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The Economics of the Stock Market Pt. 3

What the Charts Tell Us

Stock prices go up and down over time and these fluctuations are captured graphically in stock charts. Sometimes there seems to be no rhyme or reason to the fluctuations but at other times they form recognizable patterns.

As we noted above, the supply and demand for a particular stock shifts as the interested buyers and sellers get satisfied. To induce satisfied buyers and sellers to buy or sell again takes a shift in price or a change in news. If the fundamentals of a stock stay the same, the only thing that changes is the dynamic interactions of buyers and sellers.  If a company, for example, keeps growing revenue and earnings at a steady rate, the price will rise over time.  But the stock price will fluctuate within this long term trend forming patterns. These patterns can tell us when a stock may change its intermediate short term direction.

Consider the chart below:

The price of Joe’s Widgets stock starts out by fluctuating within a pattern called a triangle. Whenever the stock hits $10, sellers move in to take profits. Perhaps they believe that a rise in price beyond that level is not likely in the short term or they believe the stock is fully valued at that level. Whatever the reason, holders of the stock start selling at $10 and the price starts to fall. It hits $8.25 and buyers move in thinking the stock is a bargain. The stock is bid up to the $10 level again. Once again sellers move in and the price deteriorates, but this time the mood among buyers has become more bullish and they move in sooner, at the $9.00 level. The stock hits $10 and sellers move in again. The stock drops again. But this time buyers move in at $9.25.

Analysing this triangle trend, we see that the mood among sellers is constant – take profits at $10. The mood among buyers is growing increasingly bullish. More buyers are moving in sooner with each downwards fluctuation.

Although strictly speaking the supply and demand curves are constantly changing as the price fluctuates, we can connect the upper trend line, in other words, the peaks of the fluctuations, to form the top line of the triangle. This line can be called the supply of sellers wanting to take profits at $10.

The rising lower points of the fluctuations can be joined to form the bottom line of the triangle. This line can be called the demand from buyers.

Demand is rising steadily. Supply is constant. At some point, namely where the two lines intersect, demand overwhelms supply and forces the price up.

The $10 level was resistance until that point. Now the stock rises to $12.00 and retraces its movements twice, testing the $10 level on the downside. Resistance has now become support. The stock is ready to make its ascent to $17.

The stock makes its ascent in fluctuations that form a channel defined by two parallel lines. Here the supply of buyers is optimistic and is willing to pay increasingly higher prices for the stock. Sellers are increasingly reluctant to part with a good thing and demand increasingly higher prices to induce them to sell.

Now the stock starts a new triangle pattern of decreasing supply peaks and steady support at $15. Buyers deem the stock a bargain at $15, but sellers are becoming increasingly agitated. With each upswing they are taking profits sooner. The mood is souring on the stock. With this triangle, supply overpowers demand where the lines cross and the stock starts to fall in price.

As this chart shows, the concepts of supply and demand for this stock can be shown visually. This is not always the case, but where patterns emerge, we can look at them as representations of supply and demand.

Triangles are the very simplest and easiest to understand of the many chart patterns. We can see in our chart how demand first overpowers supply, causing the price to rise. We see how former resistance now becomes support. And we see how supply overpowers demand to force prices down again later in the life cycle of the stock. A trend channel indicates steadily rising demand and increasing reluctance of sellers to part with the stock unless they can get a higher price.

Beyond the scope of this analysis are many other patterns including such esoteric patterns as the cup and handle or the head and shoulders. All are interpretations of the changes in the supply and demand for a stock over time with a look to predicting future trends.

Hard core technical analysts believe that a picture is worth a thousand words, that you don’t have to bother researching a stock or finding out anything about it. Just look at the charts and they tell the whole story. I don’t agree. The charts provide valuable clues to what is happening and future possibilities. But changes in the company’s fundamentals are the ultimate foundation for changes depicted by the charts.

That said, the charts do tell a story all other things being equal. They are one more tool in the stock investor’s research arsenal. Make them your friends!

Part 1: Understanding the Concepts That Move the Market
Part 2: Supply and Demand and the Stock Market
 

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