A stock is a trading and investment instrument that is representative of an underlying company. This sounds simple enough, but surprisingly it is too often misunderstood in a bear market. In other words, a stock is not the company. A company is an organization that operates on a daily basis to pursue growth and profit for its shareholders. A stock is a three or four letter symbol that demonstrably represents the performance or expected performance of the underlying company. While this logic holds in the long run, a stock’s price can become completely disconnected from the company’s performance over shorter periods of time. This explains why blockbuster companies are firing on all cylinders Pure Storage (NASDAQ: PSTG) beating earnings estimates and lifting guidance decline (-11%) or Lululemon (NASDAQ: LULU) down (-19%) or Abbott Labs (NYSE: ABT) have fallen (-21%) over the year. These solid companies are making record sales and profits, but you wouldn’t know it from their stock prices.
Market climate is important
A rising tide lifts all boats describes what happens to stocks in a rising bull market. The opposite is also true if a volatile ocean sinks all boats in a falling one bear market. Essentially, the same company performance in a bull market can have its shares trading at $50, while the shares are trading at $25 in a bear market. This is where the decoupling often occurs between a company’s operations and the stock price. That’s why it’s important to consider the background of the market environment when analyzing your stocks.
News is for companies as charts are for stocks
There are two forms of performance analysis research. The underlying company’s earnings, operating performance and news are analyzed as fundamental research. The company’s stock price is analyzed using charts as technical analysis. While we’ll cover the fundamental research in a future article, the technical analysis focuses solely on the stock’s price. This is tracked on a grid called a graph.
Candlestick charts are one of the most commonly used types of charts to properly analyze stock prices. A candlestick represents a single period of time. For example, a single candlestick would represent one trading day on a daily chart. Each candlestick is formed using four pieces of information; open, close, high and low. The opening is the price of the first trade on the 9:30 am EST opening of the day. The close is the price of the last trade recorded at 4:00 PM EST. The highest is the highest price the stock trades during the day and the lowest is the lowest price the stock trades during the day. These four pieces of information are represented by the candlestick by plotting the open price and the closing price and connecting them and coloring the “body” green if the close is higher than the open and red if the close is lower than the open. The high and low lines above and below the body are called “wicks”.
Simple Moving Averages
Every charting platform and online brokerage has these basic indicators called simple moving averages. A moving average is the running average of the number of specific periods on the timetable chart. For example, a simple moving average over 5 periods is the average price of 5 candlesticks, each representing a trading day. Each of these charts is connected to form a moving average line on the chart. A simple 5 period moving average (MA) and a simple 15 period moving average are used together to form two moving average lines. The shorter time period, the 5-period line, is the lead moving average and the longer period is the 15-period moving average. They both represent the support levels when a stock is uptrend making higher highs and higher lows. They both represent resistance when a stock is trending down and making lower lows and lower highs. The reason we use two moving average lines is not only to provide two levels of support and resistance, but also to determine a trend reversal when the 5-period MA crosses the 15-period MA. When the 5-period MA crosses the 15-period MA, a breakout causes an uptrend. When the 5-period MA crosses the 15-period MA, a breakdown causes a downtrend. A charting program provides the real-time values for each moving average, which can then be used to determine support and resistance and trade accordingly. Moving averages are dynamic because they always update with each candle close by, while pivot points are static because the values remain the same, represented by horizontal lines. A trader or investor can choose to use either the 5-period MA ahead or the 15-period MA for trailing stops, or the crossover of the 5-period MA through the trend reversals of the 15-period MA to stop from a position.