Chart formations and patterns

BY: Den Somera

We have learned that one may use fundamental or technical analysis as an effective method in investing and speculating in stocks.

Fundamental analysis uses external information such as the financial condition of a company along with other factors such as the state of the economy and its possible impact on business, particularly on the company that the investor is interested in.

Technical analysis is the reverse. It ignores all the fundamental aspects surrounding the company.

It focuses instead on so-called internal information, namely the price patterns created by the actual buying and selling of the shares of stock.

Between the two, it is said that technical analysis can read the rhythm of price movements better. Instead of just being able to give a general direction of prices at some vague time in the future - something that is attributed to fundamental analysis - it can actually give clear signals when prices will begin to go up or down and how far they will go.

And depending on the way you process your trade following the precepts of technical analysis, you can be either a called picker or a follower.

When one focuses on picking the bottom or top prices of a stock, he is said to be a picker. When he is concerned more in getting a confirmation of the direction and trend of stock prices rather than on capturing the stock's top or bottom price, the person is called a follower or trend follower.

What's amusing with the picker and follower is that both share a common index reference where they base their trading moves on chart formations and patterns. Let's begin our examination of chart formations and patterns with the theory of trends and trend lines. This is the crux of decision making for the followers.

The theory behind trends and trend lines is that prices move in trends because of the imbalance of supply and demand for a given share of stock.

When the supply of the shares is greater than the demand for it, the trend will be down since there are more sellers than buyers. When demand exceeds supply, the trend will be up. Buyers will bid up the stock price.

If the forces of supply and demand are nearly equal, the market price of the stock will move sideways in what is called a trading range.

Eventually, new factors will enter the market and the stock price will begin to trend again either up or down, depending on whether the new factors are taken in positive or negative light.

Trends that are very brief are called minor trends. Those that may last for a longer time such as several weeks are called intermediate trends. Trends that may last for a month or longer are called major trends.

Trend lines determine which trend is in force. You will know that the price of a stock is trending up when, after drawing a line connecting each successively higher bottom, the prices of the stock remain above this line.

The uptrend is in force, as they would describe it. Conversely, a downtrend is in force if prices are below the line connecting each successively lower top (See examples in the book Technical Analysis of Stock Trends by Robert D. Edwards and John Magee).

The main theory of trend line states that once it is penetrated or broken, the trend previously in force is reversed. An uptrend, therefore, that is violated or penetrated is a signal to sell.

A downtrend line that is broken is a signal to buy. The violation, however, is not decisive enough. You must wait for a second line point, another higher top or lower bottom as the case may be, to connect with.

The trend becomes more valid if prices establish a third bottom or top point to connect your second line bottom or top point. At this juncture, stock prices are said to have been tested on its downtrend or upward trend. And, prices have held on, as they technically describe it.

Very steep trend lines are not considered very authoritative. These kinds of trend lines are most often broken by a brief sideways movement of prices (called consolidation) that allows prices to shoot up again. It is the trend lines with gentler slope - either upward or downward - that usually offer more technical significance.

In summary, factors to consider in weighing the validity of a trend line include the number of bottoms (or tops) that have formed on or near the trend line; the overall duration of the trend line; and the steepness of the angle.

The successive sharp drop in prices causes a steep downtrend pattern. Often, this trend line will be broken by sharp rallies, at which point a new trend line must be drawn.

This second trend line might be broken by another rally and a third trend line would need to be drawn. These lines are called "fan lines" (owing to their fanning ray-like lines spreading out).

The rule on fan lines is that, when the third downtrend fan line is broken, the trend has changed on to the uptrend, and vice versa.

The changing of trends can be obfuscated by what is called pullbacks or throwbacks. They occur after a trend line is broken.

Even professional traders become victims of this phenomenon. When they buy or sell as a trend line is broken, the price of the stock after a few days will go higher than the price at which the trend line was broken. This is the pullback.

A pullback may also never materialize. In order not to be waylaid by this phenomenon, it is recommended to buy or sell half of your position on the trend line break and the other half on the pullback.

