The Start of a Bull Market

The bottom of the market starts at a time when the stock market is weak and the general population is pessimistic. At this point most investors sell after having endured a long and torturous bear market. This extreme pessimism found at a bottom is always irrational and undeserved. Now the market is undervalued and is a bargain. Savvy investors, the “smart money”, buy bargain stocks knowing that they will be able to sell them higher in the near future. Smart money buying, called accumulation, causes stocks to rise.

The smart money often consists of operators, and corporate insiders (promoters of companies). These traders have access to information that the general public does not.

Rising stocks eventually gain the respect of institutional investors, as billions of dollars of capital is introduced into the market place. Mutual fund investment causes the stock market to advance in a powerful manner. Much of the steady large trends are powered by institutional investors. After the stock market has gained, stocks are now fairly valued and are no longer considered bargains. The smart money is now sitting on a large profit, as well. The average investor is still skeptical, however.

As bull market events unfold, retail investors begin to take interest in stocks. Retail investors, or the unsophisticated little guy, make up the vast majority of investors. This group does not invest for a living. Retail investors often make investment decisions based on what they read in financial magazines, from their brokers and from tips from friends. As the flood of retail capital is invested, the market soars, causing great euphoria. At this point in the cycle, many companies become public, or launch an IPO. Companies go public when investor sentiment is most optimistic so as to gain the highest possible stock price. IPO’s generate even more optimism as unsophisticated investors buy into the fallacious thoughts of instant riches. Now is the time when many small investors become wealthy. In this phase, stocks are doubling and tripling as the media cheers on the advancing bull market.

At this point, the smart money sells, or distributes, the now overvalued stocks to overconfident retail investors. The smart money knows that overvalued stocks are no longer worthy investments, and will soon drop in value. Widespread greed always occurs, in some form, at stock market tops. Sometimes this greed takes form as stock market scams and fraud. These immoral activities can take place because irrational retail investors will buy a stock simply because it is glamorous. To compound the problems, investors will now start to use margin, or leverage, to further accelerate gains. All caution is thrown to the wind as investors think “the old rules don’t apply”.

The Start of a Bear Market

After mutual funds and retail investors are fully invested, the market is overbought. This means that there is no more cash to fuel the rally. The market can only go in one direction: down. All it takes is just a hint of negative news and the market collapses under its own weight. Investors quickly realize the market is made of smoke and mirrors, as frauds or other scams come to light.

When panic selling starts, a market will always fall quicker than it had risen. Oftentimes, as everyone heads for the exit at the same time, there isn’t anyone willing to buy the stock. This can be especially disastrous for margin users as they grow deeply indebted to their brokers. Bankruptcy is the usual result for these foolish gamblers. The majority of retail investors don’t sell even as the market is plummeting. This crowd keeps holding on to stocks in hopes that the market will recover. As the market plummets 25%, then 50% the average retail investor foolishly holds on, in complete denial that the bull market is over. Finally retail investors sell every stock they own plummeting the market even further. This mass exodus is called capitulation.

The Cycle Starts Again

It is at this point that stocks are undervalued once again. The smart money is accumulating and stocks rise. The majority of retail investors bought at the top and sold at the very bottom. This is the very essence of the “dumb money”. They are perpetually late into the game. This cycle continues over and over. Only the smart money actually “buys low and sells high”. After trading in this manner, the dumb money will adhere to adages such as, “the stock market is risky”. In reality, however, the stock market is only risky if you trade like the mindless majority!

The chart below of Amazon.com (AMZN) shows the Triangle continuation pattern:

Generally, when prices make significant moves, they go through a period of resting. Usually with a Triangle pattern, the price consolidation period consists of higher lows and lower lows, forming the shape of a “triangle”. When the resistance and support lines (see: Support & Resistance) begin converging, price will usually burst out of the consolidation area and resume trending in the direction that prices have been moving previously.

Triangle Breakout Buy Signal

The signal to buy is given when the resistance line is penetrated to the upside. The signal is generally stronger if prices have been in an uptrend prior to the upside breakout.

Triangle Breakout Sell Signal

A sell signal occurs when the support line is penetrated to the downside. Usually the sell signal is considered stronger if prices have been in a downtrend prior to the downside breakout.

Two other closely related variants of the Triangle pattern are the Ascending and Descending Triangle pattern; these two patterns are shown on the next page.

