Stock Trading
Handbook
STOCK TRADING
HANDBOOK
NOTICE
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SETTING THE STRATEGY
TABLE OF CONTENTS
What Should I Do Before I Start Trading....................................................................1
Step One: Maintain Discipline..........................................................................................1
Step Two: Learn Basic Technical Analysis......................................................................1
Step Three: Become Familiar with Trade with at Least One Trade Setup......................2
Step Four: Practice with Virtual Trading.........................................................................3
2) Is There Only One Way to Trade?...........................................................................3
3) What Is Technical Analysis?...................................................................................4
4) Why Do Traders Believe In Technical Analysis......................................................5
5) What Is a Watch List?.............................................................................................6
Why Ignoring a Watchlist Can Be a Mistake for New Traders........................................7
Day One: The Trader Adds Company XYZ and Company ZYX..........................................7
Day Two: The Trader Adds Company ABC and CBA........................................................8
6) What is Fundamental Analysis?.............................................................................8
7) What Are Exchanges and Indexes?........................................................................9
8) What Are Industries and Sectors?.......................................................................10
9) What Is Day Trading?...........................................................................................10
10) What Is Swing Trading?......................................................................................11
11) What Are Earnings?...........................................................................................11
Why Consensus Earnings Estimates Matter.................................................................12
The Quarterly Earnings Report.....................................................................................12
Earnings and Your Trading............................................................................................13
12) What Are Candlesticks?.....................................................................................14
Bar Charts......................................................................................................................14
Line Charts....................................................................................................................15
The Origin of Candlesticks.............................................................................................16
Candles Lighting the Way..............................................................................................17
13) Why Use Different Time Frames and Which One is Best for Me?.....................18
14) What is the Difference Between a Market, Limit, and Stop Order?..................19
15) What Are Trends?...............................................................................................20
Trends - Understanding the How and Why....................................................................21
Going Beyond That It Works..........................................................................................22
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STOCK TRADING HANDBOOK
WHAT SHOULD I DO BEFORE I START TRADING?
Becoming a professional trader has many attractive advantages. New technology allows the
modern-day trader to work from just about anywhere. Whether it is from the comfort of your
home or a coffee shop, you can access the stocks you are following or research information
necessary to make proper decisions. Trading also doesn’t require an excessive amount of
capital to start with. While you won’t be able to quit your day job on a $1,000 account, small
initial investments are attractive to an individual just getting their feet wet.
Regardless of your ambition – to manage your current holdings, to provide supplementary
income, or to quit your day job to eventually trade professionally – there are several areas
that need to be mastered before you place your first trade.
Step One: Maintain Discipline
If you are not a disciplined individual or have the mental state to maintain it, you should
never consider starting down the trading road. At best, you will spend your time spinning
your wheels, giving away in a day profits that you spent weeks earning. At worst, you will tear
through your investment cash leaving yourself in a financially precarious position.
Trading can be successful if one follows the rules and guidelines. There have been countless
times a trade has gone bad because a trader went with their gut or decided to make an
exception to their trading rules. Develop a passion for becoming a disciplined trader. Find
delight in passing on trade after trade that does not fit your technical criteria. You might have
no idea at this point what your technical criteria will be, but you will learn how crucial it is to
follow it.
Nothing you learn or do will ever be as important as mastering this first step. Successful
trading is simply about maximizing probability and discipline is the cornerstone of this
process.
Step Two: Learn Basic Technical Analysis
Almost every trade you ever make will be based on the technical reading of a chart. While
there are intermediate and advanced technical skills that you will eventually learn that will
help maximize the probability of a winning trade, understanding the basic tenets of technical
analysis is essential. Without this mastery, your chances of becoming a successful trader
are low.
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Here is a starting list of items to master for the beginning trader:
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Candlesticks: Most charts will have candlesticks that represent the movement of a stock
for the given time. These candlesticks will represent the high, low, open, close, and
amount of volatility for any given day. When combined in a pattern, these candlesticks
can give additional information. However, at first concentrate on learning to read what a
candlestick tells you. This should become instinctive with a little practice.
•
Trends: There is an old and often used saying among traders, “the trend is your friend.”
Trends give you valuable information about which direction the stock has been going,
and increase your probability of a winning trade. You need to easily identify whether a
particular stock is in an uptrend, downtrend, or trading sideways.
•
Support and Resistance: Support is the price point where selling momentum has been
exhausted, and buyers attracted by the perceived undervalued price step in and start
buying up shares driving the price higher. Conversely, resistance is the price point where
buying momentum has been exhausted, and new buyers are not willing to pay that high
of a price. Being able to identify support and resistance points is critical as many of your
trade setups will be based on this.
Step Three: Become Familiar with a Trade with at Least One Trade Setup
After becoming familiar with the basics of technical analysis, you can start practicing when
to enter a trade. There are numerous trade setups that occur, but trying to learn them all at
once can be overwhelming. I suggest starting with one setup and mastering the basic tenets.
