The secret behind charts

We learned a helpful lesson in the last chapter: how to evaluate a company's stock price.

But what are the factors affecting the price?

Well, fundamentals represent one side of the coin, while technical analysis is often the other.

Stock prices rise and fall. It’s nothing unusual. Even for a wonderful company, there are ups and downs. So the question is, how to spot the highs and lows?

The answer is sought after by almost all market players. Among all approaches in the market, technical analysis is a widely used one.

Technical analysis involves many tools. Let’s get started with the most basic and commonly used one: candlesticks.

If you pay attention to a stock’s daily chart, you’ll find that price movements are usually not displayed in the form of a line chart. Instead, they are displayed in what is known as a candlestick chart, which conveys more information about a stock.

Let’s first take a look at this line chart. What does it tell us?

Apparently, we can tell there’s a sharp price decline, but is there anything else? The answer is probably no. To learn more about a stock, we can turn to a candlestick chart.

From the candlesticks, we can tell that the stock made multiple attempts to drop below $100 but eventually failed and bounced back.

In this example, $100 is known as a support level where traders step in to avoid a further price drop. Likewise, if the price meets pressure on its way up and cannot climb over a certain level, such level is known as a resistance level, where a growing number of sellers sell the stock at that price.

Candlesticks reflect the trading activities of buyers and sellers.

Before you can read a full candlestick chart, you need to know what each candle is made up of. Let’s start with the body, shadow, and color of a daily candle.

The body tells the day’s opening and closing, the shadow shows the day’s high and low, and the color tells the direction of movement during the period the candle was formed.

If the closing price is higher than the opening price, the candle will often be colored green to represent a bullish candle. Conversely, if the closing price is lower than the opening price, it is usually colored red to represent a bearish candle.

For example, a green candle will be formed if a stock opens at $155 and closes at $156, with the intraday high and low being $157 and $154, respectively.

Based on the candle’s body, shadow and color, we could quickly understand its intraday price movements. Every candle reveals a battle of emotions between buyers and sellers. In general, there are three types of candlestick interpretations: bullish, bearish, and neutral.

A full-body candle indicates strong buying or selling, meaning that the buying or selling power is strong enough to push the stock price far from the open and to maintain the trend at market close.

If a candle has long upper and lower shadows, it indicates high volatility occurred during the trading session, meaning that the stock price fluctuated substantially with both bulls and bears unable to overcome each other. That’s why a candle with long shadows often indicates a neutral sentiment.

We can more or less sense the intraday sentiment on a stock from one candle, but the information we gain from a series of candles can be a lot more valuable.

Let’s start with two daily candles, a bull and a bear.

If we combine the two candles into one, what would we get?

The result is a third candle representing the open, high, low, and close over the past two days. The third candle has a small body, a short upper shadow, and a long lower shadow, suggesting that the price dropped sharply before buyers stepped in and pushed it back.

From this example, we can tell that by switching the time frame for candlesticks, we may get a completely different story.

To further explore the meaning of candlesticks, let’s take a look at another example. This daily chart seems to show a downward trend, right? But when we set a longer time frame, say weekly, guess what will happen?

It seems that the stock maintains an upward trend!

By referring to both daily and weekly charts, we can tell that the recent drop in share price may indicate a correction instead of a downward trend or reversal.

Keep in mind that although candlesticks are helpful in quickly reading market sentiment, they should be used along with other technical analysis tools to interpret the overall market trend.

“How can I better understand the market trend?” you may ask.

No hurry. We’re going to figure this out in the next chapter!