Introduction to Stocks

Stocks are among the most talked about and most popular investment opportunities
available. But although virtually everyone has heard about stocks, many people don't
understand the basic concepts underlying them. Indeed, the starting point for any investor
interested in investing in stocks should be to understand what shares of stock actually
represent and why there is a market for them.
Simply put, shares of stock represent partial ownership in a company. That is to say,
when you own a share of stock, you actually own a part of the company, not just a fancy
sheet of paper. This means that you have a say in how the company is run and that you
have a claim on the company's profits if and when they are paid out in the form of
dividends. The more shares of the company that you own, the more say you have in how
the company is run and the greater your claim on the company's dividends. Ownership in
the company is determined by the number of shares you own divided by the total number
of shares outstanding. So, for example, if a company has 100 shares of stock outstanding
and you own 50 of them, then you own 50% of the company (of course, most companies
have millions of shares outstanding.)
That, in essence, is what it means to own stock. In reality, of course, there is much more
to it, starting with the reasons why companies have stock in the first place. In fact, not all
companies have stock. Only a certain type of company called a corporation has stock;
other types of companies such as sole proprietorships and limited partnerships do not
issue stock. What distinguishes a corporation from these other businesses is the structure
of its ownership. A corporation is in itself its own entity and is owned by shareholders,
whereas in a sole proprietorship or limited partnership the company is directly owned by
the sole proprietor or partners, respectively. The owners of the corporation own it through
the ownership of shares of stock.
There are many reasons why a company might choose to become a corporation. First of
all, incorporation gives the company separate legal standing from the owners and protects
the owners of the company from being personally sued in the event that the company
does injury or harm to another person or corporation. This concept is known as "limited
liability" and it protects the owners of a corporation from being held personally liable in
the event that the company is the subject of a lawsuit. Incorporation also provides
companies with a more flexible way to manage their ownership structure. In addition,
there are different tax implications for corporations (although these can be both
advantageous and disadvantageous).
So how does one obtain stock ownership in a corporation? For many companies, shares
of stock are limited to the founders of the company and/or their employees. These
companies are called "private" companies because their stock is owned privately; that is
to say, it is not possible for the public to buy shares in the company. All corporations start
out private; after all, the founders of the company usually want to maintain control over
the company and its profits. However, after a company has grown for a while, the private

owners will sometimes decide to sell shares of stock in the company to the public. This is
what is called "going public" or performing an "initial public offering" Companies choose
to sell shares of their stock to the public in order to raise money for the company. They
might need this money in order to expand their operations, pay off existing debt, develop
a new product, or for any number of other reasons. So for a certain price the corporation
decides to sell its rights of ownership to the public.
Once a company has sold shares of its stock to the public, those shares can then be resold
by the initial buyers to other investors. This buying and reselling of stock is done on what
is called an exchange, which is essentially just a marketplace for stock. As the demand
for a stock rises and falls on the exchange (which can be due to a number of different
reasons), the price for the stock will also fluctuate. Price fluctuations, in turn, create
another opportunity for investors to make money through stock, namely through capital
gains. Capital gains are those profits that an investor makes when he or she buys a stock
for one price and then later sells that stock for a higher price. Capital losses, the opposite
of capital gains, occur when the investor sells the stock for a lower price than he or she
originally paid.
So, companies sell stock in order to raise money and investors buy stock in order to make
money. But, as economists are forever reminding us, there's no such thing as a free lunch.
Each side must give something up in order to have the opportunity to make money. As
mentioned, corporations, when selling their stock, give up some control as to how the
company is run and what is done with the profits. In return, they get an influx of capital
for the business. On the flip side of the equation, individuals give up their money in order
to buy the stock (and become "shareholders"); in return, they gain control over the
corporation and the right to future profits. There is, however, the chance that there won't
be any future profits, that the profits will be much lower than what the investor
anticipated, or that the company will go out of business entirely. That means that the
investor takes on a certain amount of risk when investing in a company's stock, If any of
these things happen, the investor could lose most or all of the money that he or she paid
for the stock in the first place. That means that there is a certain amount of risk associated
with investing in stocks.
Of course, most of the above is a vast simplification of what is actually involved in
investing in stocks. Deciding how much a stock is worth, evaluating the risks associated
in investing in them, and trading them are all very complicated processes that are
discussed in detail in this paper.

Types of Stock
Stocks can be classified into many different categories. The two most fundamental
categories of stock are common stock and preferred stock, which differ in the rights that
they confer upon their owners. But stocks can also be classified according to a number of
other criteria, including company size and company sector. This paper look at the

different types of stocks that are available and the important characteristics of each of
them.