(The article has been prepared for general circulation to the reading public and must not be construed as an offer to buy or sell any securities or financial instruments referred here or otherwise. Moreover, the public should be aware that the writer or any investing parties mentioned in the column may have a conflict of interest that can affect the objectivity of their reported investment activity. You may reach the Market Reader at densomera@yahoo.com)

Averaging up

MARKET READER: Averaging up

BY: Den Somera

William O'Neil is a strong advocate of what is known in stock trading as "averaging up." It's a powerful concept of maximizing trading profits. It blends and works well with his investment management style, which is to buy and keep more stocks that are doing well.

This is not exactly his original idea. O'Neil claimed to have picked up the method from the book of the legendary Jesse Livermore, who lived in the early part of the last century. The book was How to Trade in Stocks.

I introduced William O'Neil in my previous column as one who could certainly be in our golden gallery of market winners, owing to his unique approach and success in beating the market.

O'Neil is best known as the founder of Investor's Business Daily, a national competitor of The Wall Street Journal, if you don't know that yet. He is a professional investor with a unique investment concept reflected in his famous CANSLIM system.

At 30 years old, he accumulated enough trading profits to buy a seat at the New York Stock Exchange and founded his own investment research organization.

In 1988, O'Neil wrote How to Make Money in Stocks: A Winning System in Good Times or Bad. The third edition is its latest and is completely updated.

The principle of averaging up is simple. The game plan is to buy more shares of the stock that is increasing in value.

In other words, it is a process by which you buy additional shares at higher prices. The investor accumulates an increasingly larger position in a stock while keeping the average cost of the position lower than the stock's current market price.

For example, you buy Pacific Online shares for P12 apiece, and as the stock rises you buy equal amounts at P16, P20 and P24. This will bring your average purchase price to P18 per share.

Assuming that you sell, even at P24 per share, you would have made about 33% (estimated total sales proceeds of P96 less total acquisition cost of P72).

In actual terms, the final return on investment is derived by deducting related transaction costs such as broker's commission and other trading charges and slippages.

If you average up by buying shares in decreasing volume as the prices of the shares go up, you will be realizing a higher net return than when averaging up in equal volume.

The process will also result in a pyramid-like formation of shares when you stack up the shares according to their volume and share prices. This is the reason why averaging up is also called pyramiding.

Other than this visual form, this process is in no way similar to the pyramiding scheme that recently hit a number of moneyed residents of Forbes, Dasmarinas, Urdaneta and highbrow scions in the business circle.

This pyramiding scheme is a classic investment fraud in which the operator pays high returns to current investors from the contributions made by new investors.

The funds are not invested or insufficiently invested in any productive asset. These are simply paid out as a return to those who invested earlier. The operator must continue to attract more prospects and receive more contributions. A snag or decline in the stream of investment money coming in will result in a serious deterioration of the scheme. This is called the Ponzi scheme, named after its original proponent.

When averaging up, you will notice that the average price that the investor pays for all the shares goes up. Thus, the payoff of averaging up comes as a result of the stock price continuing to go up.

Otherwise, the investor will suffer substantial losses if the stock price quickly drops. Its successful application will largely rely on the right market condition or timing.

Averaging up is the opposite of the natural tendency to buy additional shares at lower prices, called averaging down. O'Neil does not agree with the merits of averaging down. It's something that produces the same false hope that the turkey trap story promises.

To him, "The whole secret to winning in the stock market is to lose the least amount possible when you're not right." Thus, when wrong, don't average down.

The first mistake is the cheapest. Don't add more to your mistake. But when right, exploit it to the fullest by averaging up. We'll have more of William O'Neil's CANSLIM and trading schemes next time.

Trading was mild on Wall Street on Friday, but relatively stronger on a weekly basis. Overall, nothing positive is expected to happen in the near term.

There are those who insist that the Federal Reserve can't stop recession in view of the disappointing latest retail sales figures. The rate of increase fell to 0.3% in August from 0.5% in July.

The slide came as a surprise as economists had expected another 0.5% jump. Household spending accounts for two-thirds of the US economy.

The fears sparked by falling home prices, costly gasoline and tighter loan standards may cause consumers to put away their wallets.