With time, you can add other setups to your skill set.
An easy trade setup to learn is the bullish breakout. During this setup, the stock is in an
uptrend, selling pressure is not enough to push price lower, and the price of the stock is close
to reaching the resistance (the high point) of the stock. The old resistance, once broken, can
provide new support and a nice gain if entered now with a lower risk as you simply exit the
trade if the stock falls below the old resistance point.
A simple checklist can be created for this trade setup. This list will become more
comprehensive as you expand your knowledge of technical analysis:
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Is the stock in an uptrend?
Has the stock broken resistance?
Is there any resistance to interfere with the breakout?
Are the candle/pivot lows getting higher as price approaches resistance?
STOCK TRADING HANDBOOK
Please note, this is simply a sample list to start becoming familiar with the basics of this
trade. There are many things to add to this list before executing an actual trade with this
setup. This is a good starting point for practicing.
Step Four: Practice with Virtual Trading
While every new trader is excited for their first live trade, one should first hone their skills in
the virtual world. Virtual trading is available through most online brokers at no charge and
is an invaluable aid for the beginner. Virtual trading allows you to practice your order entry,
and placing triggers and targets. Your trigger is simply the price point at which you enter the
trade. In simple terms, for the breakout trade setup explained above, this would be the point
where the price of the stock broke through the old high (resistance). The target is in basic
terms the point you anticipate the stock to reach. For a starter, I recommend basing this on a
reward/risk of 1 to 1.
You can calculate the reward/risk by setting the point at which you are going to exit the stock.
Let’s use an example to illustrate this. Let’s assume that you are using a breakout strategy
and the stock’s high (resistance) is $100. Our trigger would be when the stock breaks through
that $100 barrier, so let’s use $101 as the trigger. If we set our target at $102.50 and our
point where we exit the trade at $99.50, then we have a potential reward of $1.50 and a risk
of $1.50 per share, giving us a 1 to 1 ratio. While this is overly simplistic for an actual trade as
other variables are to be considered, using these simple formulas can be of great practice for
someone trying to learn the nuts and bolts at the beginning.
The main point to take from this is that virtual trading can provide you invaluable experience
at no risk. You can practice learning your skills in a simulated environment without going
through the school of hard knocks. The life of a trader can be an exciting and rewarding
world.
2) Is There Only One Correct Way to Trade?
The variety of ways one can approach trading can cause new traders a great deal of
frustration. It is a very common hope amongst new traders that they will be taught the
“universally accepted can’t fail method of trading.” Most new traders want there to be only
one correct way to trade. They hope that after they put in the time and effort to learn that
superior method trading simply will become easy. At this point they can simply repeat the
process time and time again until financial success is ensured.
Once new traders come to the realization that there are multiple roads to success they
naturally want to seek out the “best” one. Rarely do they ask the most important questions:
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what is the best path for me? What are the strategies and techniques given the capital and/or
time restraints that I face? Their inexperience all too often leads them down a path of wasted
time and missed opportunity.
To maximize your trading experience, here are a few rules, guidelines, and truisms for you to
remember as a new trader:
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There is no Holy Grail system or infallible technical indicator waiting to be found. You will
have better luck searching for Atlantis than a fail proof system. Markets in part move in
price based on human emotion and unpredictable events. Because of this simple fact
trading will never be an exact science.
•
Even though trading is not an exact science, you can take comfort in the fact that
probability will work in your favor as a trader. While any unexpected event may occur, as
a student you will be taught numerous high probability trade setups, strategies, and even
system trades. Once understood and properly executed these can lead to situations with
high probability outcomes.
•
While there is no singular “best” system or strategy out there, you CAN become
successful by choosing to simply become adept at a singular strategy or trading system.
While the hardcore trader will attempt to become a master at everything, many students
simply do not have an abundance of time due to work and family restraints. While they
do not have all the time in the world, these students are still passionate about achieving
financial success and escaping the Rat Race.
•
At first, even the student/trader with ample time on their hands should attempt to narrow
their learning to a few strategies and techniques. After developing expertise in these
initial areas, they can continually broaden their horizons by learning more strategies,
adding additional techniques, and refining their approach to trading.
•
As you start off with any new strategy or system, virtual trading should be used. Virtual
trading can help you understand order entry and help you gain valuable experience
without having beginner mistakes impact your bottom line.
3) What Is Technical Analysis?
Many would say that technical analysis not only answers the question of what one should
buy, but also excels in identifying when one should buy it. Technical analysis is the practice
of assessing current and past price action to forecast future price direction. Those utilizing
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STOCK TRADING HANDBOOK
technical analysis can be referred to as chartists, as their primary focus involves analyzing
charts. The price action consists of the trend, momentum, and support or resistance levels
within the price chart. Next to price action, volume is another quintessential tool used by
chartists. In addition to price action and volume, there are hundreds of secondary indicators
that are used, such as moving averages, stochastic and MACD to name a few. It is important
to realize that while it is impossible to predict future price movement, it is possible to gauge
the probability of the price moving in a certain direction.
