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Candlestick Charting Demystified
By WAYNE A. CORBITT
The McGraw-Hill Companies, Inc.Copyright © 2013The McGraw-Hill Companies, Inc.
All rights reserved.
The Case for Candlesticks
Congratulations. By purchasing this book, you have declared that you will no longer fall for the Wall Street myth of "buy and hold." While there are investments that perform well over longer periods, blindly holding on to stocks or commodities during steep declines is not necessary or wise.
In this chapter, you will
Uncover the Wall Street fallacy of "buy and hold"
Recognize the value of becoming defensive when market conditions warrant
Understand that trader psychology moves markets
Learn a brief history of candlestick charting
Buy and Hold Leads to Unnecessary Losses
The buy-and-hold methodology benefited from the greatest bull market in U.S. history, 1982–2000. Even then, however, it was not necessary to "hold on" through the 1987 market crash, the 1998 Russian currency crisis, or the bursting of the tech bubble in 2000. Do you realize that as of December 2011, the Standard & Poor's (S&P) 500 Index was trading at the same level it was back in December 1998? So for all of the ups and downs, those that followed the Wall Street mentality for stock investment are at breakeven over a 14-year period, using the S&P 500 cash index as a benchmark (Fig. 1-1), which does not even keep up with inflation.
Of course some stocks outperformed while others have underperformed the broader market during that period, but from a pure benchmark index standpoint, the index value is virtually the same. The buy-and-hold philosophy evolved from the mindset of salespeople who made a living by convincing investors like mom and pop or the average Joe to hold their investments through the good times as well as the bad. The market climate has changed drastically over the past decade, however, as years of profits can now be wiped out in weeks. This is no longer the market environment in which your parents accumulated wealth. The current environment that features high-frequency trading, instantaneous news releases, and sovereign debt drama can be devastating to the average investor. In order to combat this mentality, it is necessary to take a more active role in managing your assets. This involves trading your account more than the talking heads on Wall Street would have you believe.
Within the investment world, the word trader evokes different reactions in different people. To some it is a way of life—entering and exiting trades based on a preset, tested methodology. To others it is a "bad" word, lumped in with market timing and day trading, but those are bad words only because the media and Wall Street declare them so. The fact of the matter is we are all traders because each position has to have an entry trade and an exit trade. The only difference among viewpoints is the length of time the position is held. While some positions can be held as briefly as a few minutes (day trading), others are held for days, weeks, or months.
The ability to get a read on the market and step aside during periods of market weakness is the key to accumulating wealth. Limiting losses in down markets is an often overlooked component to successful investing, especially for those that are managing their own retirement accounts for the long haul. In today's market, declines can be as sharp as 23 percent in a week and more than 27 percent in a month as the S&P 500 demonstrated in October 2008! Those that dutifully held on during the 2008 financial crisis lost more than 51 percent of their equity portfolio value using the S&P 500 as a benchmark. Holding on to positions because "they will eventually come back—they always do" makes very little sense. Do you realize that a loss of 20 percent in your portfolio requires a subsequent gain of 25 percent just to get back to even? Or that a loss of 40 percent requires a gain of 67 percent just to get back to your starting point? Those that "held on for the long haul" from the 2007 high to the 2009 low needed to more than double their money just to get back to even! In order to protect your own personal wealth, you need to step away from the buy-and-hold myth, which I refer to as "buy and hope." Being able to read the market conditions and to take action before major declines is like putting up an umbrella when it begins to rain. You see the storm clouds and feel the rain, so you instinctively put up an umbrella to keep yourself from getting soaked. Making adjustments in difficult markets can be that simple. The advantage of being able to adjust in adverse market conditions is very similar to a technique used by miners. Have you ever heard of the expression "canary in the coal mine"? This alludes to a trick miners used to alert them to toxic gases being emitted in the mine shaft. They would take a canary in with them, and any toxic gases that were present would affect the canary first, allowing the miners a chance to escape with minimal harm. The same concept of an early warning system can be employed when protecting your wealth.
By using the techniques in this book, you will have your own canary with you when you venture into the markets. It makes no sense to continue to "hold on" during the bad times when your own signals are telling you that there is trouble ahead. By being able to sell and step aside, apply hedge positions (by raising cash or using inverse exchange-traded funds [ETFs]), or simply enter short positions (make profits when the market falls), you will be in a better position to protect what you have worked so hard to accumulate instead of willingly accepting steep losses because "the markets always come back."
The tactic of stepping aside in unfavorable markets is called market timing, but that term has been used negatively by the high spin media machine. The term originated in 2003 as the name given to the illegal practice of mutual fund companies allowing favored clients to trade more frequently than the fund's prospectus allowed—in some cases even accepting trades after the market had closed. This resulted in more favorable pricing for these selected clients. The term's negative connotation to label those that choose not to hang on during painful market declines shows the length Wall Street goes to in an effort to discourage those that want to take a more active role in managing their own assets. While trying to catch every twist and turn in the market is indeed a fool's game and a recipe for disaster, there is nothing wrong with using robust, market-tested indicators to tell a trader or investor when the market is beginning to enter a period of sustained weakness.
When you have finished learning the concepts in this book you should be able to read market messages and react accordingly. While candlestick charting on its own typically gives short-term signals that last anywhere from two to five days, those signals can be given longer term meaning when combined with technical analysis. Candlestick charting can also provide a longer term perspective when used in the weekly time frame.
Becoming a trader is quite easy when compared to other moneymaking endeavors. The barriers to entry are low. There is a wealth of online brokers who just want you to fill out paperwork, fund your account, and begin trading. This is a dangerous path chosen by those who are out to make an easy buck, however. For example, the mentality surrounding Internet stocks in the 1990s was as irrational as the gold rush back in the 1800s. It seemed that all one had to do was buy any Internet stock and instant wealth was within his or her grasp. However those that hung around too long following the burs
Excerpted from Candlestick Charting Demystified by WAYNE A. CORBITT. Copyright © 2013 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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