Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’re going to be laying the foundation of technical analysis so let’s get started.

First and foremost, let me tell you right at the beginning that we’re not going to look at a bunch of chart patterns like flags and head-and-shoulders like we’re looking at the stars and try and tell the future. This information series is not a game and I’m not going to waste your time with some hokous pokous theories about getting rich in the stock market. Fact is; there are some very real indicators we can use to better understand what’s happening to a particular stock and get an idea where it’s likely to go in the future. Other indicators are sketchy to say the least. We’ll be focusing on the proven logical indicators that shed real light on a stock’s current and future performance. But before we do, there are a couple things we need to discuss.

The first thing is to realize is that stock prices don’t jump up and down in a single day. Yes, a stock can have a big day and shoot up 5% or even 10% but a stock’s ability to double or triple takes time. The same is true on the down side. Yes, a stock can plummet 5% or 10% in a day but losing ½ its value or ¾ of its value takes time. And you can see this on any stock chart. Incidentally, I’m not talking about penny stocks here. And there are some other volatile stocks where that type of stuff can happen from time to time but we’ll talk about avoiding those stocks in detail later.

Bottom line; stocks generally TREND up or down over a period of time. It makes sense. A company might get on a roll with a new product or a new market or a new advertising approach and the company’s actual economic performance starts improving. As the company continues to capitalize on its new fortunes, its performance improves even more, building profits and the whole thing continues. Profits lead to growth and that leads to more profit and that leads to more growth and so on. This effect plays out in the stock market as well and the company’s stock will TREND upwards during this growth phase.

It’s also worth nothing that generally speaking, a stock’s price TODAY is based on the EXPECTED earnings about 6 months down the road. Again, this makes a certain amount of sense. Everybody who buys a stock is hoping it will go up in value in the future so everyone’s always looking forward. And it’s certainly true that some investors buy a stock only expecting to hold on to it for a day or two while others buy stocks to hold for years and years but the average investors is usually looking about 6 months down the road. So the price of a stock isn’t necessarily a reflection of the company’s earnings TODAY but rather of what the consensus opinion is for the company’s earnings about 6 months from now.

Anyway, a company’s performance can improve steadily over years and years and the stock’s price will TREND upwards throughout that period as investors watch the company grow and are willing to pay more for the stock as the company’s earnings get larger. Well, that’s a huge advantage for you and me. Our job is to identify a stock that’s TRENDING upwards and jump along for the ride. And we only need to jump back off when the trend is broken. As long as the trend continues, we don’t have to worry too much about why; just watch for the trend to break, and we’ll talk about that in detail later on. For now, the important thing is to realize stock prices generally TREND up or down.

Now, I said in an earlier chapter that the stock market is like a sociology experiment where the sample size is the ENTIRE population and I’d like to revisit that point here. For me, this is one of the most fascinating truths in the stock market. If you think about it, most sociology experiments that are conducted out there focus on some “sample” of people and then they try to draw conclusions about the greater population based on the results they get within their sample.

Great examples of this are the political polls we hear about on the news. They’re always talking about some poll that was done about one topic or another and the results of that poll supposedly tell us what the entire population thinks about that particular issue. Fact is; these polls are usually based on sample sizes of 2000 people, maybe less. And I’m sure I’m not the only one wondering who these people actually are. I mean; I never get included in these polls. And truthfully, if someone called my home and asked me to participate, I’d probably say no. So who ARE these people and do they really reflect MY opinions??

Well, in the stock market, the sample size is the entire population. In other words, the price-volume action reflects every single buyer and every single seller that’s involved with that stock at any particular point in time. Between the volume and the price change, you get a 100% accurate summary of the market’s opinion on that stock so you can have 100% confidence in that information. You can ALSO have 100% confidence everyone else watching the stock sees the exact same information you do and that makes technical analysis more accurate. If everyone’s watching the same thing and reacting according to certain common “rules”, the results on the stock market become more and more precise. We’ll talk about that later as well.

Right now, I’d like to back up and take a simplified look at a fictitious stock to try and better understand the buyer and seller psychology as prices change. Consider a stock that’s trading at $20 and it’s trending higher and gets up to $25. It trades at $25 for 5 days and an average of 1MM shares trade each day. So we know that buyers exist out there somewhere that purchased 5MM shares of the stock (1MM shares per day for 5 days) at $25. Now, what do those buyers want? Why did they buy the stock? Well, they bought the stock hoping it would go even higher, right? They’re optimistic about the stock and want it to go higher.

Okay, so now the stock starts trading lower again and drops all the way back down to $20. So who’s mad? Who’s happy? Well, the people who bought at $25 are mad. They’re now at a loss. Those 5MM shares that were bought at $25 have now lost 20% of their value (from $25 down to $20 is a 20% loss). On the other hand, the people who watched the stock climb from $20 to $25 in the past are happy. They think $20 is a good price. In fact, they might be surprised they’ve got a second chance to buy this stock for just $20.

Let’s assume the stock hovers around $20 for another 5 days and an average of 1MM shares trade each day. So now, we have a new set of buyers who purchased 5MM shares at $20, hoping the price would start climbing back up again. And for the sake of this example, let’s assume it does. Let’s assume the stock climbs back up to $25. What happens here? Who’s mad? Who’s happy?

