The Stock Market Cash Flow Page 13

  Since we want to be in harmony with the trend, we need to be aware of when it changes. And technical analysis helps signal when the changes occur. Many people, however, get into the bad habit of thinking they can perfectly predict the future from patterns in the charts. They start saying, “I know this is going to happen.” But none of us can predict the future perfectly. A better way to think of using technical analysis is in terms of “likelihood.”

  By reading the charts, you are using information to help develop a strong idea of what is most likely to happen. But reading charts isn’t like a carnival fortuneteller who tells you that you will soon meet the man or woman of your dreams. It’s more like a weather forecaster who gives you the probability of whether or not it will rain tomorrow. The forecaster doesn’t predict the future. Instead, the forecaster informs us of what is likely to happen based on several metrics at his disposal.

  The Continuing Trend

  Let’s look at the story of ACME company again and, by following its chart, see if we can identify a point at which it’s likely for the trend to change direction:

  We can see in the figure above that after ACME backs off its high price, it reaches a new higher support level where investors feel it’s a good value for the price. They decide not to wait until it goes down to the previous bargain support level. They now see ACME as a bargain and they begin buying, forming a new and higher support level.

  As we can see from the previous rise in price, investors said “no” when it hit a certain price point. With this new upswing, the question we must ask ourselves is whether investors will continue buying through that previous resistance level or will they stop again.

  At this point, we don’t have enough information to make a good decision. We don’t yet know what’s likely to happen. Remember that an uptrend means a higher swing high in addition to the higher swing low. This is a situation where we wait for the market to show us what investors are thinking based upon how they act. Their buying or selling behavior will soon tell us the trend of the chart.

  We can see that investors have pushed the price of ACME through the resistance level. We can also see that this stock fits the criteria for an uptrend by hitting a new level that’s higher than the previous swing high. No matter where it meets a new resistance level, we’ll have a higher swing high, and we have also had a higher swing low. What we can say is that right now investors are buying it higher and right now they’re willing to push it to new levels.

  If we follow the trend, we would position ourselves to benefit from the continuation of that trend. You will enjoy profits as long as the trend continues. Of course, this uptrend could end at any time. The good news is that with technical analysis there are often warning signs to show us when the trend could change. The important thing is to have our eyes open to the reality of the situation as we wait for the right time to exit or change our position.

  When Does No Mean NO?

  Okay, we’ve been talking about a lot of complicated financial stuff, but let’s move to a really simple example because the financial world is just like the real world. The same psychology that drives our personal lives drives the business world—just on a larger scale.

  In my life, as you might guess, March is a very special month. It’s a month of brackets and excitement. It has been for as long as I can remember. But whereas March Madness used to mean running and jumping and burning off calories faster than I could get them into my body, these days it means my couch, my TV, and Ben & Jerry’s ice cream. That trio has become more than a habit for me, it’s become a hallowed tradition.

  I’d been trying to drop a few pounds for a while, and I’d enlisted my wife’s help. I knew I had to change my March Madness policy if I wanted to see my weight drop. But when she suggested I cut out Ben & Jerry’s, I thought, “Why don’t you stab me in the heart.” But after months of getting nowhere on my own with my weight loss, I’d promised to do what she suggested. My new policy was to listen to her. And even though I made the promise before I’d known the depths of depravity to which she’d sink (No Ben & Jerry’s during March Madness? Did she even love me?) I agreed to try.

  So we were sitting in our home theater—me and my boys and my wife—watching basketball, and all was right with my world except for the absence of Ben & Jerry’s. I decided to see if she would allow a small exception for a special occasion and let me cheat for just one day and have my ice cream.

  And she said “No.”

  But the number one rule of sales is to never take “No” for an answer, and I love sales, so I had a pitch ready. I said, “Aw, come on, please?” And I gave her my best sad eyes.

  To my surprise, she gave in said “Okay.” She said I’d been so good about sticking to my diet, and she understood my love of March Madness, and it was only once a year…so she totally caved.

  But it’d been so long since I’d had any ice cream, the whole carton was gone in less than 20 minutes. I just devoured it. We got to half time and the score was within a possession and I was out of Ben & Jerry’s. So I suggested I have some more.

  And she said ”No.”

  I tried my best puppy-dog please.

  Ah, the basketball gods were smiling. My wife said “Yes” again. But again I devoured the ice cream before the buzzer.

  The clock ran down. The score was tied. Overtime! And I was out of ice cream again. I decided to press my luck once more. This time my wife said “No, absolutely not, enough is enough!”

  If I were to chart my wife’s responses, you could see a pattern. She said “No” once and I pushed, and she gave in. She said “No” twice and I pushed, and she gave in. But when I asked that third time, she hit her limit and she dug in. She’d hit her level of very strong resistance. I knew not to ask again.

  People often react the same way to high prices.