Within the financial markets there is always a certain degree of uncertainty. Thus, rather than
speaking of trading as a world of certainty, we refer to it as a world of probabilities. Chartists
use tools to assess the likelihood of an upward or downward move in price occurring. If
based on their technical analysis they decide there is a high probability that the stock will
rise, they may start buying stock. Conversely, if based on their analysis they decide there is
a high probability of a downward move in price, they may sell short stock to profit from the
expected fall in price.
4) Why Do Traders Believe in Technical Analysis?
Few new traders take the time to think through the underlying belief structure that is governing
their trades as they simply become excited about making money through technical analysis and
take that proverbial leap of faith. This type of trader is more likely to break the rules of technical
analysis, go on hunches instead of trade setups, and eventually stop trading altogether when
their short trading life doesn’t work out. The first step in avoiding that fate is to develop a belief
system that serves as the foundation of your trading system, as discussed in the last Rich Dad
Education article.
Working with a basic definition of technical analysis being “Analysis of past price changes in
the hope of forecasting future price changes,” our quest becomes to decide why we believe that
past price changes can give us some insight into where the price of a stock might be heading.
As you form your own belief system, here are a few points to consider that other technicians
believe:
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Technical analysts believe price moves in trends over periods of time. This is perhaps the
oldest tenet of technical analysis going back to DOW Theory. The trends that are created
can last for weeks, months, or sometimes years. Trends last in part due to investors
receiving information at different times but also in part due to the irrational nature of
investors. The greed and fear that oftentimes encompass the individual traders in the
market can send a stock soaring up or crashing down for prolonged time periods.
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•
Investor behavior repeats itself often and when it does, predictable patterns will develop
on a chart. For example, a stock might go up to $100 and then sell off. A week later it
goes up to $100 and then sells off again. Technicians believe supply and demand is in
effect here, but what is creating the supply and demand at $100 is not the stock’s true
worth but how investors and traders behave at that price point. The motivation for the
investor or trader may vary but the net result of the behavior in this example is that more
supply than demand is created at this price point, and consequently that stock sells off in
the short term.
•
The market is full of both rational and irrational people, but both affect supply and
demand and thus help create trading opportunities. Let’s take the example of a stock
approaching $100 again. As the stock approaches $100, an irrational person might sell
due to the psychological barrier that $100 presents to the person. The rational person
might also sell and take a short-term profit due to the examination of past price action
(how the stock has behaved at that price level). When the stock breaks out of $100 (when
the price finally starts climbing above $100), the irrational person might jump on board
at $110, $120, and $130 as the trend continues thinking that the stock can do no wrong.
The rational person¾through examination of the trend or price data¾may enter the trade
based on the development of a new trend or knowing that once the psychological barrier
was broken that tremendous upside now exists in the stock.
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If you believe in these principles, then when you look at a chart you don’t simply see
numbers or symbols. When you look at a chart you see the full range of human emotions
in effect over the past action of the price chart. You see times where greed took over and
took the stock to new highs. You see other times where fear took over and sent the stock
crashing down. You see times when a stock hit certain points and just struggled to climb
any farther, and other times where a stock seemed to hit a bottom and a floor formed.
•
Once these principles are set, a wide variety of technical indicators can be used in
combination with other signals, chart patterns, and indicators to produce trading signals.
These signals will be your green light to enter trades and red light signaling it is time to
exit. They will help guide your decision making and provide a framework to trade within.
5) What is a Watch List?
In the beginning stages of a new trader’s venture into the trading world, one of the last things
on their mind is developing a watch list of stocks to follow. Between learning terminology,
trading platforms, basic technical analysis, scans and so forth, there is enough on a novice
trader’s plate to keep them occupied. Along with this information overload, most new traders
are primarily focused on making those first few successful trades and getting in the action.
Because of these factors the development of a watch list is often ignored, which can be a subtle
mistake that many new traders make.
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STOCK TRADING HANDBOOK
A watch list is simply a list of stocks that you are watching or following. These stocks are
followed with the intention of becoming familiar with them so that if a high probability trade
setup starts to develop on one of the stocks, a trader will not miss out on this opportunity. This
list can be stored on trading software, a spreadsheet, or even handwritten on a notepad if that
is a trader’s preference. Where the information is stored is not important. What is important
is that the list is used and that the stocks and notes you have on the stocks can easily be
accessed.
Why Ignoring a Watch List Can Be a Mistake for New Traders
Every new trader wants their first trade to be a success. Naturally, most new traders also
want to place their first trade as quickly as possible. These two goals can sometimes come
into conflict. For example, in a new trader’s haste they sometimes make questionable trades
due to the anxiousness of getting into the trading game. In their impatience to place that first
trade, a new trader will run a scan or go through a few stock charts until they find a trade
setup that looks “good enough” and they then place their trade. This impatience can lead to
placing a questionable trade and getting their trading career off to an ominous start.