While the Fed is expected to cut rates at its policy meeting on Sept. 18, experts are divided on whether this could be of help to prevent a much feared recession in the economy.

In the meantime, oil prices have reached all-time highs and are expected to still go up in the long term.

This reminds me that we'll soon have production in the Palawan area. Watch out for more details.

(The article has been prepared for general circulation to the reading public and must not be construed as an offer to buy or sell any securities or financial instruments referred here or otherwise. Moreover, the public should be aware that the writer or any investing parties mentioned in the column may have a conflict of interest that can affect the objectivity of their reported investment activity. You may reach the Market Reader at densomera@yahoo.com)

CANSLIM

MARKET READER: CANSLIM

BY: Den Somera

Let's get back to William O'Neil as promised and finish the review of his winning model, CANSLIM, which may give us a fresh insight on what could be a very difficult market to track this week.

The Dow Jones industrial average plunged by more than 366 points on Friday due to worsening fears of recession, as the price of oil went past $90 per barrel during early trading. Coincidentally, the US market ended down in the same manner as the so-called Black Friday market crash exactly 20 years ago.

By the way, the drilling of the programmed vertical pilot hole at the Galoc oil field should have been started at the weekend. This is done to provide core samples needed by the drillers to refine their plans to produce the oil field.

The drilling is set to intersect the top of the oil core all the way down until it hits water, which should be the bottom of the oil reservoir. The drilling is estimated to take about nine days, and based on the actual calendar of drilling activities, the vertical pilot hole should be completed by Oct. 28 or thereabouts.

After that, the operator will proceed with drilling of the horizontal holes that will take about 20 days each to finish. This will bring the drilling time zone at the end of the first week of December. The vertical pilot hole will provide exciting findings critical to the commercial operation of the oil field. The findings, therefore, may affect production strategies and, most importantly, to investors like us, it may affect the behavior or direction of stock prices. This week is crucial and exciting. Stay tuned.

William O'Neil with his CANSLIM has a piece of advice for those who believe in predicting market prices: Don't waste time trying. It's impossible to exactly predict market prices. Like the other greats in our golden gallery of winning investors, he believes that "Making money in stock trading does not mean knowing the secrets of forecasting future prices."

Instead, O'Neil advocates the use of an automated trading system. This will prevent you from falling prey to your emotions. Good decisions and timely actions are often hindered by emotions. Use some mechanical decision triggers: Stop losses at 8%; add more money to winners up to 5% above the buy price; make gradual moves into and out of a stock; don't buy or sell at one time; and buy or sell in parcels.

O'Neil also insists that in choosing stocks, one should ignore valuation. Low price earnings (P/E) ratios oftentimes indicate that the stock is cheap for a reason. It can become even cheaper. Instead, he insists on looking for growth features in the financial variables of a company. This is where he radically departs from the advice of the other trading greats. CANSLIM is all about looking for growth in the financial performance of companies.

The C pertains to current quarterly earnings per share. The earnings performance of the company should be accelerating. The A is for annual earnings per share. It should be accelerating, too. The N deals with something new in the company. In other words, there should be something driving the stocks to new highs.

The S stands for shares in limited supply while demand should be high. In other words, the share float of a company must be actively sought by the investing public. The L refers to directing your focus on the stocks of companies that are leaders in an industry, while the I stands for institutional sponsorship or ownership being moderate.

Demand needs to be high to drive stock prices higher. Institutional buying is the best source of demand in the stock market. They drive prices up when buying. But too much of them in a stock can translate to being overowned, and the stock might get dumped and its price will drop. The M is for market direction. The stock price should be upward because of strong fundamentals present in the company. Even if the market on the whole is down, it may stand strong and buck the market trend. Most importantly, like what the other trading greats are saying, O'Neil insists on being well informed. If you are not well informed in your task, you might miss a great opportunity.

(The article has been prepared for general circulation to the reading public and must not be construed as an offer to buy or sell any securities or financial instruments referred here. The writer may have a conflict of interest that can affect the objectivity of his reported investment activity. You may reach the Market Reader at densomera@yahoo.com)

The Basics of Technical Analysis

BY: Jason Meyer, Associate Editor.

