Candlestick Trading Blog

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Generalized profit taking temporarily depresses a stock price during an upward stock trend. Traders and investors take profits in order to lock in gains on an advancing stock. A famous old saying is that you don’t have a profit on a stock until you take a profit. The temporary drop in stock price from profit taking is different from a correction in which the market analysis of a stock changes, driving the price down. In fact, investors and traders often take profits when they anticipate a correction.

Taking short term profits is the heart of day trading. The point for the day trader is to buy stock and sell stock during market fluctuations throughout the day. Someone who only does long term investing will typically only engage in profit taking after a substantial run up in a stock price and when he or she believes that the stock is ready for a large correction. Long term investors will usually stay invested during swings in stock price caused by profit taking. In value investing the investor will take their profits and get out of a stock position when the stock has increased in price to where it represents normal value and not a buying opportunity.

Profit taking usually occurs after rapid advances in stock prices. The thinking is usually that the market has gotten ahead of itself and will correct. Thus many wise traders and investors “take a little off the table.” This is one of the simple stop loss strategies that help reduce investment risk. When a stock drops back with profit taking and then advances again it’s often an indication the stock is going to continue its advance.

One of the basics of stock market investing is to know how to set reasonable goals for investing in stock. There are many investors that will set a goal, based upon market analysis, of how much gain to reasonably expect from a stock before periodic profit taking turns into a substantial correction. Getting greedy and trying to milk the last two of three percent profit out of a stock too often results in the investor losing much if not most of his or her gains.

The same applies in day trading. Setting reasonable limits, getting out of a position bit by bit and taking profit may seem to be giving away profits but, over the long term, this sort of sound trading strategy is more profitable.

Many investors get irritated at the dip in a stock price as investors take profits as it, temporarily, reduces the value of their stock shares. However, this is part of what makes the stock market work. The long term value of a stock has to do with the success and prospects of the company’s business. However, no matter how attractive a company is, its stock needs to compete with others for buyers. If other opportunities arise in other market sectors, a company’s stock price may correct. Traders may take profits from a successful stock and put their money in alternative investments. It is all part of a fluid and open market which, in the end, provides the investor with the best set of investing opportunities.

The Standard and Poors 500 is a weighted stock market index of the largest 500 companies with common stocks in the United States. The S&P 500 is weighted by capitalization of the companies and is commonly followed, along with the Dow Jones Industrial average. These market indexes are considered bellwethers of the American economy. A number of mutual funds, pension funds, and exchange traded funds buy stocks in the Standard and Poors 500 in appropriate quantities so that they track the performance of the S&P 500.

The Standard and Poors company dates back to 1860 when Henry Varnum Poor began to compile comprehensive information about the operations and finances of United States Railroad Companies. Later the company added information about non railroad companies and became Standard and Poors. By 1966 Standard and Poors was bought out and became the division of the McGraw Hill Company that publishes research on bonds and stocks. Standard and Poors also is a credit rating agency for public debt and for corporate bonds. It issues long term and short term ratings for the debt of both private and public corporations. Borrowers are rated from AAA to D with multiple steps in between. S&P periodically announces possible upgrades and downgrades on the quality of corporate bonds. This guidance in turn often affects the stock price of the companies in question.

For investors interested in detailed information about a possible stock market investment, S&P publishes equity research and funds ratings as well as credit ratings. Bonds rated AAA down to BBB by S&P are considered investment grade. Non investment grade bonds are also referred to as junk bonds. These bonds carry a higher risk of default. However, investors have found that by pooling many junk bonds in an investment portfolio that it is possible to average out the investment risk involved and many junk bond portfolios have done quite well over the years.

Besides publishing the S&P 500, Standard and Poors publishes a market index on at least one stock exchange in each of several countries throughout the world. These indexes cover large and small cap stocks as well as investments such as REIT’s and preferred stocks. The S&P Small Cap Index and Mid Cap Index often provide a different view of the US economy than the S&P 500. S&P’s 48 issue a year stock market analysis is “The Outlook” and is available both online and in print version.

Information from Standard and Poors has been sought and trusted for years. However, S&P and other credit rating agencies are still heavily criticized for giving top credit ratings to the collateralized debt obligation market in 2007 before it suffered huge losses. A common criticism of S&P is that companies pay to have their debt issues rated. Many feel this practice leads to a conflict of interest and inaccurate debt ratings. Much has been said about the recent stock market meltdown. The failure of many to conduct independent and skeptical market analysis is partly to blame. The failure of many to use time honored analysis techniques such as Candlestick chart formations to obtain an accurate view of where the market was going added to bad stock picking contrary to the basics of stock investing.