Creating a watch list during this process does not magically give the new trader more
patience; however it can add a little methodical behavior that can benefit the new trader. For
example, let’s assume that a new trader is starting from scratch. They have acquired a basic
education on stocks and are starting the process of looking for trade setups. They decide to
put two new stocks on their watch list each day until they feel they have the right balance of
stocks to follow.
Day One: The Trader Adds Company XYZ and Company ZYX
During their daily routine the trader adds these two stocks to their watch list. They take the
time to look at the stock’s history, examine the patterns that have developed over time, study
how the stock behaved, and look for current potential trade setups. In this example, on day
one with just two stocks to look at, it is unlikely that the new trader will find a high probability
trade setup that is occurring. However, the trader’s time has been well invested as they
have become very familiar with two stocks. Perhaps even more importantly, the new trader
could apply some of the education or training they acquired through the mental exercise of
examining past trade setups of the company. They might understand the concepts of support,
resistance, trends, pullbacks, breakouts, etc. But being able to identify them easily on a chart
is part of the learning curve that every new trader must go through.
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Day Two: The Trader Adds Company ABC and CBA
During day two the trader adds two more stocks to their watch list. They go through the same
process that they did the day before in studying the history of the stock chart, attempting to identify
past trade setups, and then determining if there are any current trade setups worth trading. In this
example, the trader does not find a viable trade setup on either of the stocks. The trader then looks
at the two stocks from the previous day to see if any new trade setups had developed. Where the
process of examining and becoming familiar with these two stocks might have taken hours the day
before, to the new trader’s surprise it only takes a few minutes to examine the two stocks for new
trade setups on day two.
In the same amount of time, on day two the new trader could examine four stocks instead of two.
They could gain invaluable experience studying charts and attempting to identify concepts on the
stock charts they have chosen. While no actual trades may have been placed, the time put into
studying these charts and slowly developing the watch list can have a tremendous payoff down the
road.
If this new trader adds one or two new stocks each subsequent day, then they will continue to
receive all of the practical educational experience of studying the charts. Over time they will find a
high-quality trade to place a setup on and will be in a much better position than a new trader who
simply hurries to place a trade. Almost as a side bonus, once they place this trade they have the
start to a developed watch list of stocks that they have become familiar with!
Tips for Beginners Building Their Watch List
•
There is no correct size to a trader’s watch list. Some expert traders only have a few
stocks on their watch list while others have hundreds.
•
A watch list should not expand beyond your ability to properly manage and go through it. If
it starts to feel like a chore then it might be too big.
•
There is no right or wrong reason for a stock to find its way onto your watch list.
•
A trader can still use daily scans as a means to supplement potential trade setups or use
their watch list as a means to supplement scanning if that is the trader’s preference.
6) What Is Fundamental Analysis?
Fundamental analysis is the practice of assessing a company’s current financial condition
and future growth potential. Fundamental analysts use a myriad of metrics, such as P/E ratio
(price to earnings ratio), ROE (return on equity), PEG ratio, earnings per share, growth rate,
and others, to determine the fair value of a company’s stock price. According to Investopedia,
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STOCK TRADING HANDBOOK
“The end goal of performing fundamental analysis is to produce a value that an investor can
compare with the security’s current price in hopes of figuring out what sort of position to take
with that security.”
If based on your analysis you deem the stock to be undervalued (too cheap), then you would
buy the stock. On the other hand, if you deem the stock to be overvalued (too expensive), then
you would probably sell or sell short the stock. It seems logical that companies with minimal
debt, consistent earnings, and enormous growth potential should experience a rise in their
stock price over time. Conversely, companies that are laden with debt, have a poor earnings
record, and have no potential for growth will probably see their stock price decline over time.
Thus, a trader who utilizes fundamental analysis sifts through the thousands of publicly
traded companies to find those that are fundamentally sound and poised for growth.
7)
What Are Exchanges and Indexes?
An exchange is simply an institution, organization, or association that hosts a market where
stocks and other financial instruments are traded. Exchanges impose rules and regulations
on the firms and brokers that are involved with them. If a company is traded on an exchange,
it is referred to as listed.
Some examples of U.S. exchanges are:
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•
•
•
•
NYSE
NASDAQ
Chicago Board of Options Exchange
Pacific Exchange
American Exchange
An index is simply a list of stocks that the chosen index chooses to incorporate. Some of the
more popular indexes followed are:
•
•
•
Standard & Poor’s 500 (S&P 500, Spiders SPY): 500 of the most influential companies in
the U.S. economy
Nasdaq Composite (Q’s QQQQ): consists primarily of technology-based companies
Dow Jones Industrial Average (Dow 30, Diamonds DIA): comprised of 30 of the largest
cap stocks
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8) What Are Industries and Sectors?
These two terms are often used interchangeably by traders. They are normally used to
describe companies that are similar in their type of business. While this is basically true, the
main difference between the two is a difference in scope.
