3 ways to use price charts to make money in stocks

Question: I often hear the terms resistance and support from my broker whenever I ask for advice on when to buy or sell a stock. Sometimes, I also hear funny names like hammer and morning star. Is this some kind of a Holy Grail in trading stocks? How reliable is this?—Jennifer Rodriguez by e-mail

A: Stock prices are reflection of market emotions determined by demand and supply. When there is more demand than supply for a particular stock, share price tends to increase while when there are more sellers than buyers, share price tends to fall.

The factors influencing the demand and supply can be rational and irrational. The market may be buying or selling a particular stock based on a rational belief that it is fundamentally undervalued or overvalued, but it can also be irrational sometimes when it is motivated by extreme greed or fear.

When irrationality happens, this is where the market presents a trading opportunity. As soon as market players recognize this, share prices will correct by itself and may signal a new direction based on the prevailing market sentiment.

Analyzing price patterns in stock charts assume that what happened in the past can happen again in the future. The price patterns reflect how the market feels about the future of a stock.

Whether it is positive or negative, regardless of the fundamental position of a stock, the majority view of the market determines the general trend of the share price. Here are five ways you can use price charts to trade profitably in the stock market:

1. Identifying shifts in price trends

In charting, trend lines are essential in identifying whether a stock is on upward or downward trend. Trend lines are drawn by connecting two or more historical price points and extending that into the future. For as long as the stock moves along the line, the trend remains intact.

These trend lines also serve as support and resistance. If a stock is on uptrend, the line holding the price points is called support while if the stock is on downtrend, the trend line above it is called resistance.

When a stock breaks resistance or support, a shift in trend can be expected. The change in trend signals change in demand and supply for a stock.  Such change can be a minor or major correction.

The PSE Index has broken an upward trend line support recently. The shift in trend can be a minor correction that can bring the index down to its historical support at 7,500.

2. Identifying changes in trading volumes to confirm price trends

Trading volume can reveal significant information about a price movement. A rising stock that is not supported by rising volume may mean that the uptrend may not last. In the same way, when a declining stock is not supported by rising volume, it may mean that the decline is weak and the stock should be able to recover soon.

The stock price of Calata (CAL) recently spiked by 28 percent from P2.77 to P3.55 on news that the company is partnering with a foreign company to set up REIT in the country. The surge in stock price was equally supported by spike in volume trading. Share price continued to go up the following day supported by higher trading volume. When the stock corrected, volume also followed.

Whether this project will push through or not, the bullish share price movement of CAL is valid because the trading volume confirms that there is conviction behind such move.

3. Identifying market overreactions through price gaps

Market psychology suggests that investors tend to overreact to unexpected news or announcements that affect movement of the stock. One sign of market overreaction is when a stock creates a sharp move at market opening resulting to a price gap. Gaps happen where there is a newsworthy event overnight affecting the stock that has not yet been discounted by the market.

Philweb (WEB) shares made a price gap recently to open at P13.20 from its previous close of P14.25 after news have circulated overnight that the gaming regulator would not be renewing the company’s expired franchised license anymore.

The gap represented strong selling pressure which sent the stock price to as low as P3.02 in few days. Traders started picking up the stock in the days that followed and made quick profits when the stock rallied by over 100 percent from the bottom. The temporary recovery was pure market emotions and has nothing to do with fundamentals.

No Holy Grail

Success in using price charting needs discipline and commitment. You need to monitor price action daily to spot potential price patterns for trading opportunities. Timely trading that captures early buying or selling signals is key to succeed in price charting.

You don’t need to trade at all time. Trade only when there is a good opportunity. Always consider your time horizon when you invest. If you intend to trade for short-term gain and your strategy failed, try to have the discipline to cut your losses unless you really intend to make it your long-term investment.

Trading can be source of excitement to some people. But be aware that frequent trading in general always lead to losses. This is because of the trading costs that can accumulate over time.

There are hundreds of patterns and charting techniques that are available in the market but you only need to master a handful of them that can fit your investing style. If you feel that you find your techniques no longer effective or need to improve your skills, you can always research and learn from experienced traders.

Henry Ong is registered financial planner of RFP Philippines. Stock data and tools are provided by First Metro Securities. To learn more about stock valuation and analysis, attend the 9th Accredited Financial Analyst (AFA) program on Sept. 10-Oct 15. To register, e-mail [email protected] or text <name><e-mail> <AFA> at 0917-9689774.