This Weekend's Trading Lesson From TradingMarkets

Editor's Note:
Each night we feature a different lesson from TM University. I hope you enjoy and profit from these. E-mail me if you have any questions.
Brice

Clarifying The Long-Term Outlook Using Candlestick Charts
By Tsutae Kamada

If you have a bird's-eye view, you won't be afraid of getting lost in the woods. All you have to do is fly up, look around, and immediately you know where you are. Many shopping malls have directories in map form, so you can quickly locate exactly where you are standing. In other words, a bigger picture can be a great help in focusing on your destination. 

Many traders make similar mistakes. Often, they are so busy looking for daytrading opportunities that they become trapped in short-term frames such as three- and five-minute charts. A five-minute bar chart may help a trader spot the immediate direction of the market, but it is useless in detecting the dominant trend of the market. 

If you are a scalper, you need only three- or five-minute bar charts because you do not hold stocks for more than a few minutes. But if you hold stocks for more than an hour, you must arm yourself with longer-time-frame charts such as daily and weekly, in addition to your own time-frame charts. Longer-time-frame charts reveal important resistance and support levels, so you won't be caught in sudden reversals. In this lesson, I would like to show you how longer-time-frame candlestick charts can help to clarify the long-term outlook of stocks.

As we know, some Internet stocks have been making a fierce comeback lately. For instance, Amazon (AMZN)) was trading slightly above $8 at the beginning of April, but its value today (5/4/01) is $17.56 a share, more than double. The obvious question is: Can Amazon continue this upward momentum?

Let's look at different time-frame candlestick charts, and see what kind of insights we can gain from them. 

Below you see a five-minute chart of Amazon from 5/4/01. We can't detect any weakness at all. Even the bearish shooting star that appeared at 3:20p.m. was negated by a strong belt-hold line (opens near the low, but ends near the high) at the closing. Look how heavy transaction volume was in the last 30 minutes of trading. What's your forecast? I'm sure that after studying this chart, nobody would be planning to short the stock.

Now, let me give you a different picture by showing you a daily chart of Amazon. It doesn't look as bullish as the five-minute chart above, does it? The stock managed to break out above its 50-day moving average on April 12, and on April 18, it formed a bearish shooting star (a long upper tail with a small real body). Often, the high of the shooting star becomes a resistance level. With that in mind, I want you to look at the daily chart again. The stock is now challenging the high of the shooting star. Can it take out the high? Some candlestick chartists are betting on a breakout because the issue formed a bullish engulfing pattern (a real body totally engulfs the previous day's real body) on 5/4/01. Anyway, watch out for a potential breakout or breakout failure.

The next natural step is to study Amazon's weekly chart. Can you convince me to buy the stock after glancing at this chart? The only thing I can say is: Amazon is pulling back from its April low. I don't see any candlestick patterns indicating imminent major bullish reversals. If I'm allowed to use a momentum indicator, it may be signaling a minor rally. Even though the stock is declining, the momentum indicator is rising. It is telling us the intensity of price decline is weakening, but I don't want to give too much credit to one indicator. 

The long-term trend of Amazon is still down, as its weekly chart reveals, but daily and five-minute charts indicate tradable patterns. If you use the five-minute chart only, you are in danger of becoming too bullish on the stock. After studying the daily chart, you become cautious because the stock is facing its resistance level. By adding weekly charts to your toolbox, you may even look for potential short opportunities. The lesson here is loud and clear. Don't trap yourself into one time frame alone. Remember, successful traders have a bird's-eye view of the market.

Good luck and happy trading.