Well, the people who sold their shares at $20 are mad. Had they held on to their shares, they could’ve sold them for $25 but they probably got scared and sold too soon. On the other hand, the people who bought those same shares at $20 are thrilled. They’re up 25% on their investment ($20 to $25 is a 25% gain). And what about the people who bought 5MM shares at $25 earlier? Well, they’re relieved. They’ve been carrying the stock at a loss for a while now and are relieved the price went back up so they can get out even. They can sell their shares without losing anything and move on to some other stock.

So if there’s still some buying interest in the stock at $25, they’re going to hit some resistance at that point, aren’t they? I mean, there are a bunch of people who own 5MM shares of this stock and they all want to sell at $25 to get out even. That means buyers of 5MM shares will all get their buy orders satisfied at $25. And what happens if there are only enough buyers to buy 4MM shares? Well, those orders will all get satisfied at $25 and then the sellers will probably start winning out and since all the buy orders have already been satisfied, the price will start going down again.

If the price dropped all the way back down to $20, there would be a bunch of people who watched the stock drop to $20 the last time and go back up, and all those people will have buy orders at $20, hoping to ride the next wave. If you remember, there were even some people so sold the stock at $20 last time and they’ve been beating themselves up about it ever since. So all those guys are waiting as well, hoping the price goes to $20 so they can buy in.

So if there’s still some selling pressure when the price gets down to $20, they’ll hit some support at that point, right? I mean, there are a bunch of buy orders sitting on the $20 line. For this example, let’s assume there are orders totaling 7MM shares at $20 – 5MM from the people who sold too soon earlier and an additional 2MM from people who watched it all happen and want to get in on the action. So if there are only 5MM shares trying to be sold at $20 and there are 7MM shares waiting to be purchased, all the sell orders will get satisfied and then the buyers take over again. With all the sell orders now satisfied, the price for the stock will start going back up again.

What we’re talking about here are the concepts of support and resistance. These are at the very core of technical analysis. This type of thing happens all the time. Maybe some of us have bought stocks in the past and experienced these emotions. There’s nothing hokous pokous about it. These are very real emotions that come up when you’re buying and selling stocks.

If you could see all the buy and sell orders that are out there for a particular stock, just waiting to be executed, you would see all sorts of these lines. You’d see clusters of sell orders above the current trading price and you’d see clusters of buy orders below the price. The placement of these orders is driven by peoples’ interpretations of the stock’s past performance and you can watch a stock battle through these lines, either successfully or unsuccessfully, every day.

Some of these clusters are much larger than others and battles are often lost at those points. Stock prices often trade within a “channel” with strong support at the bottom of the channel and strong resistance at the top. Sometimes for months at a time, the stock price can bounce off the support and resistance until, finally, something significant enough pushes the price through the line and the price breaks free again.

When that finally happens, there’s usually a bunch of pent-up energy right on the other side of the line. Again, there are people all around the world watching this stuff and they see the same thing you do. Using our previous example, they might have place buy orders at $25.50, just waiting for something to push the price beyond $25. Besides, they know all the sell orders are sitting squarely on $25 so if the price pushed through all that resistance and all those sell orders were satisfied, there would be almost no one left to fight against. That means the price could jump up quickly if the $25 resistance line was broken.

As it turns out, that’s exactly what usually happens. Any time a support or resistance line is broken, the “break-out” is usually dramatic. And the longer the line has remained unbroken, the more dramatic the break-out is.

Now, our example so far has related to a perfectly horizontal channel with support at $20 and resistance at $25. Well, in the real world, channels are rarely perfectly horizontal. Most channels are slopping upwards or downwards depending on the company’s underlying performance. But either way, you can look at a chart and quickly see these channels and draw the lower and upper lines defining these channels. And in the industry, you’d refer to those lines as “trend lines”. In fact, if the channel is trending upwards, the LOWER line would be the trend line and if the channel is trending downwards, the UPPER line would be the trend line.

A lot of people watch these lines to identify buy and sell points for a particular stock. Another set of lines commonly watched by investors are “moving averages”. Moving averages are exactly what they suggest; they represent an average of the stock’s price over some number of days – so you can have a 9-day average, a 13-day average, a 50-day average or a 200-day average (or anything else in between). With each passing day, the new closing price is added to the average and the most distant closing price is dropped, keeping the average continuously updated with the stock’s price.

Obviously, a 9-day moving average would be a lot more responsive to the stock’s current trading price than a 200-day moving average. With only 9 days to consider (that’s less than 2 trading weeks), the average will always be pretty close to the current trading price. But with a 200-day moving average (that’s about 40 trading weeks), the current price could be materially higher or lower than the average.

Either way, the moving average, by definition, FOLLOWS the stock’s trend and is commonly used as a gauge of when the trend is broken or when a new trend begins. Much like trend lines, there are usually a lot of buy and sell orders on either side of the line, marking places where individual investors believe those battles will take place.

I’ll introduce you to a FREE online charting platform in a later chapter where you can select a moving average and draw trend lines for yourselves. Until then, it’s important to understand that investors use different tools to try and understand where the buyers and sellers are for a particular stock. It’s like using a map to cross a mine field; the more information you have about where those mines are located, the better chance you can avoid getting hurt.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick@FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.