Friday, June 28, 2013

Psychology of Chart Patterns

Chart Patterns Represent a set up and formations that have historically signaled buy points and identify a change in trend. Typically they are an upward trend followed by some sort of congestion and then the trend resumes. Those who have gains start to take profits, and those who recognize the dips may start to buy and those who think stock is over extended may try to short. But once it breaks to the upside the shorts are forced out and the buyers pile in causing a "short squeeze". So before we get started I want to explain the nature of a "short squeeze.

The people who "go short" are betting on the prices going down. If prices go down they basically have the opportunity to buy what they already promised to sell at a given price. For example, they identify the price of $30 and promise to sell. If the price goes to $27 and they "cover" they then buy and the shares are immediately taken off at $30. So they might "short" 100 shares at $30 or $3000 worth and effectively borrow shares they don't own to sell, (from someone else who is buying at that price). They then BUY the shares for $2700 and make $300.

The risk of course if the stock goes higher. They already promised to sell the shares at $30, so now if the shares goes from $30 to $40 they have to pay $4000 to sell at $3000. If they don't have $4000 in cash including what they got from the short sale (so they need an extra $1000) they then will be given a "margin call" they either can send money into the account or else they must sell shares. If they do not, the broker will sell shares FOR THEM at his own discretion, and may even charge a fee.

This is extremely relevant to stock prices. Short sellers are the FUEL for bull runs to continue. The reason is, if you go short and I buy your shares, you have created 2 buyers one (me) and another on credit. In other words, you must eventually BUY back your shares. Of course you might argue there has to be a seller on the other side too so it evens out, however if price continues to go higher and no one wants to buy until much, much, much, much, much higher.... you still have to buy by any means necessary. So you don't REALLY create a seller on credit, but the short seller better hope there isone when he needs to buy, or he's in trouble. If there i no one asking to sell and only buyers forced to buy, prices are going to go up and up again and up again. You may see them GAP up drastically after a positive earnings announcement or FDA apporval that in the perspective of shareholders increases the value dramatically.

However, regardless of how dramatically the price increases, if the shareholders still want to sell the news, and there aren't enough people with demand to buy it to cause all the selling demand to liquidate and then some, prices won't go up. The stock market is very very psychologically based, which is why many believe it's a "random walk" because they don't know how to read the tealeafs. The psychology of investors is much different usually (or at least should be) they don't care about day to day values of the company, they are just looking to be part-business owners and share in the company through future dividends and book value appreciation that they hope will EVENTUALLY manifest itself in great price appreciation.

But short sellers are generally the fuel. The fuel for lower prices are too many buyers that are underwater. Volume profile analysis REALLY can come in handy if you understad this kind of thing. But an individual institutional fund (mutual funds, index funds, hedge funds, money managers) take time to develop a position.
The stocks that get stretched going really high then consolidate for awhile as some take profits and then others tame their buying. Some buy on a dip while they still can and then some more take their profit as the trend starts going sideways. Eventually some shorts come in and finally it either breaks upwards squeezing the shorts out, or downward. In either case tight price ranges signals a battle between bears and bulls and equalibrium of sellers and buyers that will not continue forever. Eventually some party will leave seeking an alternative or more will come in force and drive the other party out. Knowing where the support/resistance ranges are, who's under water (shorts or longs) and how much, and other htings like momentum can help you to predict patterns.

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