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by Jayesh Patel, MBA, CFA
Having been trading stocks since early years in college, I am always in a pursuit for trading secrets. I tried educational route- MBA and CFA charter. They gave me solid understanding of the market- mostly from fundamental, academic perspective. I have also read lot of trading books published by trading gurus. I have come across many trading systems and experimented almost everything that sounded reasonable. As I have spent significant resources during my pursuit for secrets, I am thinking to share my findings over next few paragraphs.
Before I get in to details, I want to warn prospective traders. In my opinion, it is relatively easy to be successful in investing than in trading. Investing is for a longer term. Fundamentals always win in the long run. However fundamentals are constantly changing and that is a major problem for investors. As the time horizon for an investor is usually long compared to slowly changing fundamentals, it is difficult, and always late for most, to know when things have turned from good to bad. This is an investor's headache but with time diversification, as markets usually go up in the long run, and with asset diversification (by investing in multiple stocks), investors have fair chances to be successful over years. Trading on the other hand is a more difficult game. It is impossible to know with certainty what is going to happen today, tomorrow or next week. However rewards in trading, monetary as well as psychological, seem very rewarding and gets many of us in playing this difficult game. Truthfully, my advice for most people is to stay away from trading stocks for short-term and be an investor in the market. Success is never a guarantee for traders and contrary to what appears, it is a difficult time-consuming process to be good at stock trading. Though many people are lured by quick easy money, stock trading may not be suitable for most people in my opinion.
Everybody knows something about something, but the market is the only one who knows everything about everything. The market is the sum total of all the players. For any stock, it knows at any point in time every piece of news- public or private, every expectation held by every individual as well as every trade executed in that stock. However, this enormous amount of information held by market is available in one simple number- the current stock price. Prices reflect every bit of information - public or private --, and the impact of every trading action of every market participant. So it is foolish to think that the price of a stock is some useless number; actually it is the most comprehensive indicator of the aggregate/consensus view held by all the market participants at a given point in time. Prices is the only thing that reflects complete picture of what all participants-- day traders, specialists, market makers, hedge funds, insiders, foreigners, individuals or institutions- are collectively thinking and how they are acting as of the moment!
As such, any market is a battleground where a war is constantly being fought between current, as well as prospective, buyers and sellers; and to decide who is winning, we just need to look at how the prices are moving as of that moment. By paying attention to price fluctuations, we can determine who, buyers or sellers, is gaining control and what is the magnitude of the control. Based on this insight, there are moments when we can predict with pretty much confidence in which direction the stock prices are likely to go. Once we know in which direction prices are heading, we can make profitable trades! Besides prices, I have used various other trading methods, tools and indicators. However what I have found is that the four daily prices, OPEN, HIGH, LOW and CLOSE, give us much more than what we need to identify which stock to buy and when. They tell us of a change on the very same day it takes place.
Any market is made of buyers and sellers/suppliers and there is always a conflict going on between these two groups. Buyers want to pay the minimum possible price while sellers on the other hand want to get maximum possible price. If the price is too low, buyers would demand a large quantity but sellers would not want to sell much at this low price. If price is too high, sellers would love to sell a large quantity but buyers would not want to buy much. This is a kind of war between two groups - one trying to push prices lower and the other one trying to push prices higher. In market economy, price keeps changing until it reaches a point where the quantity demanded by buyers equals quantity supplied by sellers.
Stock market is the mother of all markets. One will see these Demand and Supply curves change more rapidly for a stock than for any other item. That is why we see stock prices changing almost every moment. For a stock, individuals and institutions that hold the stock or intend to short the stock are the potential sellers and they collectively define the supply curve. There are thousands, if not millions, of reasons that may motivate or prompt a market participant to sell a particular stock he or she is holding or intending to short sell. Similarly, individuals and institutions that are thinking/planning to buy the stock form the Demand curve. There would also be several reasons why they want to buy this stock. As we all know, a stock's price is likely to go up if the Demand is increasing or the Supply is decreasing. Similarly it is no rocket science to figure out that a stock's price would drop if the Demand is shrinking and/or the Supply is expanding. So when a trader is buying a stock, he wants its prices to go up after he has bought it. He wants the Demand for the stock to go up or the supply to dry up.
The demand and supply curves for any stock are constantly changing. Variety of economy, industry related or company related events, news, discussions, analyst reports and political and global developments constantly change the demand and supply curves for any stock. Add to this, the fact that given a certain piece of information, a person can't be sure how people will react to it. Aren't you surprised to see that even after some unexpected strong positive news about a stock, the stock keeps being traded! Ideally, if the news is too good, everybody should be a buyer and there should be no seller! If there were no seller, there would be no trade! But the fact that most of the stocks keep trading every moment when the Market is open indicates just one thing: There are people with totally different views about the prospects of a stock at any given moment. Everyone who is driven to buy or sell a stock has his own criteria to value the stock, his own set of expectations, and his own unique financial situations and circumstances. This makes it almost impossible to draw complete demand and supply curve for any stock at any point in time. And if we do not have any idea about how aggregate demand and/or supply are changing, how can we predict future stock prices with confidence?