Sector – Refers to broad areas of the economy. Examples of sectors include:
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•
•
•
•
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Basic Materials
Capital Goods
Communication
Energy
Financial
Healthcare
Technology
Transportation
Industry – Refers to a specific group of companies that are very similar in nature. For
example, within the basic materials sector you will find the following industries:
•
•
•
•
•
•
Agricultural Chemicals
Aluminum
Copper
Gold
Oil and Gas Drilling and Exploration
Oil and Gas Equipment and Services
Some traders focus on one industry at the start so they can become very familiar with it,
including its main companies as well as related news.
9) What Is Day Trading?
The public often categorizes anyone who trades short-term under the broad classification of
day trader. Technically, a day trader is someone who buys and sells stock while the market
is open. A day trader generally closes out all its positions by the time the closing bell rings.
Where buy and hold traders look at longer term trends and use fundamental analysis, day
traders use a variety of short-term tools to help determine when optimal entry and exit points
are during the course of a given day.
Day trading generally requires a large amount of capital, discipline, and available time to
become successful. Still, the failure rate at day trading is extremely high due to the stress
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STOCK TRADING HANDBOOK
and swings (both emotional and financial) that it can create. However, those that do succeed
at day trading swear by it and could not envision making a living any other way.
10) What Is Swing Trading?
Sometimes traders debate the definition of a swing trade. Sometimes they try and pigeonhole
it into a certain time frame, which is nonsensical. A swing trader uses a variety of tools to
help determine the movement of a stock. When they enter a trade, they do so with the intent
of exiting the trade once they have been given signals that the direction of the stock is going
to change or when other set criteria have occurred. The trader may be given these signals
to exit their trade in a few days, but they may not be given signals to exit for weeks or even
months. The intent is simply to enter and exit their trades at optimal times. How long this can
take can vary.
Swing trading has become very popular amongst new traders who cannot stare at a computer
screen all day due to their work or other responsibilities. They can place automated trades
after hours and go about their day. If one of the goals of a new trader is to become a full-time
trader for a living, then swing trading can be a wonderful place to enter the world of trading.
You might like it so much you might decide to stay.
11) What Are Earnings?
When you were in school as a child you received a report card. This report card measured
your academic success during the time period in question. Each quarter publicly traded
companies issue a quarterly earnings report, which is their version of a report card. This
report is designed to let shareholders, as well as potential investors, know how well the
company performed over the time period in question.
On the quarterly earnings report, a slew of financial information is released for investors to
analyze. Among this information are the earnings per share (EPS), net revenue, and potential
changes in guidance for upcoming quarters or fiscal years. While this quarterly earnings
report is not as straightforward as the report cards you received as a child, there are some
parallels.
When children bring home their report cards, parents are likely to have certain expectations.
One child may receive an A-minus in math that slightly disappoints parents who had been
expecting an A. Another child’s parents may be delighted with a B when they had been
expecting a lower grade. The market’s reaction to company’s earnings reports is very similar.
Certain expectations are held by analysts and if those expectations are exceeded, then
the market often reacts very favorably. However, if those expectations fall short, then the
market’s reaction may be swift and furious.
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Market Expectations
The market’s expectations of what a company will report on their earnings report is covered
by the term consensus earnings estimate. Analysts are constantly measuring the financial
data of a company to attempt to determine the proper valuation for the stock of that company.
Because analysts cannot determine the company’s current worth simply by looking in the
rear view mirror at past performance, they attempt to determine what the future earnings
of the company will be. These forecasts are used to calculate what they feel should be the
appropriate current price for the stock. These future estimates are made for future quarters
and upcoming fiscal years for the company.
Numerous brokerage firms hire countless analysts to help make these forecasts on what
companies will earn in the coming quarters and years. The consensus earnings estimate is
normally the average of all the individual forecasts of analysts covering the stock. Several
separate companies compile this data from individual analysts and the consensus earnings
estimate is calculated. When you go to any popular financial website you will see this
consensus number, and whether it has been recently revised upwards or downwards.
Why Consensus Earnings Estimates Matter
There are thousands of publicly traded companies and few professional mutual fund
managers, let alone your average investor, have time to sift through the financials of every
company. The consensus of analysts is used as a type of shortcut for professional and active
individual investors in making their investing decisions. This does not mean that professional
analysts are always correct as they are far from perfect, but in an imperfect world they are
viewed by many as the quickest way to accurately determine what future earnings will be and
how the company will perform in upcoming years.
The Quarterly Earnings Report
Heading into the release of each quarterly report for a company, the market estimates\ what
that quarterly report will look like. It will have estimates on what it predicts the company’s
earnings per share and revenue will be. It may look something like this on a financial website:
Company XYZ
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Q4 EPS estimate $0.30
Q4 Revenue estimate $741M
When the actual results come out you may see something like this:
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Q4 EPS of $0.27 misses by $0.03
Revenue of $731M (+9% Y/Y) misses by $10M
STOCK TRADING HANDBOOK
or
• Q4 EPS of $0.35 beats by $0.05
• Revenue of $761M (+9% Y/Y) beats by $20M
These are the raw numbers for that quarter and the results can greatly impact the immediate
price of the stock. Most of the time a company will issue their quarterly report before or after
normal market hours and you will often see that the stock gaps up or down before the market
opens based on the results and reaction to the report. It is well worth noting how the market
reacts to the quarterly earnings report is never as simple as whether the company beats its
EPS estimate. Analysts and investors often react to what future guidance the company gives
for upcoming quarters and years when issuing the report.