The chart below shows a Head and Shoulders pattern:

Head and Shoulders Components

1. Left Shoulder: Bulls push prices upwards making new highs; however these new highs are short lived and prices retreat.
2. Head: Prices don’t retreat for long because bulls make another run, this time succeeding and surpassing the previous high; a bullish sign. Prices retreat again, only to find support yet again.
3. Right Shoulder: The bulls push higher again, but this time fail to make a higher high. This is very bearish, because bears did not allow the bulls to make a new higher or even an equal high. The bears push prices back to support (Confirmation line); this is a pivotal moment – Will bulls make another push higher or have the bears succeeded in stopping the move higher.

Head and Shoulders Sell Signal

If prices break the confirmation support line, it is clear that the bears are in charge; thus, when price closes below the confirmation line, a strong sell signal is given.

Note that a downward sloping confirmation line is generally seen as a more powerful Head & Shoulders pattern, mainly because a downward sloping confirmation line means that prices are making lower lows.

Reverse Head and Shoulders

The opposite of the Head & Shoulders pattern is the Reverse Head & Shoulders pattern which is another strong pattern, this time a bottoming pattern.

Reverse Head and Shoulders Components

The reasoning behind a Head & Shoulders pattern is as follows:

1. Left Shoulder: Bears push prices downwards making new lows; however, bulls begin to return and push prices slightly higher.
2. Head: Price gains don’t last long before bears return and push prices even lower than before; a bearish sign. Prices then find buyers at the new lower prices.
3. Right Shoulder: The bears push downward again, but this time fail to make a lower low. This is generally seen as bullish sign, bears were unable to push prices further down. Decision time occurs when the price is pushed higher back to support (Confirmation line); either bears will push prices back down or bulls will push prices higher, regaining control of the stock, future, or currency pair.

Reverse Head and Shoulders Buy Signal

When price closes above the confirmation line, a strong buy signal is given.

Usually an upward sloping confirmation line is seen as a more powerful Reverse Head & Shoulders pattern, mainly because an upward sloping confirmation line means that prices are making higher highs.

Volume analysis is important when using the Head & Shoulders chart pattern. How to incorporate volume into the study of the Head & Shoulders pattern is discussed on the next page.

The chart shows many Flag patterns:

Flag Buy Signal

When price has moved higher and prices have consolidated, creating a channel of support and resistance, a buy signal is given when prices penetrate and close above the upward resistance line.

Flag Sell Signal

Assuming prices previously moved downward, then after a period of price consolidation, a sell signal is given when price penetrates and closes below the support line.

For more information on the concept of support and resistance, (see: Support & Resistance). Another similar pattern discussed is Triangles (see: Triangles).

The chart below illustrates the Double Top reversal pattern:

Double Top Formation Components

1. First High: Bulls push prices upwards making new highs; however, these new highs are short lived and prices retreat.
2. Second High: Prices don’t retreat for long because bulls make another run, making a similar high. Nevertheless, this is bearish, because bulls were unable to push prices higher; bears held their ground at the previous high level. The bears push prices back to support (Confirmation line); this is a pivotal moment – either bulls will make another push higher or bears will take control and push prices even lower, more than likely taking over for good.

Double Top Sell Signal

Sell when price closes below the confirmation line.

Note that traders expect a significant increase in volume to accompany the confirmation line break; if there is very little volume when price pierces the confirmation line, then the move downward is suspect. Small volume usually means weak support of price movement (see: Volume).

Another similar chart pattern is the Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Top is the bullish Double Bottom (see: Double Bottom).

The chart below illustrates the Double Bottom reversal pattern:

To create a double bottom pattern, price begins in a downtrend, stops, and then reverses trend. However, the reversal to the upside is short-term. Price breaks again to the downside only to stop again and reverse direction upwards. With the second bottom of the double bottom pattern, it is usually more bullish if the second low is higher than the first low.

Double Bottom Buy Signal

The signal to buy is given when the confirmation line is penetrated to the upside. The confirmation line is drawn across the top of the double bottom pattern (see chart above).

Often, after price penetrates the confirmation line, price will retrace for a short time, sometimes back to the confirmation line. This retracement offers a second chance to get into the market long.

Volume also plays an important part of interpreting the Double Bottom pattern; this is illustrated in the chart below of Pfizer (PFE):

Generally, volume should explode when the confirmation line is penetrated as it did in the chart of Pfizer (PFE).

The Double Bottom reversal pattern is a heavily used and effective charting reversal pattern. Another similar and popular bottom reversal pattern is the Reverse Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Bottom is the bearish Double Top pattern (see: Double Top).

