IN THIS CHAPTER
Understanding the roles of price, volume, and the security cycle of life in the charting world
Getting up close and personal with four standard charting methods
Making sense of well-known chart patterns
Simplifying security analysis with candlesticks
Using trendlines to guide your swing trading path
A picture’s worth a thousand words, or so I’ve heard. The stock chart is, perhaps, the best proof of this old cliché. For centuries, charts have assisted traders in profiting from buying and selling an underlying contract. Candlestick charting, for example, was developed by the Japanese in the 1700s to profit from changes in the price of rice.
Over time, investors became more sophisticated in understanding charts and the information contained within them. In fact, they became so sophisticated that they started identifying certain chart patterns and giving them funny names. Would you believe that head and shoulders is more than just a shampoo brand, or that cup and handle applies to trading and not just your favorite coffee container? Sure, these patterns may be the result of investors and traders staring too long at charts. After all, I sometimes see funny formations in clouds if I stare long enough. But they are useful tools for your swing trading ventures.
In this chapter, I share how you can predict the likely direction of a security — be it sideways, upward, or downward — by understanding the basic cycle of securities and the specific roles price and volume play in what you see on a chart. I also introduce you to several charting patterns every swing trader needs for success. The patterns are presented in order of complexity, so go ahead and skip straight to what you need based on your familiarity with charting. All set? Then chart away, my friend!
All charts come down to basically two inputs: price and volume. The majority of this chapter focuses on price, because patterns within price are more meaningful than patterns within volume. You’re rewarded or punished for being right on price, not volume. But I don’t want to gloss over volume. It’s a major tool in your swing trading kit and is worth close examination.
Volume communicates conviction on the part of buyers or sellers:
An old saying on Wall Street notes that amateurs trade at the open and professionals trade at the close. If a security closes higher than it opened, it represents a victory of sorts for the bulls. They were able to overwhelm sellers during the day. On the other hand, if a security closes lower than it opened, that represents a win for the bears, who were able to overwhelm buyers during the day. If a security closes at the same price it opened at, bulls and bears are at a stalemate.
Reading a chart isn’t difficult, but there are different ways of viewing the same price information, be it a line chart, candlestick chart, or bar chart. Most swing traders choose one chart type and stick to it. The most popular chart type for swing traders is the candlestick chart because it reveals the most information.
To get the most value out of charting for your swing trading ventures, you first need to be able to recognize the four main types of charts in the finance world and how each can help you — or harm you if you’re not careful. Following are the four main chart types and a brief description of each (from the most common and basic to the least common):
Candlestick chart: This chart type clearly depicts a security price’s open, high, low, and close. Traditional bar charts do the same, but candlestick charts do it more effectively. Candlestick charts are made up of two components: the range between the open and close (called the real body) and price movement above and below the body (called shadows). If the security closes higher than its open during that period (a bullish sign), the body is usually white. If the security closes lower than its open during the period (a bearish sign), the body is usually black (Note: Different charting programs use different colors to shade in the body.) When prices open and close at the same level, the candlestick body is reduced to a horizontal line, and the remaining parts are the upper and lower shadows. Figure 4-1 shows what typical candlesticks look like.
Candlesticks are a great way to examine charts, and you can use these patterns to assist you when entering and exiting securities. However, I don’t know any swing traders who rely on candlestick patterns exclusively. So avoid putting all your eggs in the candlestick basket. Like every technical tool, the candlestick is an imperfect instrument. Look for candlestick patterns as confirmation of a trend or reversal, but avoid looking to trade a security primarily because of a candlestick chart pattern.
The three charts in Figure 4-2 contrast a line chart, bar chart, and candlestick chart. All three charts cover price action for Alphabet (popularly known as Google) (symbol: GOOG). The bottom chart demonstrates a rising trendline, which highlights a support area that, when broken, signals the end of the uptrend. Figure 4-3 shows the other main chart type: P&F.
This book focuses on bar charts and candlestick charts, primarily the latter. Both chart types reveal intraday or intraweek (depending on the time period set) strength of bulls and bears, making them favored tools of swing traders far and wide. Support or resistance areas are also occasionally easier to see with bar charts or candlestick charts.