  Now let’s look at an example where I’m the one saying “No.” Suppose my kids want to stay up past their regular bedtime. While I’m generally a pushover when it comes to my kids, I know they have little league practice early the next morning, so they’ll need a good night’s rest. When my boys beg me to stay up an extra hour, I gently tell them “No” and explain that they need their rest. Kids are notoriously good salespeople, and sometimes act as if they don’t know the meaning of the word no.

  After my initial “No,” the boys try again—and this time give their personal guarantee that they will get up early with smiling faces and be ready to go. Now I give them a more emphatic “No.” I still have a smile on my face to let them know I love them, but my tone makes it clear to them that they’re not going to change my decision.

  Let’s look at a chart to see how my sons’ agenda failed to advance not just once, but twice.

  When my sons run into resistance at the same level, it tells them that I’m ‘digging in’ and I am much less likely to change my feelings on the matter. The same is true with the market and the price investors will pay.

  So a technical analyst might not read too much into a single resistance point on a chart. But if we see resistance occurring at the same point more than once, it tells us that the market has reached a limit for the time being on what investors are willing to pay.

  The Double-Top Alert—Two “Nos” Are More Stubborn than One

  What happens when buyers backed off at the same resistance level? They have now resisted twice at the same level. Obviously, they are not willing to pay more than that for the stock. For whatever reason, the market does not see value at that price point. This is called a double top pattern.

  The story of a double top tells us that at the first resistance level, investors answered with a small “no” to the price at that level. After the price heads down and bounces back up again, this time the investors gave an emphatic “NO!” that shows they are serious about it. They are not interested in buying at that price. It’s possible, of course, that they could change their minds the next time the price heads to that resistance level. However, since we are using the informatio
n and our intelligence to determine the likelihood of a situation, we can be aware that it is now less likely that the stock will achieve a higher swing high in the near future.

  But does the double-top pattern by itself tell us that the trend is now going to change? No.

  Simply because buyers are saying “no” at a certain price point doesn’t mean the trend is changing downward. Again, it’s too soon to tell, but it does get our attention, and we certainly can see that a change is more likely. For this reason, a double-top pattern is an alert. Like a fire alarm, it does not guarantee a fire, but it makes us pay attention.

  This is a good example of how we can better understand the minds of investors purely through seeing what is happening on the price chart.

  Support Often Turns into Resistance

  Since stock charts are about the behavior of investors, watching what they do after a double top can be quite interesting. By nature, we all love falling prices. Psychologically, we think there is a deal waiting for us as the price drops lower. It’s no different in the stock market. In our example with the chart of ACME, we can imagine investors saying to themselves, “Wow, just a few days ago the price was up there. Today’s price is really cheap.”

  With the price falling below the previous support level, investors now have a very interesting situation in front of them. Typically, they would see a great buying opportunity and begin to buy shares of ACME at this apparently low price level. This, of course, would drive the price back up again. As it reaches the previous support level again, we call this point a little kiss. The question is, what kind of a kiss will it be? It could be a kiss goodbye, where it bounces off this old support level and it becomes a new resistance level. If this is the case, the price can drop again for a time.

  In the example above we can see a full-fledged kiss goodbye. This illustrates how the previous support line now becomes a level of resistance. Investors are unwilling to buy above this level and are saying “no.” When we see the support level becoming a new resistance level, it helps us see that the trend is truly changing.

  There is now a real downward pressure on ACME’s stock price. Investors are resisting that price level and, as a result, the price is falling. We have had a lower swing low followed by a lower swing high. Now we can decide to make money by positioning ourselves to profit from the downtrend.

  Again, let me stress that chart patterns cannot predict the future. A double top does not mean that the stock will continue to fall. It simply means people said “no” once, and then they said “no” a second time. A double top should get your attention as a warning alarm. It might be a false alarm, but it should at least make you watch the situation more closely.

  Suppose you saw the stock in an uptrend and were considering buying the stock to make a capital-gain profit on the increase in price. A double top should cause you to wait and see whether this was a false alarm. As an alert, it is helpful for reconsidering which direction the trend is really headed.

  At this point, it’s important to note that patterns like the double top for the kiss goodbye are merely the tip of the iceberg when it comes to learning about technical analysis.

  One of the challenges in writing any book is determining scope. Not only are entire books written on this topic alone, there are entire books written on single aspects of technical analysis. It’s less important at this point that you grasp the idea of a double-top pattern or a kiss-goodbye pattern. It’s more important to grasp the general idea that investors can look at a chart and better understand the minds and hearts of investors.

  You can imagine the incredible advantage you have as an investor when you can more fully understand what’s behind the markets. Whether you’re a real estate investor, a commodities investor, a business owner, or a stock investor, this is a skill that’s worth having. Earlier in this book we saw that the world economy is in pretty rough shape based on a basic fundamental analysis and the monetary policies and fiscal policies of the larger countries around the world. Our ability to read charts is what will help us see how all of this plays out in the markets.

