Inflection Points, Optimism, Pessimism and Who is in Control of the Market
Stockscores.com Perspectives for the week ending July 21, 2006
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In this week's issue:
Stock chart reading is not easy. It is simple, but the ability to do it properly can take a long time to comprehend. Like all things that are not easy, breaking chart reading down in to simpler component pieces makes it easier to understand. First learn how the pieces work and then work to put them together.
It is important to not only understand how to read stock charts but to also know how to make money from them. It is not enough to be able to predict the future with a high probability of success. You also have to be able to make money with those predictions. A strategy that is right 80% of the time is not worth utilizing if it does not make money. That makes it necessary to not only be right but to make more money when you are right than you lose when you are wrong.
Let's work to understand a few of the key components of chart pattern reading and then utilize them to create a strategy for trading the chart. The components of chart pattern reading that we need to understand are inflection points, optimism and pessimism. Combined, these components help us to understand who is control of a market and how we can make money by being on the side that is in control.
An inflection point on a chart occurs when a stock's trend changes direction. If the stock was going down, it stops going down at the inflection point and starts going up. This point of price inflection is called support and it establishes a psychological floor price for the stock. The point where a stock stops going up and starts going down is also an inflection point, but this establishes a ceiling price that we call resistance.
Optimism is found on a chart when a line drawn across the bottoms of inflection points slopes upward. This means that there are rising bottoms on the stock chart.
Pessimism is found on a chart when a line drawn across the tops of inflection points slopes downward. This means there are falling tops on the stock chart.
The first phase of trend reversal occurs when this line that is drawn across the bottoms or the tops of the chart is broken by price. Consider this chart:
Over the previous two months, this stock has been controlled by the sellers, creating the falling tops that you see on the chart. On the current trading day that cycle of falling tops is broken. This takes the stock out of the control of the sellers but does not yet put the stock in control of the buyers because there is not yet a rising bottom. Remember, a rising bottom must occur at an inflection point. At this moment, it can go either way. Now look what happens over the next few days:
As of the last day on the chart above, the stock has made an inflection point that creates a rising bottom. Notice that the stock has closed above the high of the previous day when the stock hit a new, three day low. The three day downtrend has been broken and a rising bottom has been formed on the chart. This puts the stock in control of the buyers and provides a signal for the trader to buy this stock.
What is nice about an entry at this point is that it allows for an effective control of risk. If the stock were to close below $70 then the inflection point that gave control to the buyers would also be broken. It would put the stock back in control of the sellers, making entry in to the trade a mistake. The disciplined trader would take their small loss at this point and move on to a new opportunities.
The expectation is that the stock will stall at the highest inflection point on the chart, at about $77, because that is the next level of resistance. Ultimately, however, the buyers show their true strength and push the stock through that price level anyway, providing a nice profit for the trader who acquired the stock on the day the buyers took control at about $73. As of today, the stock is at $81.45.
The particular company is the subject of a takeover which will make many ask how reading a chart can have anything to do with what is happening in the business of the company. They will assert that a stock does not go up because of patterns on the chart, but instead, because of what goes on with the business fundamentals.
They are exactly right. What a chart does, however, is tell us what the market thinks about the fundamentals. It represents the market's perception of fundamentals, as proclaimed through the giant voting mechanism we call the stock market. The stock chart shows what the most well informed investors expect to happen in the future with the company's fundamentals. Learning how to read charts allows you to predict future fundamentals rather than react to historic (and essentially useless) fundamentals.
Inflection points, optimism, pessimism and who is control of the market. These four simple components can be combined to help you understand how to make money.
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Let's take the concept above and apply it to some other Canadian resource stocks that are showing a shift of control between buyers and sellers.Back To Top
1. T.IMO
T.IMO hit a new high five trading days ago. That new high was a lower high than the one set in late May, which was then lower than the one set in mid April. That means that over the long term time frame, the sellers are in control of the market. Yesterday, T.IMO shares closed below the low set on the day it hit the peak in its recent upward trend, breaking that trend and telling us that the sellers had taken back control in the short term as well. The stock moved lower today and looks likely to move lower over the next few weeks, perhaps falling to the low inflection point of $37. This makes the stock a good short sell candidate provided resistance at $42.50 is not violated.
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2. T.HBM
If we only look at the last month of trading in T.HBM we see a stock that has been in control of the buyers, who pushed the stock upward almost 50% during that time period. The stocks upward trend found its high 8 trading days ago and then fell. The stock tried to push upward again over the last three trading days but today failed. This creates a falling top and puts control in the hands of the sellers. The breakdown today is a short sell signal for short term swing traders. So long as resistance at yesterday's high of $14.80 is not violated, the sellers remain in control and the short sell remains valid. That gives minor loss risk relative to the reward potential. If this trade works, the stock should fall to the next level of support at about $10.30.
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References
Get the Stockscore on any of over 20,000 North American stocks.
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Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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