How To Read Stock Charts

The prices on a stock chart provide a fossil record of the stock’s trading history. While prices have no memory, the humans who trade them do. It is true that anomalous things happen, but it is also true that price history – especially read in conjunction with volume – does not lie.

Figure 7.12 – BHI – Deciphering Price

Figure 7.12 tells the story of Baker Hughes (BHI) as price bottomed after a brief sell-off, advanced sharply only to sell off again (to retrace), and to begin a new advance after a bit of stuttering.

Here is what the stock-price tea leaves tell us:

  1. Note how price hit the initial low, bounced up and down over weeks and only then began the real uptrend. The repeated bounces are caused by a combination of short pressure and uncertain longs willing to quickly take profits. As shorts realized they could not contain buying pressure and moved out of the way, the stock began the uptrend in earnest. Point 1 lows constitute a major support level.
  2. The sharp uptrend briefly retreats as traders and investors take profits. However, buying is strong enough at every pullback to keep price advancing.
  3. Buying finally runs out of gas. Traders and investors have been losing conviction as the stock has continued advancing without a real correction – they expect a retracement to occur. They are selling to take profits and then more and more of them are fence-sitting, waiting either for the retracement to happen or for the uptrend to resume convincingly. Not enough new longs are coming in to take their places. At the same time, short sellers smell blood in the water and begin shorting the stock. Selling decisively overwhelms buying.
  4. The sharpness of the decline – even sharper than the uptrend – tells how completely buyers have left the party. Canny investors and traders know the stock is in a natural retracement. At Point 4, a brief bear flag forms as buyers put a tentative toe in the water, but the shorts still are in charge.
  5. Think of the Point 5 bottom as a gunfight. It is hard fought, but the longs take over and the shorts get pushed aside. A quick, sharp uptrend results.
  6. Price zooms up and down even more violently than it did at Point 1, when the stock bottomed. This stock clearly shows a lot of volatility. Longs and shorts keep trading the price momentum back and forth. It is easy to seen when buyers or shorts, respectively, run out of gas. Price peaks: The longs start bailing out as price spikes and start taking profits; emboldened shorts pile on and start pressuring the stock. Price troughs: The shorts grow exhausted as the stock falls and begin to cover their short positions. At the same time, buyers are coming back in.

As more and more buyers decide the stock has retraced enough, the stock gathers strength for a new move up. Though not visible on this chart, the stock recovered to its pre-retracement high and then just kept climbing.