Candlestick Trading Blog

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Playing It Safe Is Risky Business
There is a great deal of hazard to investing in the stock market; some of the investment risk is within your control, some of it is not. While you can’t eliminate your investment risk, you can develop a stock trading plan that defines your desired goals. This will help you to keep your investment risk at a level you can accept.

There is investment risk for which there is no control. It is possible that the investor can foresee it and will be forced to either adjust the stock portfolio or wait out the problem at hand. Below are four main types of investment risk and where possible, strategies to cope with these events.

Economic Events
The watermark for the effect of economic events is the post 9/11 economy. The stock market had just taken a significant hit and after the terrorist attacks, the US economy plummeted. This dive took most of five years to turn around. For many investors, doing nothing in times like these is the best thing to do. For others, looking at conservative companies or overseas investments can be another alternative.

Inflation
Inflation creates an investment risk for everyone. It is like an insect that eats away at a fruit crop, eating away profits as it goes. The problem is that sometimes the poisons used to eliminate the bugs are worse than the pests themselves. Inflation causes investors to look for investment options with less investment risk, such as gold and real estate. It is also good to maintain some assets in stocks as well since companies do have the ability to adjust prices to the rate of inflation.

Changes in Market Value
This includes the entire concept of undervalued stocks. With all of the media focus on the stock market, there are too many times that investors will drop a company to chase other hot stocks. This phenomenon will drive down the value of a perfectly good stock for no apparent reason. The key here is to avoid investment risk with portfolio diversification. Avoid having all of your stock in one stock sector to eliminate this danger.

Over-Conservative Approach
Of itself, being conservative isn’t an investment risk; being conservative is actually the best approach for long term investing. The investment risk in a conservative approach is when you are so conservative that you can’t meet your financial goals. Let’s face it, if you put your money in the bank, it’s very safe. The question is, can you accumulate enough with that 2% interest to have the type of life you want when you retire? In a case like that, the investment risk isn’t losing your money; it is not having made enough to subsidize your future.

There are many investment risks in the stock market; some of these can be foreseen and others can’t. It is important to identify your goals, be diligent with fundamental analysis and react appropriately to changes in the stock market.

For some people, it is difficult to grasp the basic concept of the stock market. Stock quotes, indexes, trends and forecasts just sort of run together. With the help of the “Dean of the Stock Market”, Benjamin Graham, we’re going to make it clear for you today.

Benjamin Graham is considered by many to be the most influential figure in the history of the stock market game. Books that he wrote fifty and sixty years ago hold market principles that are still true today. Yet with all of this wisdom, Graham still felt the need to create something to help people understand such stock market basics as stock price quotes. That something, or someone, was “Mr. Market”.

Think of stock price history and stock quotes like this; you have a business and you are partners in this business with Mr. Market. Everyday he offers you a choice; you can sell your part of the company to him or you can buy his part from him. The decision is up to you. There is one problem; it seems that your business partner is suffering from bi-polar disorder. His moods are either sky-high or filled with deep, dark lows. When he is up, his asking price soars with him and he is only willing to sell at a premium price. When he is low, his price tumbles to reflect his mood, even to the point of selling to you at a loss. In either case, his price is his price and he doesn’t care about the business’ value. Nothing about the business changes, it’s just the difference in Mr. Market’s mood and your own greed and fear.

The good news in this business relationship? You can just ignore Mr. Market and his stock prices if you want; he will simply show up tomorrow with another offer! It’s a beautiful thing; if you know the value of the business, you can catch him on one of his down days and make a great purchase.

This in a nutshell is the way to view stock quotes and the stock market in general. These are simply parts of doing business and should be viewed unemotionally. The twist in this “basics stock market investing” story is that one day Mr. Market will be on one of his highs and offer to buy back his portion of the company at a much larger price.

Stock prices are really the same thing; simply stock quotes from a partner who is very unstable. The stock market will be made easy for you and before long, you will have a smile on your face no matter which direction the market moves. Today’s hot stock quotes will be your next sell; tomorrow’s struggling stock quotes, your next buy.

The stock market is complex and confusing, yet elementary and easily understood for beginner investing. It is your crazy business partner who symbolizes stock quotes. It is the ability to act on or ignore those stock quotes that makes the analogy, and investing in the stock market, the place to be free from your crazy partner!

And the Survey Says...
Anyone past their teens remembers the television game show “Family Feud”. There would be a survey and 100 people would give their answer for each question that was asked. The teams on the show would then have to guess their answers in order to win. That survey is a sampling of thoughts. In the stock market, if you wanted to do the same thing you would take a look at the market indexes known as the Dow Jones Industrial Average, the S&P 500 or the NASDAQ Composite. These market indexes represent the performance of a portion of the market and their numbers give traders an indication of whether the direction of their market is going up or down.