Much of stock market investing is an attempt to exploit stock market inefficiency. Market timing takes advantage of short term fluctuations in stock prices. Scalping, during periods of high trading volume and great volatility, takes advantage of market inefficiency. Trading in penny stocks and low cap stocks in general takes advantage of market inefficiency because many small cap stocks are largely unknown to investors.

A large, mostly transparent, equity market such as the New York Stock Exchange (NYSE) or NASDAQ is quite efficient at assigning accurate value to stocks. With large cap stocks and mid cap stocks it is typical that a sufficient number of analysts follow the company. A sufficient number of traders and investors buy stock and sell stock in the same company. Thus its stock price times the number of shares outstanding is an accurate reflection of the value of the company.

When there is bad economic news many investors may sell their stocks in anticipation of a widespread drop in stock prices. Many companies that are doing perfectly well will see a drop in their stock price also. This market inefficiency typically corrects itself as those who engage in value investing see that the stock is underpriced and buy, driving the stock price up. Buying when a stock is unnecessarily low in price is a good exercise of market timing and takes advantage of this type of periodic market inefficiency.

When there is news that affects the perceived value of the company, such as a new product or news of a takeover bid, the price consensus will change rapidly and, often, fluctuate before it settles in to a new price range. During this time of market fluctuation and inefficiency traders can profit by buying stock and selling stock during swings of the stock price.

Both scalping and market timing take advantage of temporary, albeit repeated, situations. The lack of information about penny stocks and many low cap stocks is a constant source of inefficiency that awaits exploitation by the wise investor or trader. Although hundreds may engage in stock analysis of Cisco, Intel, and General Mills there may not be many analysts following small companies making routers, pursuing a technology that will lead to the next generation of computer chips, or a mom and pop company making instant dinners for an ethnic market. Fortunes have been made by investors who saw the promise in a new company and bought low priced stocks before they went up a thousand fold. The inefficiency in this situation is the lack of information available to the investing public, not the fact that a company is new and unproven.

Exploitation of the periodic inefficiency of the stock market has to do with value investing in the case of market timing. It has to do with understanding technical analysis and skill in using trading software in the case of scalping. Taking advantage of market inefficiency has to do with a lot of homework in the case of penny stocks and small caps. Many startups fail. Finding winners in picking stocks is an acquired skill but it mostly has to do with lots of time spent reading reports, evaluating products, market analysis, and understanding the company’s market sectors.

What constitutes a successful stock trade? Success in trading stock is defined by making a profit. However, one stock trade, a buy or a sell, is only half of the job. The day trader needs to buy and sell, almost always on the same day. Picking stocks with low prices that seem to be on their way up may look good until a market trend reverses and the price goes down. What started out looking like a good stock trade becomes a recipe for loss. Successful stock trades come in pairs. In and out with a profit is what works.

Trend trading is when the trader assumes that a stock going up will keep going up and one going down will keep going down. The trader buys on the way up and shorts the stock on the way down. A variation of trend trading that requires very rapid execution is scalping. Scalping works on highly liquid stocks. The trader aims to take advantage of market inefficiency when volume is very high. This technique applies technical analysis and looks for stocks that are over or under bought, support and resistance zones, trend analysis and trading channels. The basis of scalping is to enter and exit the market quickly during periods of high volatility and, typically, wider trading ranges. This is trend trading on steroids. Scalping relies heavily on trading software that reads technical indicators and offers suggestions that the trader takes or not. Scalping is for experienced traders and not for someone just learning the basics of stock investing.

A way to trade stock without the second to second ulcer causing potential of scalping is options trading. The trader or investor can buy options, either put options or call options, when he or she believes that a stock will move appreciably up or down but does not have the time or expertise to execute very rapid trades to make a profit scalping. The trader or investor can trade stock options by buying a call. This gives him or her the right to buy a stock after if has gone up but at the original contract price, called the strike price. He or she then sells at the market or spot price and pockets the difference minus the premium paid to buy the option. To buy put options is to buy the right, but not the obligation, to sell a stock at the strike price if it goes down in value. The options trader then buys the stock at the lower price while selling at the higher price and is richer by the difference, minus the premium.

A successful stock trade is often the result of understanding Candlestick patterns and Candlestick trading tactics. These techniques are hundreds of years old and work as well today as when they were invented in Japan. The basis of a successful trade is understanding the stock involved as well as market sectors that come to bear on the stock. Knowing trading tools and how to use them is essential for trading to win. Whether in day trading or after hours trading a practical trading strategy, diligently applied, will help in picking stocks to trade and making successful stock trades.