Common Stock
Most shares of stock are called "common shares". If you own a share of common
stock, then you are a partial owner of the company. You are also entitled to certain voting
rights regarding company matters. Typically, common stock shareholders receive one
vote per share to elect the companys board of directors (although the number of votes is
not always directly proportional to the number of shares owned, The board of directors is
the group of individuals that represents the owners of the corporation and oversees major
decisions for the company. Common stock shareholders also receive voting rights
regarding other company matters such as stock splits and company objectives.
In addition to voting rights, common shareholders sometimes enjoy what are called
"preemptive rights." Preemptive rights allow common shareholders to maintain their
proportional ownership in the company in the event that the company issues another
offering of stock. This means that common shareholders with preemptive rights have the
right but not the obligation to purchase as many new shares of the stock as it would take
to maintain their proportional ownership in the company.
But although common stock entitles its holders to a number of different rights and
privileges, it does have one major drawback: common stock shareholders are the last in
line to receive the companys assets. This means that common stock shareholders receive
dividend payments only after all preferred shareholders have received their dividend
payments. It also means that if the company goes bankrupt, the common stock
shareholders receive whatever assets are left over only after all creditors, bondholders,
and preferred shareholders have been paid in full.

Preferred Stock
The other fundamental category of stock is preferred stock. Like common stock,
preferred stock represents partial ownership in a company, although preferred stock
shareholders do not enjoy any of the voting rights of common stockholders. Also unlike
common stock, preferred stock pays a fixed dividend that does not fluctuate, although the
company does not have to pay this dividend if it lacks the financial ability to do so. The
main benefit to owning preferred stock is that you have a greater claim on the companys
assets than common stockholders. Preferred shareholders always receive their dividends
first and, in the event the company goes bankrupt, preferred shareholders are paid off
before common stockholders. In general, there are four different types of preferred stock:

Cumulative: These shares give their owners the right to accumulate dividend
payments that were skipped due to financial problems; if the company later
resumes paying dividends, cumulative shareholders receive their missed payments
first.
Non-Cumulative: These shares do not give their owners back payments for
skipped dividends.

Participating: These shares may receive higher than normal dividend payments if
the company turns a larger than expected profit.
Convertible: These shares may be converted into a specified number of shares of
common stock.

Since preferred shares carry fixed dividend payments, they tend to fluctuate in price far
less than common shares. This means that the opportunity for both large capital gains and
large capital losses is limited. Because preferred stock, like bonds, has fixed payments
and small price fluctuations, it is sometimes referred to as a "hybrid security."

Stock Classes
Although common stock usually entitles you to one vote for every share that you own,
this is not always the case. Some companies have different classes of common stock
that vary based on how many votes are attached to them. So, for example, one share of
Class A stock in a certain company might give you 10 votes per share, while one share of
Class B stock in the same company might only give you one vote per share. And
sometimes it is the case that a certain class of common stock will have no voting rights
attached to it at all.
So why would some companies choose to do this? Because its an easy way for the
primary owners of the company (e.g. the founders) to retain a great deal of control over
the business. The company will typically issue the class of shares with the fewest number
of votes attached to it to the public, while reserving the class with the largest number of
votes for the owners. Of course, this isnt always the best arrangement for the common
shareholder, so if voting rights are important to you, you should probably think carefully
before buying stock that is split into different classes.

Large Cap, Mid Cap and Small Cap

Stocks can be classified according to the market capitalization of the company. The
market capitalization of a company represents the total dollar value of the company's
outstanding shares. This is equal to the current market price of its stock multiplied by the
number of shares of stock that it has outstanding. That number gives you the market
value of the company, which is one measure of the companys size. Roughly speaking,
there are three basic categories of market capitalization: large cap, mid cap, and small cap
(although some analysts include others such as mega cap at the large end and micro cap
at the small end). The definitions for each of these might vary somewhat depending on
whom youre talking to, but usually they are as follows:

Large cap: market cap valued at more than $10 billion

Mid cap: market cap valued between $1 billion and $10 billion
Small cap: market cap valued at less than $1 billion

In general, the larger the cap size, the more established the company, and the more
stable the price of its stock. Small cap and mid cap companies usually have a higher

potential for future growth than large cap companies, but their stock tends to fluctuate
more in price.

Penny Stocks
A penny stock is a stock priced under one dollar per share (or in some cases, under five
dollars per share). Most penny stocks have only a few million dollars in net tangible
assets and have a short operating history. Penny stocks are almost always small cap
stocks, but the reverse isn't necessarily true. The term "penny stock" is sometimes used in
a derogatory fashion, since many penny stocks are virtually worthless and should be
considered extremely high-risk investments. There are also many cases of fraud involving
penny stocks each year

Sector Stocks
Stocks are often grouped into different sectors depending upon the company's business.
Standard & Poor's breaks the market into 11 different sectors. Two of these sectors,
utilities and consumer staples, are said to be defensive sectors, while the rest tend to be
more cyclical in nature. The other nine sectors are: transportation, technology, health
care, financial, energy, consumer cyclical, basic materials, capital goods, and
communications services. Of course, other groups break up the market into different
sector categorizations, and sometimes break them down further into sub sectors.

Cyclical Stocks
Stocks can be classified according to how they react to business cycles. Cyclical stocks
are stocks of companies whose profits move up and down according to the business
cycle. Cyclical companies tend to make products or provide services that are in lower
demand during downturns in the economy and higher demand during upswings. The
automobile, steel, and housing industries are all examples of cyclical businesses.