For example, if as a parent you were expecting an A-minus and your child brings home an A
then you will be excited. If in addition, the child says that based on work already done they
are expecting an A for the next couple of semesters, then as a parent you are extremely
excited. The market behaves similarly, if a company not only exceeds expectations but offers
wonderful guidance for the future, then a surge in the stock price will likely occur.
On the contrary, if as a parent you were expecting an A-minus and your child brings home an
A-minus but tells you that it looks like they might deliver B work for the coming year, you are
going to be disappointed. Remember, the market is always attempting to determine what the
future price of the stock will be worth and lowered guidance from companies usually results
in at least a short-term price correction.
Earnings and Your Trading
Because of the impact earnings reports can have on the price of a stock, many traders
develop rules that prohibit them from holding positions through a company’s earnings
report. An at-the-money call bought on a company that misses earnings can quickly become
worthless, regardless of whether a stop-loss was put in place. Remember that companies
often report their earnings after hours which can result in the gap in the price of the stock,
which your stop-loss will not protect. Some traders also use strategies that can maximize the
volatility surrounding earnings.
Whatever your approach to trading is, you should always be aware of the earnings report date
of the stocks you are following. This date can easily be found on numerous financial sites by
searching for the company you are interested in. Awareness of this date can help you manage
your positions before earnings and help you determine through technical analysis if a new
trend is likely to develop because of the earnings report.
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12)
What Are Candlesticks?
If you have ever ventured into the trading arena, the odds are good that you have been
exposed to price charts. Although they come in all shapes and sizes, price charts are the
crux of technical analysis and should be considered the most important weapon within a
technician’s arsenal. Trading without them is akin to entering a gun fight with a butter knife –
a virtual act of suicide, unless you are Chuck Norris.
Although traders often add secondary indicators, such as Stochastic, MACD, RSI, volume,
moving averages, and Fibonacci retracements, price action outranks them all. Within the
technical analysis university, price and price alone stands out as the big man on campus.
Throughout the years, there have been various methods used to chart the price of any
security. Nowadays, bar, line, and candlestick charts are the most prevalent.
Bar Charts
Bar charts, also known as Western bar charts or OHLC charts, display the open, high, low,
and close of the price over a certain period of time (see figure 1).
Figure 1
High
High
Close
Open
Open
Low
Low
Close
As depicted in figure 1, the bottom of the vertical bar represents the lowest price at which the
security traded during that time frame, and the top of the vertical bar represents the highest
price at which the security traded during that time frame. The horizontal line on the left side
of the bar indicates the opening price, and the horizontal line on the right side represents the
closing price.
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STOCK TRADING HANDBOOK
Figure 2
Within the daily bar chart, it is easy to see the highs and lows of each day and the overall
uptrend in the stock price (refer to figure 2). This can be considered one of the fortes of the
bar chart. However, trying to determine what exactly went on intraday based off the open
and the close is a bit more difficult. The lines representing the open and close are not very
pronounced, and require the trader to spend time and effort focusing on each bar to ascertain
that information. These are disadvantages that candlesticks improve upon.
Line Charts
Line charts are perhaps the simplest charts available to market technicians. They are usually
constructed by connecting the closing price of each successive time period, resulting in a
continuous line reflecting the price action of a security. Due to its simplistic nature, it is quite
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easy for any onlooker to see the overall trend of the stock. For example, take a look at the
line chart in figure 3. What is the trend of the stock: up, down, or sideways? Undoubtedly, the
trend is up! This is cleanly displayed by the ascending line forming successively higher peaks
and valleys.
Figure 3
The Origin of Candlesticks
The candlesticks chart has an interesting history. Munehisa Homma is widely lauded as an
early pioneer in technical analysis and the father of the candlestick chart. Born in Japan in
1724 to a wealthy rice-farming family, Munehisa grew up intimately familiar with the rice
market and the various factors that influenced its price, such as weather, superstitions, and
emotions. He eventually began trading in the rice futures market using his unique method
of tracking rice prices through candlesticks. His method gave him a distinct edge over his
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STOCK TRADING HANDBOOK
competitors in forecasting the future prices of rice. In fact, his candlestick charting was so
revolutionary and effective that he amassed a fortune, became a financial consultant to the
government, and later received the prestigious title of honorary samurai. Today’s candlestick
charts can be considered direct descendants of the charting methods and philosophies
introduced by Munehisa.