Securities go through a naturally occurring cycle, but not all securities follow this cycle religiously. If you can’t characterize which stage a security is in, you’re better off skipping it and finding one that’s following the normal cycle of accumulation, expansion, distribution, and contraction. The following sections examine these four cycles in greater detail.
Understanding this cycle is helpful because different phases require different strategies. Swing trading trends, for example, is best achieved during the expansion phase. Trading ranges, on the other hand, is best achieved in accumulation and distribution phases.
The accumulation phase is typically the longest phase a security goes through. During this period, a security’s price neither rises nor declines meaningfully. Instead, the price moves sideways through time. Supply and demand are roughly in balance, and institutional managers or “smart money” often accumulate shares of an undervalued security. (Smart money is typically institutional dollars that are informed by extensive research.)
Volume is usually light, reflecting a general consensus that the security’s price is correct. Buyers are unable to push prices higher than a ceiling (a resistance level), whereas sellers are unable to push prices below a floor (a support level). You can’t know in advance with any precision where these ceilings or floors will be found. You can easily identify them, however, by viewing a price chart and looking for price levels that a security is unable to climb above or fall below. These support and resistance areas are usually driven by fundamental reasons. For example, Microsoft’s stock may not be able to rise above $100 per share because that movement represents a valuation of $900 billion, and market participants may not feel the company is worth more than $900 billion. Thus, support and resistance levels vary by security and can’t be determined until you examine a price chart.
You can spot accumulation phases on charts of varying time periods. Although accumulation phases are traditionally thought of as occurring over several months, a security can technically be accumulated over a few days. The key factor is time frame. A day trader, for example, looks at intraday charts where each plot represents a five- or ten-minute interval. For day traders, the accumulation phases may occur over a two-day period.
Figure 4-4 highlights a typical accumulation phase when shares of Apache Corporation (symbol: APA) oscillated between two price levels — $75 and $60. This wide trading range allowed swing traders to buy at support level and sell at resistance level for profits.
The expansion phase, also known as the markup phase, follows the accumulation phase (see the preceding section) and is a period of increasing prices. If the movement out of the accumulation phase is truly an expansion period, the security’s price doesn’t reenter accumulation. So if you swing trade trends, this is the phase where you want to go long — as soon as possible.
This phase marks the beginning of a change in perception among shareholders and outside investors. A stock expansion may occur as the earnings outlook for a company improves. In the case of companies with a highly successful product (think Apple and the iPod), shares may begin to rise steadily out of an accumulation pattern after that product’s launch.
For a real-life example of what the expansion phase looks like, check out Figure 4-5, which reflects the expansion of Apache Corporation (symbol: APA). Notice how the breakout from the accumulation phase is on heavy volume, as highlighted in the volume subgraph, and that shares returned to the resistance level established in the accumulation phase. If prices had broken below that level, that’d indicate the expansion breakout had failed. Instead, shares returned to the breakout level and found support. This move is seen as a low-risk entry level. Yet not all breakouts give you such a beautiful gift. Strong breakouts often don’t return to the accumulation phase and allow reentry.
All good things must come to an end, including high-flying securities. During the distribution phase, the good news that propelled shares during the expansion phase is no longer so surprising to Wall Street. Share prices start to even out and move sideways instead of rising or falling. Think of the distribution phase as the end of the party. The music is bland, the food is stale, and the conversations are getting old. That’s the distribution phase in a nutshell.
The folks who built up shares of a security in the accumulation phase unload those shares during the distribution phase. Amateur investors are often buying the security in the distribution phase, having found out about the company or the investment from a front cover of a popular magazine or seeing the company talked about on a financial news show. When everyone knows the story, it usually means the story doesn’t have much farther to run.
Shares move sideways during the distribution phase, seemingly indicating a consensus on a security’s price, and volume tends to taper off. You can tell accumulation from distribution by
As a swing trader, identifying distribution phases is helpful for timing an exit. If you spot a distribution phase, exit immediately if you own the position. If you fail to spot the distribution phase, your second line of defense is your stop loss order (refer to Chapter 1). You’re likely to be stopped out by one of your sell rules during a distribution phase: a moving average crossover or the breaking of a predefined support level, for example. You may also exit based on the passage of time, a strategy I present in Chapter 10.
