Scroll to the bottom of this Guidepost for an easy way
to ask for clarification on any questions that arise!

Greetings, Pro-fundity team members -
09-12-03

At the bottom of the Guidepost, a full listing of this weeks picks are shown, in addition to the Charts via the Pick-link.

As a benefit of membership, you have access to all Guideposts (including Archived GP's) and Picks. If you miss a week or two for whatever reason, you will be able to go into the Historical Guidepost link to catch up with both the weekly guidepost and the 30 picks made for the week.

Greetings, fellow Pro-fundity team members.

Price Patterns

1. In the last lesson we closed the exit discussions with the volatility-triggered Trailing Stop. Moving ahead, to consider buying methods for highest possible return, we need to understand some principles of price patterns. This lesson will focus on three issues; 1) Why the price pattern moves around so, 2) How emotions help shape the price pattern, 3) Why this is important to us as we buy into positions (“So what?”).

2. Stock prices never move straight up or down for months without a correction. They move in jerks, at times boldly, other times timidly, with numerous corrections (pull-backs) in between. A price pattern is but a clue to the state of supply and demand in the stock. For example, when supply/demand is unbalanced, price will move to correct that imbalance… and it doesn’t take long. As a stock’s price moves to the height of its cycle, sellers move in to capture the profit, supplying shares. This reduces demand, causing the stock price to decrease. As the price decreases, buyers are attracted to these new lower prices, increasing the demand side. As they purchase shares at these low prices, fewer low price shares are available, increasing the demand. More demand, higher prices. And so it goes. (See the discussion of Supply & Demand in the Technical analysis section of our book, Provident Investing) This action creates cycles between highs and lows as shown for TRMB, one of this weeks main picks, in the following price chart.
   
   
   Fig. 1 Price cycles showing the changing Supply/Demand relationship.

3. We’ve drawn what are termed channel lines connecting the tops of the price swings and the bottoms. This introduces two important definitions:
   Support – The bottom of the channel where the price seems to be supported.
   Resistance – The top of the channel which seems to resist further price increase.

4. Important messages are sent when the price either drops through support or moves up through resistance. The channel lines drawn form an envelope around the price action giving us a measure of confidence where the near-term price might go. History does repeat itself in the movement of price patterns, just not with precision! Channel lines can be drawn on charting programs or they can be mentally noted. (TCNet has a “Drawing Tools” link for this purpose) They may be parallel, contrary to that shown in this example, and they may not extend to more than a couple of price cycles. In any event, they provide important reference inputs as we make trading decisions, particularly as we prepare to buy shares of a stock.

5. Support/resistance envelopes provide some stability to the seemingly random changes in stock price patterns. It is important to understand the psychology behind this action. Prices do not change because of the numbers of shares bought and sold. Remember, they must always be equal. Every share sold must be bought. A price rises because there are either more potential buyers than sellers or more enthusiastic buyers than sellers. Or both. Under such conditions, buyers tend to give concessions to sellers, thus bidding prices up. Prices fall because potential sellers outnumber potential buyers. Or because the sellers are more eager than the buyers. Or both. Then, it is the sellers who must compete to find buyers and who give the concessions, accepting less than they would like to get in return for their unwanted holdings, thus driving prices down. The reason price fluctuates is that one side, the seller or the buyer, blinks!

6. In any event, when a trade occurs, there is both a happy seller and a happy buyer. This is the only way market trades occur. When we say there are more buyers than sellers, we mean the tendency is toward the buy side (demand) and less on the sell side (supply). However, for a trade to occur, there must be both a buyer and a seller. This means the sellers will make more concession to execute a trade than the buyer. Are they both happy? The seller would be more happy with a higher price, but it was high enough to satisfy his need right now. Even if he thinks “okay, I’ll make it up on the next trade,” his perception of value was sufficient at that time to let the trade occur. In every trade, buyers would be happier with a lower price and sellers happier with a higher price, but at that point in time, the two parties agreed to the terms.

7. If nothing changed, we would have simple repeated cycles within channels, with the general trend moving up or down, depending on fundamental issues. This is complicated since there are multitudes of issues, considerations and perceptions that play out every day. For example, decisions by the Fed may change investor opinions and expectations causing hesitation, one way or the other. As well, how close company earnings come to analysts expectations will color the air for the perceived value of a stock. After all it is market perception of value that drives price and the supply/demand relationship. Accompany this with the fact that the real drivers of price are the institutional traders, who buy and sell in blocks of millions of dollars. They move money in and out of the market according to perceived company valuations. As a group (representing ¾’s of the market dollar), they move into and out of industry groups in cycles, driving group values up and or down accordingly.