No matter what your approach is to the market, you've undoubtedly taken a look at the chart of a stock or an index. But the information you take away from that chart does depend heavily on your approach. While many people see simply a line representing price history, technical analysts see much, much more.

Technical analysts study past price movement for the purpose of understanding what future prices may look like. They review charts of a particular company or index's price action and examine the changes in price over a particular period of time.

If you want to think more like a technical analyst, this report is a good place to start. However, it's not meant to be an exhaustive examination. Its intent is to provide a basic introductory overview for people unfamiliar with chart-reading and hopefully spark their interest. That said, there is a lot more to learn about each aspect presented here, so I'd encourage anyone interested to pursue it further, and RealMoney is a good resource to use. Now, let's move on to the charts.
Start With the Charting Basics

The first two things you need to know about reading charts are also the most important: price and volume. These are the building blocks that make up a chart's foundation; all of the other indicators and overlays which, while helpful and revealing, are ultimately secondary. Let's start with price.

Price is represented in several different ways, depending on the type of chart you're using. There are bar charts, in which price is represented by a bar, as you can see on the left graphic below; candlestick charts, in which price is represented by what resembles a candlestick, as you can see on the graphics in the middle and the right; and line charts, where price is nothing more than, well, a line.

Let's look first at a bar.

As you can see on the graphic, the line on the left represents the opening price of the trading day. The bar's length, or the center vertical line, represents the day's price range, with the top of the bar indicating the day's high and the bottom representing the lowest. The small horizontal line on the right is the closing price for the day.

Much of the same information is reflected in the candlesticks. It too features the open, high, low and close for price that time period. The primary difference between a bar and a candle is reflected in the body, with the length of both the body and the wick, or shadow, representing the type of activity -- heavy selling or light buying, for example -- that took place. In the graphic, the white candlestick represents an up day, or a day when a stock's price increased, and the black candle is a down day, when the stock's price fell.

Many analysts prefer candlesticks to bar charts because they feel that more information is presented. The reason for this is that the color and shape of the candlestick, relative to the previous candlesticks, gives an immediate visual snapshot of the day's trading and its relationship to the past. Price bars relay much of the same information, but its relationship to previous price changes is not considered as complete by itself in comparison. Volumes have been written about candlestick charting, so for the sake of brevity here, we'll concentrate on bar charts.

Volume is represented on a chart by a single bar directly below the price bar. It is adjusted according to quantity, meaning the number of shares that changed hands that particular day.

On the chart below, you can see both price bars and volume bars. The time axis, meaning the amount of time represented by the chart, is on the bottom line -- in this case, in days. The price axis runs up the upper right side, and it is the scale, in dollars and cents, by which we measure the stock. Through these, you can see the open, high, low and close of a stock's price on any particular day, plus its volume that day.

Source: Quote LLC

Since I've mentioned the subject of time scale, this would be a good time to talk about time frames. Charts can be made for any number of time frames, from long term, such as annual, quarterly or monthly, to more intermediate term, such as weekly or daily, to extremely short term, meaning intraday in anything from one- to 120-minute increments. In each case, a single bar represents the chart's time period; for instance, on a daily chart, which is the most common chart, one bar equals one day.

Now let's take a look at these two things in action and get a very basic idea of what chart analysts look for.
Trends

First, technical analysts look at a chart to determine whether a stock is in an uptrend or a downtrend. This isn't a complicated process; in fact, one of my former colleagues said it was simple enough for his 5-year-old daughter to identify.

Source: Quote LLC

Looking from left to right, is price going up or going down? Or is it just choppy? Simply take a pencil and draw a line from one swing point to another, and you'll have your answer.

What is a swing point, you ask? As you can see in the graphic, a swing point is when one price bar (or more than one with the same high/low price) is surrounded by two others that, in our graphic, are higher or lower than the high/low of the center bar(s).

So you find two swing point lows or highs, draw your line, and that's your trend line. Now you have a visual representation to show which way a stock is moving.

This brings us to the question of whether a trend line serves any purpose other than showing us something we probably already knew, namely the direction of the stock. The answer is yes.
Support/Resistance

Market watchers often talk about a stock meeting support or resistance. They're referring to lines drawn on a chart -- sometimes trend lines, sometimes not -- where price has established a high or low or, in some cases, has merely spent a lot of time trading around.