  More Technical Chart Patterns

  Now that we understand a few technical analysis concepts such as double tops and support and resistance levels, let’s add a few more technical analysis tools we can use to make smarter investment decisions.

  My goal is to give you a quick introduction to these patterns that experienced investors use to create profits and steady cash flow for themselves in the market. As you add these patterns and tools to your vocabulary and personal knowledge base, you will be able to recognize them instantly in your own investing. Even more importantly, you will have a base you can build upon for further education in your journey toward investing proficiency.

  The Head and Shoulders

  As you can see from the chart above, this pattern looks somewhat like a person’s ‘head and shoulders’…with the head in the middle with a shoulder on each side. It’s a common pattern that frequently alerts us to a coming downward trend.

  On the next page is an example of a head and shoulders pattern that developed in the U.S. dollar. This chart represents an exchange-traded fund that tracks the value of the U.S. dollar against other currencies.

  Looking at the pattern, we can see where the markets have supported the price at the bottom of the pattern, and how they have resisted at the top of the left shoulder, then the top of the head, and then again at the top of the right shoulder. Then, when the investors said “no” to another test of the upper-shoulder level, the price broke below the support and investors sold heavily for a while.

  As the chart continues, we need to watch closely to understand the story it is telling us. Remember the rule:

  An uptrend is higher swing highs. A downtrend is lower swing lows.

  A head and shoulders pattern alerts us that a downtrend has become more likely. If the chart then shows us a lower swing low, that confirms our outlook.

  The Double Bottom

  Just as the double top can give us an early indication that an uptrend could be reversing soon, the double bottom alerts us to the possible end of a downtrend.

  And just as the double top looks like the capital letter ’M,’ the double bottom looks like a capital ’W,’ making it fairly easy to identify. Your response to a double bottom will be the opposite of the way you respond to a double top. This pattern shows the price has bounced back up twice from a support level. At this point, many professionals wait for confirmation that it will break through the resistance level. Once it has confirmed that the downward trend is reversing, they put in an order to buy, just above the resistance level.

  The Inverse Head and Shoulders

  This pattern, which is an upside-down head and shoulders, alerts us to a probable reversal in the downward trend. An inverse head and shoulders is typically a bullish pattern that would lead one to place an order to buy this stock when it breaks above the resistance.

  The Ascending Triangle

  The ascending triangle is neither an uptrend nor a sideways trend. We don’t have higher swing highs but we do see higher swing lows. Investors continue saying “no” in quick succession, but each time they do they are also saying “yes” at a higher level. The beautiful thing about a pattern like this is that it can’t go on forever.

  While the resistance level on top is holding steady, the support level below is pushing ever higher. That’s why the support trend line isn’t horizontal. Instead, we should be able to visualize a straight line with an upward slope. This represents the pressure cooker situation the stock is experiencing, and we are waiting for that pressure to shoot out the top.

  There is no guarantee here, as there never can be a guarantee with any price movements, but if I put an entry order to buy above the resistance level, I am losing nothing if it goes through the bottom, and I stand to gain a lot if it shoots through the top with all that energy behind it.

  When we get into cash flow, I’ll explain in more detail how we put in an order
to buy stock. For example, I could put in an entry just a little above that resistance line. If they say “no,” and it goes down and breaks through, I was never in the trade. But, if they say “yes “and it explodes, I catch it right there. Bam! And I like the idea that when someone has said “no” for so long, if they finally say “yes,” I’m in for the ride. Those are really fun to hit.

  Gold was a good example of a fun triangle to hit. You can see the ascending triangle on the left. The chart shows an exchange-traded fund that tracks gold at about 1/10th of its value (when gold is at $1,000 an ounce, the fund is at $100). Buyers kept saying “no” for a long time at $1,000 an ounce, but when that resistance eventually broke they were saying “yes” at ever-higher levels, and the resistance level rose rapidly. Bam!

  Much More You Can Learn

  There are many other technical chart patterns and indicators available to help us better understand what is happening on the charts. There is much more available to learn about candle patterns and even special indicators that have been created to use with your technical analysis. Of course, this book is designed to introduce technical analysis to beginner-level investors. Delving deeply into the full library of these tools is beyond the scope of our conversation in this book.

  For a more in-depth discussion of these indicators, you can request information on my in-depth online training programs at www.stockmarketcashflow.com

  We’ve covered a lot of ground in this chapter. We learned some new concepts and ways to understand what happens to a stock price in the market.

  Remember, we can’t control which direction the markets go. But we can intelligently monitor them and watch for the patterns that can alert us to possible changes in the market.

  Why is learning about fundamentals and technicals so important? Because it’s the process of gathering information for our investing. Now that we know ways to gather and analyze this information, we’re ready to make money with it. We’re ready to learn how to generate cash flow from the market.