Exactly this is where stock prices come handy. The net impact of everything happening in a stock or a company gets immediately reflected in the price of the stock. Price is the point where millions of different counter acting forces balance out. So with enough attention to changes in the price of a stock over a day or two, there will be times when we can visualize changes that are taking place in aggregate demand/supply of that stock, and based on that, we will be able to determine in which direction the price of the stock is likely to move over the next few days. There is no need to get into complex world of demand and supply curves; all we need is to keep an eye on where the balance between them is heading. Once we know this, we can take calculated risk in order to earn some reward.
As such, the Open, High, Low and Close prices for a day are just plain figures/numbers. Most people are unable to extract any useful information from them so it is not surprising to see them paying attention only to the Closing prices. For most people, the Open price is a totally useless number and so are High and Low prices often times. In my opinion, the four daily/weekly prices and trading volume numbers contain tremendous amount of information and it is not a complex science or math to extract it and use it for trading stocks. Four daily prices tell us one very important thing: How the demand/supply curves for any stock are changing and how we can predict future stock prices in certain situations. It is not that difficult to read between the lines when you are looking at the four daily prices and trading volume for a stock. Though modern investment world has started ignoring Open price, it is a very important number when one compares it to previous day/week's Closing price or with the current day/week's Closing price.
I have two primary tests that form the heart of my trading system. The first test is to capture changes in sentiment. By sentiment, I mean psychology and expectations. With this first test, I attempt to capture net changes in perceptions, outlook and feelings about a stock by market participants. The second test is to summarize the actual trading activities during a session and to capture net changes in aggregate Demand and aggregate Supply. In the first test, I try to measure changes in sentiment and in the second test, I want to see how people are actually acting or behaving. Emotions/opinion/sentiment has no value unless a person actually acts on it. And, a persons action is usually based on his emotions/opinions/sentiment. So both are tightly woven in my opinion. My two basic tests do just that: they try to capture changes in how market-participants are thinking, and how they are acting. Then I have some additional tests to quantify strengths of such changes and to determine what implications they hold for future price movement.
1. What happened while the market was closed, or when the stock was not trading? To answer this question, I compare Today's Open price to the Previous Day's Close price. If Today's Open price is higher than Previous Day's Close price, it tells me that there is a change in investor sentiment, and the change is for the better. Whatever happened overnight, while the market was closed, it has resulted in positive implications for the stock today: It has caused Demand to increase and/or Supply to dwindle. Why would buyers pay higher prices today for the same thing that was available previous day for less? No one in the market system likes to pay a penny more for the same thing. This is even more true for stock market. This happens only when someone is convinced of a bigger profit down the road than the additional amount he is paying in terms higher price. For this reason, I take Strong Open as an indication of improvement in investors' sentiment towards it. (The reverse is true when Today's Open price is lower than Previous Day's Close price. Such Weak Open means deterioration of investor sentiments).
When market is in a bull run, it is not surprising to see stocks open higher on many days. This just shows that the sentiment is going strong and prices can be expected to keep going up. However if a stock or market opens lower on some day during a bull market, that sort of creates a warning signal. Likewise, a strong higher open in a down market shows some signs of sentiment becoming positive.
There is one caveat: Only a strong Open is not sufficient reason to buy any stock. It does indicate improved sentiment but it is only half of the story. Improved sentiment has to result in higher demand and hence higher prices. This can be confirmed only after watching the full day's trading. So for this, this is my second test.
2. The second test is: What happened today during the entire market session? As an answer to this question, I compare a day's Open price to the Closing price of the same day. If Today's Close is higher than Today's Open, I conclude that, during the entire session today, buying in the stock has been more powerful than selling. This also tells that sentiment at the close was at a level higher than where it was when the market opened or the stock started trading today. A comparison between the Open and the Close price for any day gives us the net summary of the war in the marketplace between buyers and sellers. Who is winning it and who is losing it. If the stock closed at a price lower than where it opened at the start of the market session, it means that the sentiment in the stock deteriorated during the session.
Let me show you some scenarios of above two tests in finding trend-reversals.
Please remember that article is to highlight the importance of daily stock prices for a trader. These two tests though they provide useful information are not generally sufficient for entering into a trading position. Prices and volume data for last few days/weeks as well as behavior of the stock compared to overall market should also be taken into consideration. And this can be done by few more tests (on stock prices, of course) to augment the strength of trading decisions.
(From a book on stock market trading, PROFIT FROM PRICES (ISBN 1434805131))