Figure 4-6 highlights shares of Sandisk (symbol: SNDK) during a distribution period. Notice that volume tapers off as shares move sideways. This distribution phase followed an expansion phase.
The fourth and final stage of a security’s price cycle is the contraction, or markdown, phase that’s best summarized as a period of lower highs and lower lows, a time when bulls die and bears roar.
Volume isn’t a helpful indicator in periods of contraction. Although heavy volume indicates sellers’ conviction, light volume doesn’t indicate the opposite. As the old Wall Street maxim says, “A stock can fall on its own weight, but it takes volume to rise.” Hence, a contraction period can be met with light volume throughout.
Securities tend to fall faster than they rise. In just a few days, a security can give up gains that it made over the last several months because greed influences price rises and fear influences price declines. Fear’s a more potent emotion than greed. If traders fear lower prices, they sell — fast. But when prices are rising, they’re not as committed to buying as quickly as possible.
Figure 4-7 highlights the contraction phase in shares of Sandisk (symbol: SNDK). This contraction followed the distribution phase highlighted in Figure 4-6. Shares of Sandisk rallied in late October and late November before breaking to fresh, new lows.
Highbrow academics in their ivory towers shun chart patterns because spotting a head and shoulders or cup and handle can be subjective. Just like seeing a pattern in a cloud or the stars, chart patterns are difficult to quantify. To be proven sound, an academic needs to establish rules on spotting these chart patterns, but programming a computer to look for patterns is difficult. The good news: Technology has advanced in the years since the publication of the first edition of this book, permitting charting software to spot many common chart patterns. For example, StockCharts.com allows you to screen for common chart patterns.
Even though computers can now perform the work traders performed themselves, it’s important to understand the characteristics of each chart pattern and what they indicate about the likely future direction of a security.
The following sections describe five major chart patterns: the Darvas box, head and shoulders, cup and handles, triangles, and gaps. Rest assured that other chart patterns exist, but these five are, in my opinion, the most common and the most useful. They occur regularly and reflect the psychology of the crowd.
The Darvas box, a rectangle-shaped pattern, illustrates that security prices tend to trade between two levels before breaching a level and rallying or falling. You may recognize this pattern as the accumulation phase described in the earlier section, “The waiting game: Accumulation.”
In a nutshell, the pattern’s creator, Nicholas Darvas, looked for securities that traded between two clear price levels: a support level and a resistance level. The support level marked the price point at which buyers stepped in and bought shares, preventing prices from going down. The resistance level marked the price point at which sellers stepped in and sold shares, preventing prices from going up. Darvas didn’t waste time with securities that didn’t fit nicely into this mold.
After identifying a security as trading between the two price levels, Darvas waited patiently until the security broke out of the upper band on heavy volume. Then he’d buy and hold the stock so long as it didn’t fall back in the old box. If the security rose and formed a new box, he’d raise his stop loss level to the area below the new support level.
Figure 4-8 depicts a typical Darvas box using shares of PLDT Inc. (symbol: PHI, formerly Philippine Long Distance) which traded between two clear price levels: $30.50 and $27.30. The excitement came on November 2, when shares broke out convincingly above $30.50 on heavy volume. This date signaled the beginning of an uptrend (see the later section, “Uptrend lines: Support for the stubborn bulls,” for more info on uptrends) and marked the first time shares had exited the Darvas box, indicating an opportune time to buy. Subsequent Darvas boxes would offer the trader a chance to raise the stop loss level.
If you bought shares on the breakout, around $31, you should hold the position unless it falls back into the old box (around $30 per share). Remember: If the breakout’s genuine, the security doesn’t re-enter the Darvas box.
Although Darvas wasn’t a swing trader per se, he was content to hold a stock longer than the typical swing trader. As a swing trader, you don’t have the luxury of waiting out a security’s consolidation period. Hence, I recommend setting a tight stop loss near the resistance level of the old box. I discuss when to take profits in Chapter 11.
Not to be confused with the shampoo, the head-and-shoulders pattern is a distribution pattern that marks the end of an uptrend and is among the most reliable of all chart patterns. The Federal Reserve Bank of New York even published a paper called “Head and Shoulders: Not Just a Flaky Pattern.” The Fed said that the pattern appeared to have some predictive value and produced profits in certain markets.