Support is a line below the stock's current price that serves as a floor from which price can bounce and go higher or, at least, stop going lower. Resistance, therefore, is a level that stands in the way of a stock's continued rise. In both cases, the more times a stock's price has touched a line without going through it, the stronger the line becomes. For example, if a stock went to $70 six times without ever actually going through to, say, $70.25, then $70 would be considered strong resistance, meaning price is having a difficult time going higher.

Conversely, if price drops down to $50 several times without ever going through to $49.75, then $50 would be considered strong support, meaning that price is having a difficult time dropping below it.

The importance of support and resistance is that they are easily seen lines on a chart that can give an investor some idea of what the future may hold for the stock, and consequently, the importance of breaking through one of those levels.

One other thing to remember about support and resistance is that once price goes through them, they change. If price breaks through resistance, that resistance now becomes support. And if it drops below support, that support then becomes resistance. The chart below has an example of both lines, and at the same time a trading range, as Microsoft(MSFT:Nasdaq) is obviously trading between tight support and resistance before gapping down below the range on extremely heavy volume on the right hand side of the chart. That sort of break on that sort of volume is a bad sign for a stock.

Source: Quote LLC

With the very basic outline you've been given on chart-reading, let's take a jump ahead, as a bit of a teaser, and see a pattern, in this case, a head-and-shoulders reversal pattern, the beginning of which is actually on the right hand side of the chart above, and see the promise that technical analysis offers.

A head-and-shoulders pattern is a reversal pattern, meaning that one would look for the stock to reverse its current trend and head in the opposite direction. If there is no trend to reverse, then it's not really a head-and-shoulders. In this case, the downtrend is a short one, but it is established by the gap down. As you can see in the chart, price makes three moves: a left shoulder, a head and a right shoulder.

What happens is that a new low is formed, then price moves up, forming the left shoulder. Price then declines further, with a subsequent rise that will sometimes break the downtrend by itself. This is the head. A third trough -- preferably symmetrical to the other shoulder, but not required -- is then formed, making the right shoulder.

A neckline is then drawn from the high that makes the left base of the head to the high that makes the right base of the head. In order for the pattern to be complete, this line must be broken, and in the case of a head-and-shoulders bottom, the break must be accompanied by strong volume. A break on light volume would call into question whether or not the upward move would continue. You would also like to see heavier volume on the up moves and lighter on the down, which we have to some degree.

As you can see on the circled bar, the stock broke through the neckline on a wide-range bar and had the proper heavy volume accompanying it. The breakout spent a short time consolidating, and then took off, ultimately peaking at $31.48 after another break forward on good volume.

Source: Quote LLC

This example is not meant as a prediction that all head-and-shoulders patterns would have the same result. Nonetheless, it provides some insight into the way technical analysis works, which is that it gauges the market's mentality regarding a particular stock through the price bars and accompanying volume to give one an idea of whether a stock has the possibility of moving upward.

As you can probably assume at this point, I have barely scraped the surface of what technical analysis has to offer. Each of the topics introduced today is worthy of an article itself, not to mention the numerous subjects we haven't even mentioned, or barely touched on, such as chart patterns and various indicators.

Technical analysis has gained in popularity in recent years, but there is quite a bit of criticism of it, primarily from investors who study company fundamentals. They say that chart-reading has no predictive power whatsoever, representing only a company's past, not its future. Their feeling is that the only way to truly judge a company is by the numbers generated by its business.

While I believe that both fundamental and technical analysis are equally valid ways to study the market, I think that critics are missing out on valuable information by not looking at charts. For example, if a stock goes up $5 in one day on great company news, but the volume is really light, you can reasonably infer from that that investors weren't as impressed by the news as the jump in price might lead you to believe. That is not the sort of insight you'll get from a company's Securities and Exchange Committee filing.

Is technical analysis the end-all, be-all, one-and-only-way to look at stocks? Absolutely not. But whether looked at alone or in conjunction with fundamental analysis, the information and perspective it provides are invaluable.