What is price, and what can we learn from an analysis of market prices? Price is a momentary expression of value between a seller and a buyer. On a simple level, low prices represent a better value and higher prices suggest better quality; but on Wall Street, prices are never that simple — a higher priced stock may be, and often is, a better value than a lower priced stock. How can that be? Understand that all issues (stocks, bonds, etc.) that trade on Wall Street are backed by the future profits of the business that issued that security. On Wall Street we should be asking, "How much am I paying for the expected stream of profits?" or put another way "How long will it take me to earn my money back?" To properly compare different stocks we should at least compare profits (bottom-line earnings) per share (P/E Ratios), which is an indication of how long it will take to earn back the investment (e.g., a P/E of 15 suggests that it will take 15 years to earn back the initial investment, to reach break-even). Other useful measures of value include: Revenues (top-line earnings) per share (P/S Ratio), Profit Growth Rate per share (PEG Ratio), Cash-Flow per share (P/C Ratio), and per share Book Value (P/B Ratio). Bonds trade mostly on the health of the issuer and their ability to meet their promised interest payments and return the principal (the face value of the bond) on the due date; and when the issuer gets in trouble, bonds will often trade at a fraction of their original value (e.g., trade on the liquidation value of the underlying assets, if any, backing the investment).
There are actually two types of prices.
An analysis of price quotes, in a quiet market, shows the price your Market order will likely be filled at. However, in a volatile market, your filled price could be almost any price. As a general rule, you should only use limit orders; and if you really, really want to make a trade, still use a limit order and specify the worst price you can live with.
An analysis of historic trades, via charts, can reveal a lot about the market, both now and in the past. Let me start by dividing the world of active market participants into three groups. The trading activity from the three groups can be seen on the charts. You need to be aware of all three groups. The first and last group creates volatility; and it's this volatility that makes it possible for the professionals in the first and second group earn a reasonable rate of return at lower risks.
The first group is called Momentum Traders. They are the fast money crowd. These guys are primarily market technicians — people who make all of their buy and sell decisions based on what they see on the charts. They know the popular trading patterns and know how to work them. For example, they know that short-term trends often reverse in the area of the standard 20, 50 and 200 period simple Moving Averages (MA) that all these pros have on their charts (and you should too). As a general rule, they only buy what is going up and only sell what is going down; and because they're mostly pros with super-fast trading systems, they close or reverse their positions when the market turns against them. This first group is primarily responsible for most of the up and down trends seen on charts; and they'll ride a trend until it stops being profitable. These momentum traders are responsible for driving prices to irrational extremes, to prices levels that cannot be justified by the underlying business and economic fundaments. This may sound like an easy way to make quick money; but it's not! In this zero-sum game, which actually turns out to be a minus-sum game because win or lose each trader has to pay The Street to facilitate their trades, the guy on the other side of your trade is now likely to be a super-computer co-located with the exchange and programmed by a team of professional momentum traders. You may find that you can win now and then, especially if you wait for and only take very favorable setups; but in time, market statistics show that more than 80 to 90% of all short-term momentum traders get wiped out by these pros.
The second and by far largest group is called Value Investors or Value Traders. In terms of size, the amount of trading capital they manage, most of these guys are the same group of large mutual fund, pension plan, hedge fund, endowment, and insurance managers introduced above in my discussion of longer-term Support and Resistance Channels. As noted above, these elephants are able to hire the best analysis on The Street, both technical and fundamental, and they have a very good working idea of what a fair value or price range should be, both near-term and longer-term. These value guys do their buying a discount prices and selling at premium prices; and this can be seen on the chart. When prices trend up and then suddenly reverse, putting in a pivot high, you can rest assured that the momentum (uptrend) was stopped by a significant supply of stock for sale — sell limit orders place by one or more of these elephants. And when prices trend down and then suddenly reverse, putting in pivot low, once again you can rest assured that the momentum traders were stopped by an elephant (maybe more than one of these large fund managers). If you draw a pair of trend lines (up, down or sideways) connecting all (or most) the significant pivot tops and the significant pivot bottoms, you're likely to see the support and resistance (fair-value) channel defined by these pros. This is a game that you can play and win at; just do your buying a little above their support level and selling a little below their resistance level. Note that news and commentary can cause these pros to adjust their S/R Channels up or down; and when market condition become too confusing or volatile, these guys will often back away (cancel their open orders) and wait for things to settle down. And so should you.
Now that I've introduced the second group (large institutional money managers), I can go back and finish my talk about the first group (momentum traders). These pros are well aware of the second group. In fact, they often work to each other's benefit. Assuming that there is no breaking news or commentary driving the longer-term trend forward, professional day-traders often spend their time probing the limits of of the current channel because that defines their risks (trading range). However, as soon as these momentum traders run into serious support or resistance, they'll reverse their position and drive the near-term trend to the other end of the channel. They also like testing for weakness in institutional S/R Channel because they know that if they can break-through; the channel could shift up or down to their benefit. Since first becoming aware of this, I've noticed two associated patterns. The first is a contraction is the width of the current channel as savvy value traders compete to ensure they get their fill. The second is associated with breaking news. Whenever news or commentary breaks, we often see a period of increased volatility caused by professional momentum traders seeking the new price levels associated with any changes in the institutional analysis; these elephants will often pull back (cancel their open orders on the narrow-end of their channel) and assess the reason and consequence, and then come back to the market with new orders and maybe a new near-term channel.
The third group is comprised of everybody else. Mostly all retail investors and some professional wannabes, who found a way to raise some money, but only seem to generate losses over time. On Wall Street, the money always flows to those who have a time tested strategy, the discipline to work that strategy when the market favors that method, and the discipline to stop when market condition turn against them. I call this group The Noise. They are responsible for most of the random up and down trading that occurs over shorter time periods. I've not yet found a way to gain any real information edge from this group, except that maybe this group goes through cyclical periods of activity and inactivity, which causes an expansion or contraction in the near-term channel.
In summary, you can use charts to find your buy and sell points. Pivots indicate where large instructional players stopped the momentum guys in the past, and could do so again (see the blue dotted circles in the chart below). Note how these pivots tend to occur at or near the popular simple moving averages. Be like the big value players. Buy at discount prices and sell at premium prices; and don't do all your buying and selling at once. Scale in and out of your positions like the pros — use prior pivots-lows to target your buys and prior pivot-highs as sell targets. Understand that charts are the great equalizers. You may not have the ability to gather fundamental information and analysis it like the pros; but you can sure see where their analysis has them doing most of their buying and selling. It pays to learn how to read charts. Go to Chart School or read books on technical analysis like The Visual Investor.
Click here to learn more about the market's nature and technical details about market prices.