The head-and-shoulders pattern is composed of three hills, with the middle hill being the tallest and the left and right hills roughly the same height. In this way, the hills resemble a head and shoulders, as you can see in Figure 4-9, which highlights shares of homebuilder Lennar (symbol: LEN).
In January, shares of Lennar rallied and met resistance at $54 per share. This occurrence formed the left shoulder of the head-and-shoulders pattern. Buyers attempted to raise prices a second time and succeeded, driving Lennar’s stock north of $56 per share. Sellers stepped in and brought shares back to the same level as the left shoulder ($52) to complete the head. Finally, buyers attempted once again to raise prices but were only able to push Lennar’s stock up to the level established in the left shoulder, a move that completed the right shoulder.
Head-and-shoulders patterns give yardsticks as to how much a security’s price will fall after breaking the neckline. Simply measure the distance between the head and the neckline and project that downward to estimate how far the stock will fall at a minimum. In the case of Lennar, the neckline was around $52 and the head was around $56. So you could’ve expected the stock to fall by at least $4 ($56 – $52) from the neckline ($52) and reach $48. Lennar actually exceeded that estimate.
An inverse head-and-shoulders pattern, which marks the end of a downtrend, literally looks identical to the head-and-shoulders pattern except that it’s turned on its head (pardon the pun). Figure 4-10 highlights an inverted head-and-shoulders pattern in shares of Latam Airlines Group (symbol: LFL). The measuring technique used in the traditional head-and-shoulders pattern applies to an inverted pattern as well.
The cup and handle is a bullish chart pattern that signals shares are being accumulated and the security is preparing for an upward move. Cup-and-handle formations must be preceded by an uptrend because they’re a continuation formation, a pattern that indicates the continuation of a trend.
The cup and handle first forms after shares rally to some peak. Then for some reason — perhaps fundamental or technical in nature — sellers bring shares down 10 to 20 percent from that peak. Amateur investors who buy near the peak kick themselves for their mistake and agonize over the 10 to 20 percent loss on their investments. They think, “After I break even on this dud, I’ll sell.”
As it happens, shares of the security give amateur investors that opportunity when they rally back to their previous peak. Then those disgruntled shareholders unload the security en masse, creating a resistance level and leaving shares unable to surpass that peak. However, shares don’t fall back to their prior low. Instead, they remain elevated as smart money accumulates shares at a slight discount. Shares may fall 5 percent or so from the peak at this point. On the second attempt to surpass the peak, shares break through and complete the cup-and-handle formation. Volume is key and should rise heavily on the breakout from the handle.
Figure 4-11 illustrates a cup-and-handle pattern in shares of Cia de Minas Buenaventura (symbol: BVN). Shares of BVN rallied to $45 per share in July. Then a general decline in the overall market helped send the shares down to $35, representing a 22 percent loss for shareholders who bought near the peak. Anxious to recoup their losses, these investors unloaded their lot when shares of BVN rose near $45 in September and kept BVN from piercing that level. But the underlying fundamentals of BVN were strong, and investors on the sidelines didn’t let BVN decline much — only $5 from the $45 peak. On the second attempt to break through $45, shares sprinted higher and passed that peak on heavy volume.
Triangle chart patterns (shown in Figure 4-12) provide traders with measurement moves, an estimate of how far the ensuing trend will travel after breaking out from the triangle. Think of triangles as a reflection of the tug of war that occurs between buyers and sellers. Sometimes buyers have the upper hand; other times sellers have it; and occasionally both sides are evenly matched.
To make use of triangle patterns in your swing trading, you need to get familiar with the three types of triangles and how to calculate price movement with each:
Gaps occur frequently in prices; they represent a break in price continuity. For example, a security may be trading in the $19 to $20 range and then open the next day at $25 — leaving a gap between the high of the previous day and the low of the next day. Gaps may represent a seismic shift in the fundamentals of a security, or they may mean nothing. In this section I cover the four types of gaps.