8. The reason all of this works is there are literally millions of buyers & sellers in the wings looking for good deals, looking for an edge. That is “why” we have the market, a place for people, you and I, to exercise skills in getting ahead, bettering their (our) condition. Will some lose? Sure. That does not deter the masses from participating. And participate they do. So we have buyers and sellers, at the same time. Those who are buyers today may be sellers tomorrow, or even change mid-day. Or even buyers and sellers at the same time. Think about it. When we choose to enter the market, that means we’re ready to buy shares in a company. We start as buyers, later becoming sellers as we further increase our edge.

9. Market psychology deals with the human element in the trading scenario. People, you and I, are captive victims (participants) in this investment/trading market-place. We deal with human emotions (greed, fear, hope, joy, pride, stubbornness, ego, etc.) that affect how we act and react to market changes. Successful investors/traders use rational rules and objectives to guide their trades, not emotions. This is what we’ve been saying from the start, we must find a trading strategy, a method, that separates our emotions from the trading arena. Further, in our quest for trading success, learning about the market is critical, however learning as much about ourselves can tip the balance in our favor. You see, lasting success will come only when we find methods that fit our own objectives and personality.

10. The market is driven by human psychology. While dramatic changes have occurred in the market through the years, human psychology has not. Because of this constant in the trading equation, we will always see similarities in price patterns. It is these similarities that have given the trader a library of high probability patterns with expected outcomes. This fact becomes a critical trading tool, one we can use to help when buying shares of a stock. This application is the focus of this lesson.

11. During the last lesson we looked at examples of price charts that told us messages without any trading indicators. Only the price and volume were of interest. In fact, all the indicators we will study later are derived from the price/volume relationships. As we study entries in this lesson, lets consider some messages in price patterns, still using only price and volume. Look at another view of TRMB Fig.1 above, a closer view of the last two months trading activity.
    
    
    Fig. 2 TRMB price cycles.

12. This view shows a closer look at the price bars within the support and resistance channel lines. This is but one way price bars are shown. The following pictures show the options commonly used.
    
    
    
    

13. The examples we have shown are all open-bar, however there certain advantages of the Candlestick format, shown in the following comparison for TRMB.
    
    
    Fig. 3 TRMB price cycles in Candlestick format.

14. Notice how easy it is with candlesticks to quickly see the direction of price pressure, the six down-days in a row the first part of August, then sustained upward action following. This is just a convenience at this point, since the open-bar format of Fig. 2 contains the same information. It is not quite as easy to visualize. The next price chart illustrates a common occurrence within the price pattern as changes take place. Notice the channel envelope on this weekly chart for the first two quarters (January 03 to June 03).
    
    
    Fig. 4 Weekly IDN price cycles in open-bar format.

15. What you should notice in this price pattern is the breakout occurring in mid-July, where the price moved above the upper “resistance” channel line. This is an important event which we will discuss, but what I would like you to notice is what follows. The resistance channel line becomes the support channel line upon which the price now cycles. Does this always work? Often enough to provide helpful signals looking forward. Remember, historical patterns repeat, but not with precision.

16. In the next chart we look at “triangle” patterns, where the cycles decrease in size within channel lines. This first example (a Main Pick this week) shows an ascending triangle on a weekly chart covering two years, with the support and resistance channel lines drawn for the most recent 12 months. Triangles are generally consolidation patterns that break out either up or down. The “ascending” triangle usually moves up, as shown in this chart and generally provides an excellent profit opportunity. The black line parallel to the lower support line shows how far we might expect the price to rise following the breakout.
    
    
    Fig. 5 ARW price chart showing ascending triangle pattern.

17. An ascending triangle develops as demand grows, while the supply continues to be met at a certain price level. A closer look at the ARW breakout is shown next on the daily chart. This pattern does not show the ascending triangle opportunity we got on the weekly chart. Another reason we should always look at price patterns on more than one time frame.
    
    
    Fig. 6 Daily ARW price chart showing the breakout.

18. Figure 4 above showed a clear parallel Support/Resistance channel (envelope) with an upward trend. If we switch that picture to a daily chart we see a couple of things. First, what was the resistance line through June becomes the support line going forward. More importantly, we have a descending triangle the last two months. The descending triangle is formed with growing supply, while continuing to meet demand at a certain price level. Once the demand is exhausted, prices breakout of the pattern and move lower. For both descending and ascending triangles, the volume decreases as the channel narrows, with marked increases as the breakout occurs.
    
