FIGURE 2-2: Bearish and bullish days on a candlestick.
Seeing into the future (sort of)
The goal of charting and technical analysis isn’t to see what’s happened in the past, but to attempt to predict the future. Basically, if you can predict the future for a majority of the time, you should be able to profit nicely through wise investing and trading. Because candlestick charts are chock-full of info, they aid a trader as they work to predict and profit from future price moves.
BULLS AND BEARS
The terms bull and bear have been in the trading lexicon for many years. Both terms apply to people and market trends. A bull is a market participant who expects or wants the market to move higher, but it’s also part of an expression that explains an up market (a bullish market). A bear, on the other hand, is a person who expects the market to decline, so bearish indicates a declining market. But where did these terms come from?
Although there’s some debate about the origins of the two terms, they might be attributed to a Thomas Mortimer, who wrote about the precursor to the London Stock Exchange in the late 1700s. He wrote that a bull bought stocks without putting any money down with the hope of selling at a higher price before having to settle up. According to Mortimer, a bear sold stock they didn’t own without putting up any money, also hoping to exit the position by purchasing the shares back at a profit before being forced to settle up.
A trader might study old candlestick charts and notice that when a security’s closing price is much higher than its opening price, it seems to open higher the next day — a situation commonly referred to as a gap opening. That trader can buy the security at the close of the day and place an order to sell the next day, thus making a profit. Figure 2-3 provides a clear visual example of a gap opening.
FIGURE 2-3: Two candles showing a classic gap opening.
Showing price patterns
Recognizing patterns on candlestick charts is easy, and you can combine two or more candlestick charts to flesh out a reliable pattern that can lead you to profitable trading. Figure 2-4 depicts a common price pattern that serves as a good sell signal.
UNDERSTANDING PRICE GAPS
Price gaps, which are very common in the financial markets, occur on charts when no overlap exists between consecutive period highs and lows. If XYZ stock’s high is 81 and its low is 80 on a given day, for example, and the next day, it opens higher than 81 — let’s say 83 — and trades in a range between 82 and 84, a gap with no trading exists between 81 and 82. That stock gapped higher and never closed the gap. If the stock had opened much lower — 77 or 78, for example — and never reached the previous day’s low, it would have gapped lower.
So what causes price gaps? These gaps are usually the result of news about a certain security being released outside market hours. This situation isn’t uncommon: Most companies release their quarterly earnings or other big news either after the market closes or before it opens. The market adjustment to that news causes price gaps. Also, a gap may occur on specific stocks just because they’re moving up or down due to a gap in the overall market. The gap may occur due to the release of some economic news before the market opens or possibly due to a macro event such as a terrorist attack.
You should remember that gaps always get filled when the high to low price action of a future day covers the price range where no trades occurred. But you can’t always tell when gaps will be filled. When the dot.com bubble was building, some Internet stocks had several price gaps on their way up to stratospheric valuations. These gaps were eventually filled, but anyone who was trying to short these stocks for the gap being filled would have ended up in the poorhouse before any gap-filling took place.
FIGURE 2-4: A common candlestick sell pattern.
The pattern is a two-day pattern, and the third day is a common reaction to the first two days. Here’s the typical progression:
1 The first day is a strong open-to-close day. The closing price is considerably higher than the opening price. The first day is a victory for the bulls.
2 The second day reveals very little price action because the close is very near the open. The second day is a wash because higher prices entice more bears to be sellers.
3 After this shift from bullish to neutral price action, the following day is a down day. The third day is a winning day for the bears!
SELLING SHORT, IN SHORT
One of the best-known trading adages is “Buy low, sell high” — the simplest way to turn a profit in a market. But other ways exist, including short selling or shorting a security. This somewhat-counterintuitive process involves selling a security and buying it back later. Traders who practice this strategy are known as shorts.
The mechanics of selling short can be fairly complex, but I’ll try to sum them up:
1 A short borrows a stock from a bank that holds it for the owners, expecting the price of the stock to go down.
2 The short sells the borrowed stock to a buyer.
3 When the stock price drops, the short buys the stock back, returns it to the bank at the original (higher) price, and pockets the difference.
Shorts get a bum rap and are often accused of being responsible when a stock trades lower. Companies have even sued shorts on claims that they spread negative rumors to drive down the company’s stock price. But short sellers are really just part of the overall market mechanism, and they can actually help keep companies honest, because they’re constantly on