The actual numbers reflected by these market indexes is not as important as the percentage of change over time. Added to this percentage is the direction and together the two will tell you if the market is changing, and if that change is for the good or bad. When used with other measurements, the market indexes can help successful traders form opinions about whether to make buys or sells.

Here are some of the most common market indexes and the markets they track:

• The Dow Jones Industrial Average – This is the granddaddy of them all. The Dow is the oldest, most widely known and most quoted of all the market indexes by those who are investing in the stock market. The Dow tracks 30 of the most influential companies in the US and because of this small sample, it misses out on the small and mid-size companies completely. It is a price weighted market index which means that if a stock price changes by $1, the effect on the market index is the same no matter the price of the stock. The Dow reflects about 25% of the total market and its changes reflect consumer confidence in stocks.



• S&P 500 – This market index is most commonly used by professionals playing the stock market as a snapshot of the market. It includes 500 of the most widely traded stocks and because it is a market cap weighted index, changes in larger companies tend to reflect more strongly than smaller companies. The S&P 500 tends to be a more accurate indicator than the Dow.



• The NASDAQ Stock Market Composite – Although this market index includes all of the stocks on the NASDAQ market (more than 5,000), it is historically weighted toward technology stock sectors. This is because it is a market cap weighted index and the technology companies strongly influence this index.



• Others – There are a number of other market indexes and each has a different focus. Mutual fund investors can find a number of funds that track almost any index they want. In spite of the different market indexes, the “Big 3” best serve the needs of most investors who are analyzing stock market indexes.

Sometimes Selling Yourself Short is a Good Thing!
We really dug deep into creativity bin for today’s title. But in the stock market, sometimes selling yourself short really IS a good thing! Selling short is an advanced trading technique that is an about-face to the typical goal of most investors. When you are selling short you don’t want to find the best stock to buy, instead you want the stocks that are falling! Short sellers (which has nothing to do with little people) don’t look for good stocks to buy; they look for good stocks to sell.

Selling short involves selling stock you don’t own, believing it will fall in price in the near future. When the price drops, you can buy the stock at the lower price, pocket the profit and return the shares to the original owner. This definitely sounds like successful trading, doesn’t it?

Here’s an example. Your stock technical analysis and candlestick charting on Acme Tea suggest that the company is poised to fall. Using your Internet stock trading account, you sell a short on 500 shares of Acme Tea. Since this is actually a credit purchase, you are required to have a margin account, which you do. When the stock is on an “up tick” (stock market talk for a rise in stock price) your purchase is made. The money is escrowed to protect the original owner.

Let’s put some flesh to the bones of this example. You are very bearish on Acme Tea, so you sell short 500 shares. The current price is $25 per share, so your account is credited $12,500 for the transaction. In no time, your faith in your Japanese Candlestick stock trading system pays big dividends; the price of Acme Tea has bottomed out at $15 per share. You sell 500 shares at $15 per share (a total purchase of $7,500), cover your position out of the original $12,500 and pocket the remaining $5,000. Remember that this example ignores the fact that you will owe commissions on your transactions; you just made $5,000 so I think you can cover it!

Are there any risks? There are definitely risks involved with selling short. In the previous example, if the Acme Tea stock suddenly rose to $35 per share instead of falling, you would be required to cover the difference of $10 per share, or $5,000. If you don’t perform your Candlestick chart analysis or if a bull market pulls the stock up, your loss is the difference between the stock price and your short. Needless to say, this could be a lot of money.

As you know, it is impossible to perfectly predict when, or if, a stock will rise or fall. It is possible to identify trends to use in conjunction with your fundamental and technical analysis of a company to get a strong idea. A strong stock trading plan, analysis matrices such as short interest ratio and due diligence with your research will take you far to being able to predict the movement of your stocks. Once you’ve done your homework, don’t be afraid to sell yourself short. If done correctly, it can reap great benefits!

Taking the Stock Market Away From the Dinosaurs
Back in the land before time (at least 25 years ago) when dinosaurs roamed the Earth and successful traders rode them to Wall Street, stock screening was a virtually unknown concept. It was a great idea, screening the stocks of hundreds of companies every day looking for the trends that would lead to buying only the hot stocks. Truth of the matter is, before the Internet, investors either relied on advice from brokers who only got paid when transactions occurred, or on basic stock information that could be gleaned from annual reports, 10-Qs and various other documents that were out-dated by the time they were received. Stock screening was an idea that was out of the question.

Now fast forward to the 21st Century. The Internet has become the source of an incredible amount of data about everything. Computers have become powerful tools, able to screen the results of stocks and decipher mountains of data literally in seconds. Aren’t you glad the “good ole days” have passed you by and that someone invented technical analysis tools?

In reality, it was nearly impossible to perform stock screening of more than a few companies without a flock of analysts. Comparing the results of two or three companies was a daunting task. Today, it is possible to compare many companies and to screen their stocks quite accurately. Today, any investor can access powerful stock market trading tools that, before the Internet, were unavailable, and many of them are free. Of course, there are some very sophisticated tools that come with hefty price tags; however, for most investors all the research they will need is free or available for a modest subscription. Welcome to the modern world of stock screening.