I hate to tell you this, but a common gap is meaningless. Prices gap up or down one day but quickly “fill the gap” in a matter of days. This phrase is a simpler way of saying the security’s price returns to the area where the gap exists. If a security trades at $50 for several days and gaps higher to $52 the next day, its price fills the gap by trading back down to $50. Figure 4-13 shows two common gaps occurring in a chart of Diana Shipping (symbol: DSX).
A breakaway gap occurs on heavy volume and indicates seismic shifts are occurring in the security. Often the percentage move up or down is significant (more than 5 percent in a single day), and the volume is at least double the average daily volume. Breakaway gaps are preceded by congestion periods. A security’s price trades for several weeks or months in a certain price area and then violently gaps higher or lower one day. The strength of the move indicates a major change is occurring in the way investors value the security. Figure 4-14 highlights a breakaway gap using shares of Contango Oil & Gas Company (symbol: MCF).
Just ensure you manage your risk properly because stocks that gap higher can fall quickly if they close the gap (such as the stock trades back down to the high of the bar prior to the gap); see Chapter 10 on how to manage your risk at the security and the portfolio level.
A continuation gap crops up in the midst of an uptrend or downtrend and signals — you guessed it — the continuation of the previous trend. Figure 4-15 highlights a continuation gap that followed a breakaway gap in shares of Flowserve Corp. (symbol: FLS). You can trade continuation gaps much the same way I describe for breakaway gaps in the preceding section. Note: Not all continuation gaps are preceded by a breakaway gap.
An exhaustion gap, which occurs in the direction of a trend, resembles a continuation gap and marks the end of that trend. If a security has been falling for several weeks and then gaps down, you may think that gap is a continuation gap. However, if the gap fills quickly, it’s likely an exhaustion gap. Figure 4-16 offers an example of an exhaustion gap occurring at the end of an uptrend in shares of Sigma Designs (symbol: SIGM).
Candlestick patterns occur a few bars (be they hourly, daily or weekly) and can signal a trend change or continuation. You can find dozens of candlestick chart patterns out there, but I cover only the ones I feel are most accurate. The next four sections feature candlestick chart patterns that are easy to identify and that may signal a change in momentum or a continuation of a trend. (For help discerning one trend from another, flip ahead to “Measuring the Strength of Trends with Trendlines,” later in this chapter.)
A hammer represents the bottom of a trend. It looks identical to a hanging man (see the following section) and occurs at the end of a downtrend.
Hammers have small real bodies in the upper portion of the candlestick bar. They have long lower shadows and small upper shadows (if any). Hammers signal that after the price of the security opened on the market, sellers drove it down. By the end of the day, buyers had recouped much of the losses to end the day near or at the high.
Figure 4-17 sheds some light on the difference between a hammer that forms below recent price history and one that forms within price history using shares of Western Digital (symbol: WDC), which bottomed on April 10. Notice how the high and low on that bottoming day were well below recent price history. Contrast this hammer formation to the apparent hammer that formed on March 14. This second hammer’s body was within previous price action, but ultimately, it didn’t mark the bottom of the downtrend.
Volume, again, should be kept in mind. Hammers that form on heavy volume are usually genuine, whereas those that form on light volume probably aren’t the real McCoy.
A hanging man looks identical to the hammer (see the preceding section). However, it occurs at the end of an uptrend rather than a downtrend. It crops up on heavy volume and is followed by price action confirming the top. If the high of the hanging man is surpassed, then its signal is invalid.
My favorite candlestick charting patterns are the bullish and bearish engulfing patterns, which involve two candlestick bars, not one.
Bullish engulfing patterns occur when a candlestick bar opens lower than the previous candlestick’s close and closes higher than the previous candlestick’s open. In candlestick terminology, the pattern begins with a candlestick bar that has a small real body and is followed by a candlestick bar whose body engulfs the previous day’s body.
Why is this pattern so bullish? It represents a major defeat, so to speak, for bears. When the second candlestick bar opens, sellers are already pushing prices below the prior day’s close. However, buyers step in and begin purchasing en masse. Not only are they able to reverse the direction from the open but they also manage to push prices higher than where sellers began the previous day. Think of a bullish engulfing pattern as a surprise victory in a battle where an infantry division loses not only the gains it made in the previous day but also much more.
