are the opportunities?
Once you have asked yourself these questions and done some research on a handful of companies that you think are promising, the next thing to do is to look at their price history. Technical Analysis is essentially predicting the direction of stock prices based on historic prices and trading volume patterns that are laid out graphically on charts. Now I know that sounds a bit confusing but in reality it’s actually quite simple. Let me explain.
I believe price data is key to your success in the stock market. When I’m doing my due diligence on a stock I would say I rely on about 40% fundamental analysis and 60% technical analysis. I don’t care if you do all the fundamental analysis in the world on a company, putting money into it just based off of what you’ve read is still a complete gamble in my opinion.
For example, let’s say I really like Tesla and I think they are the future of cars. The company has been performing well and they will be launching the Model 3 next year which I think will bring them a lot of revenue. If I go out and invest 5 grand in their stock right now, there’s still only a 50/50 chance that I will be right. Would you risk 5,000 if you knew that there was a 50% chance you could lose most of that money? Some of you might say yes, but for me I always like the odds to be in my favor. Additionally, perhaps I am right about Tesla and they do EVENTUALLY become a very successful company and their stock soars. In the shorter term, maybe the next 1-3 years, their stock may stay stagnant or even retract. So during that time you get absolutely no return or maybe even negative returns!
Warren buffet said there are two rules of investing. Rule 1: Don’t lose money. Rule 2: See rule one.
How do we avoid this problem? By looking at historic price charts.
This is a typical price chart that you will see when you look up a company. Now looking at most stock charts can be very intimidating. There are many shapes, lines, and colors on them that can leave you feeling very confused. I’m going to be breaking down the basics of the chart and by the end of this article you will be able to read one perfectly.
So take a look above again and you will see a typical stock chart that shows the daily price of the stock over the past month. The bottom of the chart (x-axis) is going to be time which is represented in days and the right side of the chart (y-axis) is the stock’s price which is represented in dollars. In the middle we have what are called candles to represent the daily movement in price of the stock. I’m going to be breaking down each part of the candle so you know what everything means.
The candles bodies will be two different colors, often green/red or black/grey. If the stock closed above the previous day’s price, then the candle would be green(black) and if it closed below the previous day’s price, then it would be red(gray). The top of the candle body will show the closing price of the stock for that day if it closed positive (green/back) and the bottom of the candle body will show the closing price of the stock that day if it closed negative (red/gray). The two lines that come from the top and bottom of the candle body are called the wicks. The very top of the upper wick is the price high for the day. This is the highest value that the stock got to that individual trading day. The bottom of the lower wick is the price low on the day. This is the lowest value that the stock got that individual trading day.
Trading volume is the number of shares traded in one trading day and is one of the top indicators when it comes to technical analysis. In the picture below you will see that each bar represents the number of shares traded that day. If the stock ends up closing at a lower price than the previous day, then the bar will be red and it if it closed higher, then the bar will be green. Traders use this information to get a better indication of where the stock is heading. If a stock has a good price move for the day and the volume on this move was above average, then it is likely that the stock will continue to go up in price. The opposite is true when you see heavy negative(red) volume.
When you think of the word trending I bet almost all of you think of Twitter. Things can be trending in a positive manner (positive news) #rallytogether or in a negative manner (negative news) #debateheadache OR they can be neutrally trending such as an event that’s catching a lot of attention. A good example of that would be one like #debatenight. The same can be said of stock prices. There are three ways in which they will trend:
It’s very simple. An upward trend is a period of rising prices
A downward trend is a period of declining prices.
And a sideways trend is neither rising or declining but staying within a certain price range.
So looking at these charts would you buy a stock that’s in a downward price trend? I would hope not unless you enjoy losing money. This is exactly why technically analysis (reading charts) is so important. It doesn’t matter if you believe that Tesla is going to take over the world of cars, if it’s in a downward trend, then now is not the right time to buy!
Technical traders find these patterns in the stock as we see above and draw trendlines on charts to show an upward or downward movement in stock price. We can expect to continue to move in these directions until it breaks out of the trendline signaling a reversal. Look below to see an example.
As you can see once this stock breaks out on the downward channel it moves in a positive direction. It would be said to be bullish when it breaks out
The opposite would be true with a stock that is trending up. Once it breaks the upward channel it will move in a negative direction. Said to be a bearish move.
Support and Resistance Levels
Next let’s talk about support and resistance levels. Stocks prices may move within a narrow range for months or even years (sideways trend). The bottom of this trading range is known as the support level and the top is known as the resistance level. A support or resistance level is established when a stock touches a certain price and reverses multiple times. The more times it touches those prices, the stronger the support and resistance. When a stock declines to its support level, the low price attracts buyers, whose buying supports the price and keeps it from declining further. The opposite is true for resistance levels. What technical traders look for in these cases is what’s called a breakout. When the stock breaks through the support level it is said to be a bearish breakout and we can expect the price to drop and go into a downward trend. When a stock breaks through the resistance level it’s said to be a bullish breakout and we can expect the price to go on an upward trend.
There are many other charting tools that we will discuss in other lessons but these are the most basic and essential to understand. Plus, I don’t want you to be overwhelmed in looking at 500 different charts at once. I hope these charts made you realize that if you are just investing in a company based on fundamentals and articles you have read it is still a gamble! Articles with opinions on companies litter the internet and can often make you feel confused. Additionally no one can predict the future! You may think a company has great potential but no one really knows if that’s going to be within the next week, next month, or years down the line. So save yourself the doubt and trust the price movements by taking a couple of minutes to look at their charts! Remember the trend is your friend!
Homework: Choose 3 stocks and look at their historic price charts. Try to pick out some of the trends we talked about in this article. Based off how the chart looks now, ask yourself, is this a good time to buy?