Reading Emotions in Charts

Originally published on Business Line August 29, 2010.

Trading is All About Understanding People

Most people incorrectly assume that trading is all about understanding the fundamentals of the market or knowing the balance-sheet of a company. It does not have as much to do with that as it does with understanding people.

People's perceptions or expectations of a company or even the entire economy are what drive prices of securities. Prices of equities, commodities, and currencies are all subject to the same laws of supply and demand, as in any other product.

Demand and Supply

In fact, this is why there is a drop in prices after a company meets expectations for an announcement. The demand for the shares prior to the release overwhelms the supply. Sellers realize this and raise their prices. Buyers, in a desperate attempt to own shares are, in turn, willing to pay more.

For instance, if Tata Motors sells more cars than expected, and traders anticipate this, then the price will not move up as one might expect. Traders expecting positive sales results would have bought the shares prior to the announcement.

This should have caused a rise in price for the reasons stated above. Once the data is known to everyone and there are no surprises, there may be some buying interest.

However, traders who already own shares are disappointed about the prices not rising or are satisfied with the profits and begin to sell. Without increased buying pressure from interested parties, these sellers must drop their price to attract buyers. So you see how human emotion, basically fear and greed, can motivate traders in the market. This is what causes price movement. So, to be successful in trading, you need to know how to read this emotion.

That is what technical analysis does. The charts show the actions of traders who are involved in that security. Candlesticks and technical tools bring out the emotions of those who move the markets. We can see when this emotion shifts.

Stochastic Oscillator

Take for instance, the Stochastic Oscillator. This indicator indicates where prices are closing within a range. If there is a bullish trend that you expect will continue, you would expect the share price to close at or near the high of the day for several days.

If the price closes away from that high, then it implies that the buying pressure has weakened or selling pressure strengthened. Either way, it is not good for those holding the stock.

If there is a close that occurs significantly below the highs, it would trigger a sell signal on the oscillator.

The Stochastic also shows when selling pressure gains or weakens. You would expect a very weak stock to close at or near the lows. If it does not, then buyers are strengthening or sellers are weakening or both.

So by viewing traders' actions in a graphical format, we can make assumptions about the strength of the movement of the stock price.

These observations are part of our decision-making process to time proper entries and exits in the market. That is what technical analysis can offer to a trader or investor.

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