Figure 4-18 highlights a bullish engulfing pattern in shares of NewMarket (symbol: NEU) that fell from $62 in May to less than $40 in June. Notice how the open on June 14, completely engulfed the entire body of the prior day (remember, body, not shadow). Subsequent price action confirmed the bottom.
Bearish engulfing patterns occur at the end of uptrends and mark important reversals. They’re characterized by two bar formations. The first candlestick consists of a small real body. The second candlestick opens higher than the previous bar’s close and closes lower than the previous bar’s open, thus engulfing the first candlestick. Figure 4-19 highlights a bearish engulfing pattern that formed in shares of Diamond Offshore (symbol: DO) and signaled the end of the prior uptrend.
Morning and evening stars are reversal chart patterns that consist of three candlesticks. Morning stars mark the end of a downtrend and the beginning of an uptrend. Evening stars mark the end of an uptrend and the beginning of a downtrend.
Figure 4-20 is an example of an idealized morning and evening star. Both patterns reflect the inability of the ruling party, bulls or bears, to consolidate previous gains. The star (the middle bar) is an exhaustion attempt by buyers (in the case of an evening star) or sellers (in the case of a morning star) to push prices definitively higher or lower, respectively. That’s why the second bar in the morning or evening star formation is small: The day begins with a gap in the direction of the trend, but the initial enthusiasm dies down. The third bar shows a swing in momentum as bulls or bears take over.
To see one of these star patterns in the context of a chart, take a look at Figure 4-21, which shows the evening star reversal in action in shares of China Mobile Limited (symbol: CHL) in late February. Notice how the star (the middle candlestick in the formation) gapped higher than the previous bar. The third bar represented a resounding defeat for bulls, as bears were able to push prices to the level of the first candlestick.
Quite literally, trendlines connect price points together and form either a horizontal, rising, or falling line. They’re helpful in establishing support and resistance levels. When a trendline breaks, shares may or may not reverse course. The most you can take away from a trendline break is that a specific trend has ended. A consolidation period (sideways movement) may follow, a new trend may arise, or the trend may reverse. All three scenarios are possible.
Much ink has been spilt on the construction of trendlines, but there’s really no science to them. So, don’t expect one trendline drawn at an angle of 65 degrees to be right and one drawn at 63 degrees to be wrong. The basics of drawing trendlines can be summarized in three simple rules:
If you find yourself drawing and redrawing trendlines (on your charting program, not by hand), then you’re misusing them.
In the following sections, I share how to distinguish and use different trendlines.
Uptrend lines connect several lows and form a support area for the bulls — the bulls’ line in the sand, if you will. They indicate the rate of ascent that buyers have maintained over a certain period of time. If your charts are arithmetically scaled, then the rate of ascent is measured in dollars per time period. If your charts are semi-log or plotted on a log scale, then the rate of ascent represents a percentage change per time period.
You want to draw your uptrend line through the lows, but don’t take it to an extreme. If the line intersects prices slightly, that’s okay. Consider Figure 4-22, which shows an uptrend line of shares of Sandisk (symbol: SNDK). The uptrend line is drawn through the lows and touches several price points. On an extreme day on August 1, prices fell below the line but basically remained above the trendline. Hence, the trendline stayed intact. However, the break below the uptrend line is mid-August was significant and did in fact represent the end of the uptrend.
Downtrend lines connect a series of peaks and represent an area of resistance. Think of them as the line in the sand for the bears. And like uptrend lines, they’re more meaningful the more times they’re touched by security prices and the longer they’ve been in effect. Figure 4-23 depicts a downtrend line that occurred shortly after a breakaway gap down in shares of Broadcom. (Broadcom was acquired by CA Technologies and no longer trades on the market.)
Notice that in late March, shares of Broadcom definitively closed above the downtrend line. This signaled the downtrend was broken — but not necessarily the beginning of an uptrend (though that did occur in this case).
Horizontal trendlines depict a stationary support or resistance level. After either of these levels is broken, a trend usually develops. Alternatively, the security may enter a new trading range with horizontal support and resistance levels.
Some common horizontal trendlines you’ll encounter as you swing trade are ascending triangles (a horizontal level of resistance) and the Darvas box (a horizontal line of support and a horizontal line of resistance). These patterns are both described in earlier sections of this chapter.