Candles Lighting the Way
Candlesticks improve upon line and bar charts by displaying an enhanced view of the price
action. This enhanced display helps in making quicker, more informed decisions. Candlestick
patterns have been found to be quite reliable over time by giving insight into what is likely to
happen in the future. This can give traders a slight edge in their trading decisions. Refer to
the candlestick chart displayed in figure 4.
Figure 4
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Candlesticks, along with line and bar charts, can be viewed on any time frame. Within
most charting software, one can view as small a window as a one-minute price chart (each
candle represents one minute), or as large a window as a monthly price chart (each candle
represents one month). Like the bar chart, candles display the open, high, low, and close of
each trading period. However, candles give a more visually enhanced view of the price action.
13) Why Use Different Time Frames and Which One Is Best for Me?
Let’s first tackle the question of why traders use different time frames. When we look at the
aggregate of stock market participants, we see investors, position traders, swing traders,
day traders, and scalpers. Each one of these traders bases their decisions off different
time frames, primarily because the duration of their trades will be different. For example,
investors, having a long-term horizon, may focus primarily on weekly or monthly charts.
On the other hand, day traders may focus on hourly and minute charts. Larger time frames
simply display the price of smaller time frames in a more compressed manner. For example,
one candle on a monthly chart represents four weekly candles; one candle on a weekly chart
represents five daily candles.
Although most traders typically use one-time frame, a few use multiple time frames to
provide additional insights into the development of price patterns, which enables them to
gauge the sentiment of different groups of traders simultaneously. The best price patterns
are confirmed in multiple time frames. Each style of trading should implement three different
time frames: main, longer-term, and shorter-term. For swing trading, the main time frame
would be a daily chart, the longer-term time frame would be weekly, and the shorter-term
would be an hourly or minute chart.
Here are a few tips for properly using multiple time frames:
1. Don’t trade against the trend in the longer-term chart. If the weekly chart is in a
downtrend and close to resistance, buying a bullish retracement on the daily chart would
have lower odds of being successful.
2. The smaller-term chart could be used to:
a. Improve the entry threshold. If the main time frame shows a bullish retracement setup,
drop down to the hourly chart to find a proper bullish pattern confirming the start of the
bounce suggested by the daily chart.
b. Manage the swing trade. The hourly chart will show weakness or strength quicker than
the daily chart, providing quicker signals for exiting the trade.
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STOCK TRADING HANDBOOK
The second part of your question asked which time frame is best for you. The answer: it
depends on what style of trading you focus on. As mentioned above, if you primarily swing
trade, then the daily chart is probably your main time frame, the weekly serving as the larger
time frame and the hourly as the smaller time frame. If you are day trading, then perhaps
the five-minute chart should serve as your main time frame, with the 30-minute chart being
the larger time frame, and the two-minute chart acting as the smaller time frame. It really
comes down to personal preference.
14) What Is the Difference Between a Market, Limit, and Stop Order?
It’s important to remember that an order can either be a buy or sell order. Thus, there are
both buy and sell market, limit, and stop orders. Furthermore, some brokers have separate
orders for shorting: sell short and buy to cover. Just remember, if you enter a trade with a
buy order, then it will be exited with a sell order. If you enter a trade with a sell (or sell-short)
order, then it will be exited with a buy (or buy-to-cover) order. Generally, after selecting
whether you want to buy or sell a stock, you then select what type of order you want to enter.
The market, limit, and stop orders are the three most common types of orders most brokers
offer. Let’s review the definition of each one:
Market order: A market order is an order to buy or sell at the best available current price.
Market orders will always get filled, but not necessarily at the exact price you want. Those
that use market orders simply want in (or out) of the market NOW, and don’t mind if they get
filled at a price worse than expected. I would recommend not using market orders on low
volume stocks or after hours as the stock may gap up or down significantly the next day prior
to your order getting filled.
Limit Order: A limit order is an order to buy or sell at a specific price or better. Generally, if
you want to buy a stock at the current price or at a lower price you would use a limit order.
For example, if stock XYZ was trading at $50 and I wanted to buy it if it dropped to $49, I could
place a buy limit order at $49. This would ensure that I don’t buy the stock unless it is at $49
or less. On the other hand, if I wanted to sell stock XYZ if it traded up to $55, I could enter
a sell limit order at $55. This would ensure that I don’t sell the stock unless it is at $55 or
higher.
Stop Order: An easy way to think of a stop order is as a trigger order. Stop orders allow you
to specify a price at which you want your buy or sell order to be triggered, or to become an
active order. There are two types of stop orders: market and limit. Let’s first highlight a buystop market order. If stock ABC were trading at $60 and I wanted to buy it if it traded at or
above $62, I could enter a buy-stop market order at $62. Then, when the stock price reaches
$62, my stop order becomes a market order.
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The stop-limit order combines the benefits of a stop order with that of a limit order. Instead
of turning into a market order when the stop price is reached, the stop-limit order becomes a
limit order. Using our previous example, let’s assume we enter a buy-stop limit order instead
of the buy market order. Our stop will be $62, and our limit will be $63. Given this order, if
stock ABC reaches $62, the stop-limit order becomes a limit order (rather than a market
order) to buy the stock at $63 or better.