    
    Fig. 7 Daily IDN price chart showing a descending triangle.

19. We should watch the price action of IDN during the days ahead. This pattern is not a definitive descending triangle, since the support line slopes moderately upward. Such are most chart messages, never absolute, racked with uncertainty, providing at best clues to what follows. As we experience many examples, through continued study of chart patterns, our confidence will grow as will our success rate in taking action on market messages.

20. As a final point in this lesson, look at the price pattern in Fig. 7. The breakout in July looks very encouraging. What a move. We might be tempted to jump on board and take advantage of such strong momentum. However, when price has moved up so far so fast, it has reached a condition termed “overbought.” That means it has gotten ahead of itself, moving temporarily at an unsustainable rate. How do we know it is unsustainable? It is not necessary to find some fancy indicator to tell us that, we can see it. It has jumped from $7.00 to $11.50 in one months time. That is over a 60% increase! Let’s see, that would be annualized at 720%. It only takes a little common sense to know that rate cannot be sustained. So what? So, the price must decrease, it must correct and probably pretty soon. Stay away from that stock until it pulls back for a better entry price.

21. Last week (09/05/03) one of our breakout picks was VRSO, whose price pattern looked like the following on that Friday:
    
    
    Fig. 8 Daily VRSO price chart on Friday 9/5/03, when it was picked as a breakout candidate.

22. This price pattern was selected because of its strong upward move with increasing volume (along with its favorable fundamental strength). However, the price move represents an overbought condition. In fact, we bought the stock on 9/10/03 at $4.37, some 12% below the close on Friday of the pick. The point here is the importance of using common sense in our trading decisions. The reason for overbought conditions is this, too many eager buyers! That could be us if we get very emotional about shooting stars. In all cases, the Pro-fundity picks are not recommendations, but examples for us to ply our trade, to consider and to make rational choices.
    
    
    Fig. 9 Daily VRSO price chart showing the marker on 9/10/03 when we added it to our portfolio.

23. What have we learned or considered in this lesson:
    1. What makes stock prices increase or decrease.
    2. What an envelope channel is and how to use it as a guide for the normal cycling action of stock prices.
    3. The meaning of Support and Resistance in a price pattern.
    4. How market psychology provides repeating chart patterns to give us an edge as chart readers.
    5. The different methods of displaying price action: Bar, Open Bar, Line, and Candlestick.
    6. Triangle pattern analysis, ascending and descending.
    7. How Overbought and Oversold conditions are created and what it means to our trading action.

24. This is a heavily loaded lesson, with a lot to absorb. Your task this week is to study each chart pattern on this week’s picks; Main, Breakout, and Quick (10 each), plus the 100 optionable possible’s. That is 130 charts in all. Look for the patterns we have discussed in this lesson and flag at least five you believe are good buys. Then paper trade the five keeping close records of the price action. Additionally, watch the progress of the stocks featured in this lesson to see if the price action follows our script. Rather than a burdensome lesson task, this should become a default routine, studying at least 100 stock price patterns each day. It is this kind of effort that will fatten your wallet immeasurably. They guy who said this was easy just didn’t do it!
    09-12-03 Pick Selection:

    Main Picks:
    ARW,CCRD,CSTL,GGNS,GISX,IDN,MOVI,SIGM,TRMB,ZL
    Breakouts:
    ABAX,CAMD,CMNT,EFII,MENT,NVEC,PAL,QUIK,SWBD,SYXI
    QuickPicks:
    ACG,AZ,GIM,KSU,NFG,NUV,SDE,SIGM,VVC,WINS

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

    Be Diligent
    Take Action!

    

    
    
    
    
    

    
    If you have thoughts, suggestions, or comments, we would like to hear about them.
    Your e-mail address:
    
    Your comments:
    
    

    
    

    ---

    COPYRIGHT © 1998-2006 by Pro-fundity (sm). All Rights Reserved. No part of this work may be used or reproduced in any manner whatsoever without the written permission of Pro-fundity(sm). Pro-fundity(sm) is an independent research firm producing research reports based on many sources believed to be reliable. No guarantees are made as to the accuracy and completeness of the information. The information in this report does not constitute an offer nor solicitation to buy or sell securities. Information obtained via the use of this site should be coupled with the individual's personal due diligence in researching individual securities BEFORE purchase and the individual is advised to contact their broker or financial advisor before making any investment decision.

    Linked sites on the Pro-fundity web site, that are not under the control of Pro-fundity, are provided as a convenience only. The inclusion of a link does not imply endorsement of the linked site or its content by Pro-fundity.