Stock Market 101 Part 4
Hey there! In this part we are going to get technical. So far we’ve been talking about revenue, EPS, profit, P/E and other ratios, all this type of analysis is traditionally called Fundamental Analysis which as you might guess, its all about the economic fundamentals of the company. For the longest time millions of investors have relied on this type of analysis to invest.
Recently Technical Analysis has gained popularity among investors, and specifically with traders (people who buy and sell a stock in a short period). This type of analysis studies the behavior of the stock market and uses trends, charts and patterns to try to “predict” what the stock is going to do next.
I’m going to tell you something critical about the stock market, there’s is a lot of psychology involved on it because human beings are involved on it. Today there are supercomputers with really complicated algorithms tracking every single stock in the market, but at the end of the day, humans are the ones making the choices.
There is a lot of investors who uses only fundamental analysis to invest who calls technical analysis fake, black magic, voodoo, etc, only because they don’t or don’t want to understand how it works. Since we are talking about investing I have to tell you that past performance is not an indicative of future performance, but I’m just surprised on how this patterns keep repeating themselves over and over and over again.
How to read Candlestick Charts
The first thing you need to do while analyzing a stock is to change the chart from line charts to candlestick charts. Candlestick charts unlike traditional line charts can tell us what happened every 1 minute, 5 minutes, 15 minutes, 1 day, 1 week, etc. in only one candlestick since the user can set this parameters on the chart.
Reading candlestick is super simple, basically there are 2 types of candlesticks, a bullish candlestick which can have either a green or white body and a bearish candlestick which can have either a red or black body. Most of the Technical Analysis software and websites uses the Green and Red candlestick format
A candlestick provides the following information:
- Share Price when the market opened
- Share Price when the market closed
- Highest Share Price of the day
- Lowest Share Price of the day
This is the very basics of candlestick charts, let’s introduce some patterns!
Basic Candlestick Patterns
Most of the candlestick patterns have japanese names, Why? Because it was invented by a Japanese merchant in the 18th century. I’m going to be honest with you, I can recognize this patterns by heart but I can’t remember their names most of the time!
This is a candlestick that has no wicks. What this means is that the share price only moved in one direction, up or down depending on the color of the candlestick. This is either a pure bullish o bearish candlestick
This type of candlestick has no or very little body., this tell us that the open and close price where the same or very close. The critical thing about this type of pattern is that it shows indecision, neither the buyers or the sellers could take control of the market.
When you spot a Doji candlestick, pay attention to the preceding candlesticks since it could mean that there is trend reversal about to happen.
Marubozu + Doji
A green marubozu followed by a doji could mean that the bullish trend is about the broken. What is currently happening is that buyers (bulls) are getting exhausted (less and less people buying the stock) and when the buyers get overwhelmed by sellers, the share price has no other way to go but down.
The same can be said about a red marubozu and doji, sellers are getting exhausted and buyers are now taking control of the market.
One thing that we have to pay attention when the doji appears is the confirmation, as in, what is the next candlestick after the doji, since this new stick will confirm if our suspicions were true or not.
Hammer and Hanging Man
A hammer (bullish) and a hanging man (bearish) candlestick looks the same, the only difference is the color of the body. To identify a hammer or hanging man look for the following:
- Upper wick: Very short or non-existent upper wick
- Real body: always on upper end of the candlestick
- Lower wick: 2 or 3 times the size of the real body
A hammer on a downtrend is an indication of a possible break of the trend and that the bulls will take control of the stock. The hanging man (a red hammer!) that appears on a up trend is a possible indication on the break and change of the trend were the bears take control of the market.
Inverted Hammer and Shooting Star
Just like the hammer and hanging man, the inverted hammer (bullish) and shooting star (bearish) candlestick look the same, and the only difference is the color of the real body. The easiest way to explain this kind of candlestick are the opposite of the hammer and hanging man candlestick.
To recognize this candlesticks look for the following:
- Upper wick: 2 or 3 times the size of the real body
- Real body: always on lower end of the candlestick
- Lower wick: Very short or non-existent upper wick
There are other types of single/double/triple candlestick patterns and we can easily go down the rabbit hole explaining those, I like to keep it simple when using this patterns and the ones we just learn are the basic ones that will get you started
The idea behind chart patterns is that history tends to repeat itself, therefore, when a pattern starts to develop, most likely the end result will be similar if not the same of what is expected from said pattern. I’m not saying that with patterns we can predict the future, but when you can recognize a developing pattern it will give you some insights on what you can expect to happen with the stock.
Another thing that I have to mention is that there is a lot of discussion and aversion to “timing the market” when deciding when to buy/sell a stock because nobody (don’t even try it) will be able to sell at the very top or bottom. While its totally true that the odds are against everyone when deciding if we have reached a top or bottom, it is also true that is very dangerous to trade against a developing pattern! Don’t be stubborn!
Cup and handle
Like the name suggests, this chart pattern looks like a cup with handle with the handle on the right side of the chart. In order for a chart to qualify as a cup and handle it needs to show the following structure:
- Prior trend: just before the cup and handle pattern starts developing, the stock must have had a bull run
- Cup: the cup must have a U shape, if the shape resembles a V instead, then it’s no longer considered a cup and handle pattern
- Handle: when the stock reached its peak on the right side of the cup, the stock will again go down, it shouldn’t retract too much
- Break out: when the stock goes up again and goes above the price when it previously started declining.
When the stock reaches the break out point its when we have to buy it and not before. Note that sometimes this pattern develops without a handle, if the stock breaks out after finishing the U shape, then this should be considered as a buying point.
This type of chart looks like a W rotated a little bit to the right where the middle tip of the W is lower that the left tip, and the second bottom of the W is lower than the first bottom. This pattern usually appears on very volatile stocks. The ideal buying point for this pattern is when the last tip of the W goes above the middle tip
This is the first pattern that I got to learn, and it’s because my account got severely hit by this pattern. Everything that goes up has to come down eventually, but when a stock goes up way too fast, it will most likely drop even faster than expected. If you ever get involved with this pattern don’t get greedy and take your profit ASAP!
See below chart for Revive Therapeutics, it went from $0.100 to $0.400 the share in less than 15 days! that is 400% return!!! And as you were guessing, it started sinking really fast too.
By this point you should be more comfortable with the idea of starting investing, you right now know a considerably amount of stock related information.
I recommend you to go to any website that has candlestick charts and start analyzing some of those charts, see if you can identify a candlestick or chart pattern.
Please leave a comment below and let me know how do you find this stock market 101 guide so far? What have you learned so far or which concept gave you an A-HA moment? Continue on Part 5