In addition to the three orders mentioned, there are quite a few additional orders offered
by different brokerage firms, including one triggers other, one triggers two, and contingent
orders to name a few. After you have mastered the basic market, limit, and stop orders, try to
familiarize yourself with the more advanced orders.
15) What Are Trends?
Once a trader is exposed to the basic tenets of technical analysis, they start to develop an
understanding of how they might be able to profit from trading. Once they place a few virtual
trades and see that what they have been taught works, they start to get excited about the
prospects of trading. When they finally place a few live trades, and start to make consistent
money, then they start to develop a belief that technical analysis truly works and they can
become a successful trader.
However, two traders can be equally successful in their early stages but still be widely
separated in how deeply they believe in the tenets of technical analysis. The first type of
trader has developed a belief because they have been taught the principles and seen evidence
in their trading that it does indeed work. In a simplified example, they have been taught that
if you follow steps 1, 2, and 3, you will be successful. When they mechanically go out and
execute steps 1, 2, and 3 and make successful trades, they start to develop a belief that what
they are doing works.
The second type of trader has been taught the same principles and has also been taught that
if they follow steps 1, 2, and 3 they will be successful. When they go out and execute steps 1,
2, and 3, they gain the same empirical evidence as the first trader, which is that what they are
doing works. What separates this type of trader is that they understand and have developed a
belief in regards to why what they are doing works. The first type of trader only understands
that it works, where the second type of trader understands why it will continue to work.
If the first type of trader has a few bad trades, their faith might be easily shattered because
their belief was only based on their perception that it worked. They might start to question
everything they thought and even start to deviate from their training. The second type of
trader does not face such issues. Because they understand why it works they continue to
place trades based on the tenets of technical analysis and ensure that they have long-term
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STOCK TRADING HANDBOOK
success. While any concept within technical analysis could be used to illustrate these type of
traders, trends is a great place to start as it represents one of the first concepts new traders
are exposed to.
Trends – Understanding the How and the Why
The concept of trends is one of the most basic concepts in technical analysis. It is one of the
first things taught to new traders and the trend of a stock is one of the first things traders
of all levels look for when examining a chart. Some of the concepts new traders are taught
regarding trends include:
•
While one cannot predict with exact certitude the future price movement of a stock, it is
possible to gauge the probability of the price moving in a certain direction
•
One of the first things you should do when looking at a stock chart is to determine the
current trend.
oo A trend is defined as the overall direction of a stock
oo When a trend begins, it has a greater probability of continuing than reversing
•
There are three categories of trends:
oo Uptrends – defined by a series of higher highs and higher lows
ƒƒ The higher highs and higher lows are simply points on the chart where the stock
bounces off levels of support and resistance
ƒƒ When stocks are in uptrends, you should look to place bullish trades
oo Downtrends – defined by a series of lower lows and lower highs
ƒƒ When stocks are in downtrends, you should look to place bearish trades
oo Sideways – trading horizontally between support and resistance
ƒƒ When stocks are trading sideways, you should look to use strategies that can take
advantage of this situation
New traders are then trained to identify not only what trend a stock is in, but also to identify
high-probable places they should look to enter a trade. There are many techniques taught to
these traders, one of which is to draw a trendline connecting various points on a chart. In the
example below the higher lows established in this uptrend are connected to identify various
spots where the trend of a stock has been retested and found support.
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Chart Example: At each point (1, 2, 3, 4, and 5) the stock established a new higher low. The
uptrend continued after each point
Going Beyond That It Works
The concept of the trend is usually grasped quite easily and makes sense to most new
traders. Once they are taught the mechanics of how to identify the structure of a trend, they
usually become proficient at doing so. Naturally, there is more to placing a successful trade
than simply identifying what the trend is (although sometimes it really can be that easy), but
for a moment let’s imagine there is not. Let’s assume that identifying the trend a stock was in,
along with a few key entry points, was all that was needed to place a successful trade.
For the first type of trader, learning these essentials can be done with the proper training.
Once they have been trained to identify the basic structure of a trend, and then placed a few
trades based on this knowledge, they learn that a trend does indeed have a higher probability
of continuing than reversing. This training quickly transforms into a belief that trends not
only exist, but knowledge of trends can lead to successful trading. Each successful trade only
reinforces the belief that their training works.
However, the first type of trader’s belief that trends have a higher probability of continuing
than reversing is only based on their training and the fact that they have seen it work.
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Probability does not ensure certainty. There will be instances where stocks take unexpected
turns and the trend reverses itself. If one’s belief is only based on a sample of empirical
evidence, then one’s faith may begin to wane. To develop a true belief in the power of
trends – and technical analysis in general – one must understand why trends often continue.
Once you gain this understanding and belief, you will likely trade successfully for the
remainder of your life.
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