On Observation
A chart is a visual representation of transactions. The results of these transactions are depicted by either a line which will look like a map of the Pacific Coast Highway, or by a bar which represents the opening price (the little notch on the left side of the bar), the low for the day (the bottom of the bar), the high for the day (the top of the bar) and the closing price (the little notch on the right of the bar). At the bottom of the graph you'll usually also find volume bars which will tell you how many transactions were completed that day.
But beyond all this, a chart is a visual representation of buying and selling behavior on the part of investors, not just a tally, and this behavior creates patterns, like ranges, or "boxes". Thus if you approach this from the viewpoint of psychology and sociology rather than cut-and-dried mathematical models, you'll have a leg up. These patterns do not exist in nature. They are created by
the buying and selling dynamic.
Begin by thinking of the market as a giant bazaar. Lots of buyers and sellers, all excitedly negotiating prices until they exhaust themselves. If a lot of people are crowded around a particular merchant's stall, he can demand premiums for his goods. If another merchant is getting little or no traffic, he must lower his prices in order to unload his stock. If he's able to manufacture a demand, he can then raise them again. Either that or use whatever demand he creates to unload whatever crap he's selling and move on to something else.
Consider also that all stocks go through accumulation/distribution cycles. These cycles can last for anywhere from a few minutes to several years. Which cycles you focus on will depend on the kind of investor you are and what your time horizon is.
Here's how it works. Somebody's attention is caught by a particular company or its stock. They like it, think the price is reasonable, and begin accumulating it. But they do it gradually and in small lots so they don't attract attention to what they're doing. If they attracted attention, others would start buying the stock as well and the price would be driven up because of the increased demand.
When they've accumulated all that they want, they'll either hold on and wait or they'll "test" the market by offering some of their shares to see what the demand is. If the demand is there, they'll offer more as the price rises (and since there are now fewer shares on the market, there's less to stop the price from rising if the demand is sufficient). If the demand increases and the price rises further (because of buyers willing to pay ever-increasing premiums), they may hold back their shares and let other holders provide the supply for the time being, then sell more of their shares, or all of them, when the price represents their target profit level. Selling into this increased demand is "distribution". It, like accumulation, is quiet. The holder of the shares doesn't want to dump a huge amount of supply onto the market for fear that there may not be enough demand to absorb it, and the last thing he wants to do at this point is drive down the price. When the stock has topped out and the real selling takes place, he's already out of the stock. Thereafter, unless demand increases, the stock falls until it represents "value", to somebody, for some reason. Then the whole process starts all over again.
This is the basic process and cycle. However, it's complicated by the fact that there are many buyers and sellers, each with his own agenda. A seller may distribute all his stock, for example, but demand continues. It may not be enough to drive the price higher, but it may be enough to keep the price from falling. So, you enter a secondary (or whatever) base – or "box" -- in which a new accumulation/distribution cycle begins.
The trick is to figure out whether this new "consolidation" period represents accumulation or distribution, and the only way I know of to be sure is to watch the relationship between price and volume. How does the stock react when a lot of stock is dumped onto the market? Does it tank or does it decline only a trivial amount? Is there follow-through to this action or are the following days business-as-usual? If it's a short, sharp decline with no follow-through, you're probably looking at a "shakeout" (forcing weak hands to sell their shares so the stronger hands can pick them up at a discount) or a spree of short-selling, but the latter is unlikely since it usually takes place over time.
Another help is to draw a line parallel to the bottom of your price-and-volume graph so that only the busiest days show above your line. Note what happens on the busier days. Is the price up or down? What about the slower days? Again, price up or down? If the price rises on heavier volume days (though not enough to break out of the base) and falls on lighter volume days, the stock is most likely being accumulated. Or vice-versa if it's being distributed.
It is important to remember that for a transaction to take place, there must be a buyer and a seller. Huge volume and an increase in price indicates a lot of buying, but it also represents an equal amount of selling. Volume, in other words, reflects only the number of shares traded. Whether the pressure is on the demand side or the supply side is reflected in
whatever happens to the price. Unless you put this activity in a context of markets, market psychology, and demand and supply, you stand a good chance of misinterpreting what's happening.
What are they doing?
Where are they doing it?
Why are they doing it?
How are they doing it?
What were they doing before?
Think of going to some game with which you are unfamiliar: football, rugby, soccer, cricket, whatever. While you're watching the game, your chief thought is not when you should jump onto the field and begin playing. Your chief thought centers around the questions above, primarily What the Hell Are These People Doing?
Same with studying charts.