The most basic stock analysis tool is the stock screener. The stock screening that this handy program does in nanoseconds would take you hours and hours of research by hand to do. The best part is there are many stock screeners on the Internet that are free for you to use. Although some of the better ones come as part of subscription packages to good online stock market trading sites, you can get a feel for how they work free of charge. The idea behind this is simple; you want to identify stocks that meet certain criteria rather than haphazardly investing in a stock because it looks good at the moment. Sounds like a good stock trading plan, doesn’t it? Enhance portfolio diversification based on comparative analysis and implement processes to track the performance of your stocks thereafter.

Stock screeners and screening programs allow you to enter different variables such as stock sectors, market cap, sales, dividends, and so forth. The more complex the screen, the more qualifiers you will include. After you enter the qualifiers, the stock screener reviews all the companies listed on the major stock market exchanges and extracts those that meet your criteria. Now you have a list of targets. If the list is too large, run the stock screener again with stricter qualifications to reduce the number of hits. The more sophisticated stock screeners allow you to run additional queries on the compiled data, while the free stock screeners tend to leave you with just the list. Either way, you have just saved yourself hours and hours of work by narrowing down the possible investment options.

Ever wonder why the dinosaurs are extinct? Their inability to adapt to their changing surroundings left them vulnerable. Thanks to the Internet and stock screeners, even a beginner investing in the stock market can avoid financial extinction.

Finding Profit Investing In Your Values
Ok, now this is a statement that will probably have you scratching your heads. Not everyone in the stock market should be value investing. What? That’s like saying not everyone should be investing in the stock market to make money isn’t it? Who wants to buy stocks that have no value? Ok, now that I’ve rocked your world a bit, I let you in on the secret; value investing has nothing to with the quality of your stock portfolio. Value investing refers to a methodology that shapes the way an investor approaches selecting stocks.

While value stock investing doesn’t specifically refer to the quality of a stock, it has nothing to do with buying junk stocks. This is not bargain basement, penny stock investing. Value investing is about finding stocks that for one reason or another have been priced incorrectly by the stock market.

The investor in value investing is like more focused on specific businesses and their fundamentals than other variables which tend to influence stock prices. Factors such as earnings growth, dividends, cash flow and book value are more important in value investing than stock prices. Value investing is buying and holding stocks for long term investing. If the fundamentals are sound, but the stock’s price is below its obvious value, the value investor knows this is a likely investment candidate. The market has incorrectly valued the stock. When the market corrects that mistake, the stock’s price should experience a nice rise.

Just because a stock experiences a drop doesn’t mean that it is a struggling stock or a candidate for value investing. This happens, yet most of the time the market is right and a stock gets hammered because of any number of sound fundamental reasons, such as declining earnings, declining revenues, or something fundamental changes in their market or product line. A pharmaceutical company has a top seller yanked off the market by the government, an event that fundamentally changes the company.

On the other hand, other pharmaceutical companies may see their stock clipped also, even though they are not part of the recall. That may make them worth a look by a value investor. The value investor is looking for situations such as this where neither the events leading up to a drop in price nor fundamental analysis of the company warrant the drop and will likely be corrected in the market at a later date.

So where do you look for potential purchases if you are value investing? Below are just a few possible locations:

• A company with a price to earnings ratio in the lower 10% of its sector.
• A company with a projected earnings growth ratio below one. A PEG ratio below one suggests that a stock may be undervalued.
• A debt to equity ratio of less than one.
• Long-term strong earnings growth. A 5 to 10 year period of 6% to 8% earnings is realistic.
• A price to book ratio of less than one.

Studying the Tides
For investors, understanding operating cash flow is a little like watching the tides of the ocean. The tide comes in, the tide goes out…but there’s a big difference in the business world. Unlike the ocean, the cash flowing in and out of a company can vary greatly and it can be very difficult to spot as well. An investor can use the operating cash flow to look for situations where a company doesn’t have enough cash coming in to meet its expenses. Fundamental analysis of such a company is required to understand if this is temporary or a chronic problem.

Conclusion
For investors, operating cash flow is one excellent measure of the health of a company. Since it is never wise to rely on only one metric, reviewing operating cash flow for previous years, calculating cash flow ratios or earnings per share can also be extremely helpful in obtaining an accurate picture of the fiscal health of a company. It is also possible to use the price to cash flow ratio; P/CF can also be used in stock screeners to eliminate companies that burn cash and increase your chances of successful trading. Operating cash flow is not a perfect measurement and should not be relied on solely for making decisions on stock purchases. It can be manipulated and should only be one the metrics used by a savvy investor to identify companies for potential purchase. Always remember that for a company, cash is a necessity of life!