Using the same chart of GE, all I am going to do now is identify a recent support level:

As you can see, in the early part of 2005, the $35 area was strong support. We also see some overhead resistance that stopped the rally in May 2005. Now watch how this signal works out, we see the stock break below $35, next we see the 50dma cross under the 100dma. What followed was a continued drop to $33. If you were a trader, you would have exited the stock at $35 and saved yourself that drop.

Not indicated on that chart is that the $33 area is a support level. Can you see why?

You could have used $33 as a re-entry into the stock.

The same concept applies to short term moving averages. Daytraders will use moving averages based on 14dma or even 5dma for general trends, they even get down to 5min and 1min moving averages, but we are not daytrading here.

Let us focus on long term and mid term trends for now.

Instead of a 200dma, lets use a 100dma and also a 50dma. An interesting thing happens when you put two different time frames together, you get two lines that move around each other.

The blue line is a 100dma, you can see how it showing the general trend of the stock. The brown line is a shorter term 50dma, it is more volatile as it more closely follows the actual day to day moves (averaged over 50 days).

Here comes the fun part: See how the 50dma moved above the 100dma Jan 04 (first blue arrow). This indicates to us that the short term trend was extremely stronger to the upside than the longer term 100 day trend. As you can see, the stock did indeed hit some nice highs. You will also note the opposite (red arrow) when the 50dma fell below the 100dma.

Look at July 04, see how the 50dma once again moved above the 100dma? I good indication of short term strength kicking in. GE went from $32 to $37 over the following months. Now look how the trend changed when the 50dma fell below the 100dma in July 05, this indicator told us that weakness is kicking in and GE subsequently dropped from $35 to $33.

Next lesson – combining what we have learned so far.

Stocks move every day, so if GE (General Electric) closed at $30 yesterday, then at $30.50 today, the average over the past two days is $30.25.

Now lets stretch this out over say… 200 days, we would get a line showing us the average closing price over that time period.

I did not randomly pick 200 days, the 200dma (day moving average) is actually one of the most commonly used indicators. Even those traders or investors who have no clue about technical indicators would know about the 200dma. It is basically the trend line that if a stock is above it, it is doing good, if it is below it, the stock is doing bad. This is obviously an extremely generalized point of view, but it gives us a general frame of reference.

The 200dma is best used with major indices and blue chips, not small or mid cap stocks.

Let us take a look at the 200dma as applied to GE:NYSE. As long as the stock is above the 200dma, it is considered to be in a healthy uptrend. A strong move below the 200dma would indicate some volatility, and if the stock stays below the 200dma for an extended period of time, it is an indication of continued weakness.

The trend of the 200dma itself is important. If the 200dma is uptrending, that tells us the underlying security is in a strong long term uptrend. If the 200dma is downtrending, then the opposite. A stock will often move above and below the 200dma, but as long as it is in an uptrend, its ok.

Next TA – short term and multiple moving averages

On the other side of the coin, we have price levels that are known as support. This terminology refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a good buying opportunity because this is generally the area where market participants see good value and start to push prices higher again.

Source: Investopedia . com

 The first thing you want to do is change your chart from a line chart to a bar chart. Lines are nice, but they dont give us enough information about what a stock did intraday. A bar chart shows us the open, the daily move and the close (candlesticks also do this, but we will get to those later). Now that you have a bar chart, lets do the most basic of all analysis, lets look for support and resistance levels.

Finding support: Starting from the left in Jan 2005, (first blue arrow), you can see that INTC hit the $22 level, then rallied. In April the stock dropped and hit $22, the rallied again. It seems that $22 is a nice support level. Investors are basically thinking “Hmm, I like INTC and would buy it if it hit $22…” and so they do. If we connect those two support levels and extend the line to the right, it shows us a nice long term support level.

Finding resistance: After that first support was found, the stock rallied, but then stalled at $25.50 in March. You can see that in May, the stock blasted right through that resistance level. Note that support and resistance levels do not have to be horizontal, in fact they can be almost any angle. INTC hit $28 in June, and pulled back, that is another resistance point. By connecting the March and June peaks, then extending the resistance level outward, we find that the next resistance point in July was predicted correctly! Later in November we can see that the old $25.50 resistance stalled the rally, but as soon as it broke through, it moved quickly.

Think of support and resistance levels as jello like barrier, sometimes a stock will bounce off them, other times it will cut through.