Defensive Stocks
Defensive stocks are the opposite of cyclical stocks: they tend to do well during poor
economic conditions. They are issued by companies whose products and services enjoy a
steady demand. Food and utilities stocks are defensive stocks since people typically do
not cut back on their food or electricity consumption during a downturn in the economy.
But although defensive stocks tend to hold up well during economic downturns, their
performance during upswings in the economy tends to be lackluster compared to that of
cyclical stocks.

Tracking Stock
A tracking stock is a type of common stock that is tied to the performance of a specific
subsidiary of the company. This means that the dividends and the capital gains for the
stock depend upon the subsidiary rather than the company as a whole. Owning a tracking
stock does not give the owner voting rights in the corporation, nor do owners of tracking
stocks have a legal claim upon the general assets of the corporation. A company will

sometimes issue a tracking stock when it has a very successful division that it feels is
under appreciated by the market and not fully reflected in the company's stock price.

Stock Actions
Dividends
A dividend is a portion of a company's earnings that is returned to shareholders.
Dividends provide an added incentive (in the form of a return on your investment) to own
stock in stable companies even if they are not experiencing much growth. Many
companies -- mature and young, large and small -- pay a regular dividend to their
stockholders.
Companies use dividends to pass on their profits directly to their shareholders. Most
often, the dividend comes in the form of cash: a company will pay a small percentage of
its profits to the owner of each share of stock. However, it is not unheard of for
companies to pay dividends in the form of stock. Dividends can be determined by a fixed
rate known as preferred dividends, or a variable rate based on the company's latest profits
known as common dividends Companies are in no way obligated to pay dividends,
although they will almost always pay them to preferred shareholders unless the company
is experiencing financial troubles.
There are basically three dates to keep in mind when considering dividends. The first is
the declaration date, on which the company sets the dividend payment date, the amount
of the dividend, and the ex-dividend date. The second is the record date, on which the
company compiles a list of all current shareholders, all of whom will receive a dividend
check. For practical purposes, however, this is an obsolete date -- the more important date
is the ex-dividend date (literally, without dividend), which generally occurs 2 days before
the record date. The ex-dividend date was created to allow all pending transactions to be
completed before the record date. If an investor does not own the stock before the exdividend date, he or she will be ineligible for the dividend payout. Further, for all pending
transactions that have not been completed by the ex-dividend date, the exchanges
automatically reduce the price of the stock by the amount of the dividend. This is done
because a dividend payout automatically reduces the value of the company (it comes
from the company's cash reserves), and the investor would have to absorb that reduction
in value (because neither the buyer nor the seller are eligible for the dividend).
Why do some companies offer dividends while others don't? For that matter, why do any
companies offer dividends? The answer, naturally, is to keep investors happy. The
companies that offer dividends are most often companies that have progressed beyond the
growth phase; that is, they can no longer sustain the rate of growth commonly desired by
Wall Street. When companies no longer benefit sufficiently by reinvesting their profits,
they usually choose to pay them out to their shareholders. Thus regular dividends are paid
out to make holding the stock more appealing to investors, a move the company hopes
will increase demand for the stock and therefore increase the stock's price.

So what is the appeal of dividends? They offer a consistent return on a low-risk

investment. An investor can buy in to a company that has a stable business and stable
(albeit low) earnings growth, rest easy in the knowledge that the value of his or her initial
investment is unlikely to drop substantially, and profit from the company's dividend
payments. Further, as the company continues to grow, the dividends themselves may
grow, providing even more value to the investor. This is one way to treat dividends;
however, there are other strategies for profiting from dividends. Some investors try to
"capture dividends": they will purchase the stock right after the dividend is announced,
and try to sell it for the same price after they've collected the dividend. If successful, the
investor has received the dividend at no cost. This usually doesn't work, because the stock
price usually adjusts immediately to reflect the dividend payout, as interested buyers
know the stock no longer includes the current dividend payment and they adjust the
amount they're willing to pay accordingly.

Splits
A corporation whose stock is performing well may opt to split its shares, distributing
additional shares to existing shareholders. The most common split is two-for-one, in
which each share becomes two shares. The price per share immediately adjusts to reflect
the change, since buyers and sellers of the stock all know about the split (in this case, it
would be cut in half). A company will usually decide to split its stock if the price of the
stock gets very high. High stock prices are problematic for companies because they make
it seem as though the stock is too expensive. By splitting a stock, companies hope to
make their equity more attractive, especially to those investors that could not afford the
high price.
Stocks can be split two-for-one, ten-for-one, or in any ratio the company wants. (The less
common "reverse split" is when the number of shares decreases, for example one-fortwo.) To illustrate what happens when a stock splits, lets look at a simple example. Say
you own 100 shares of stock in XYZ Corp. that are priced at $100 per share. XYZ
decides that $100 per share is too high of a price for its stock, so it issues a two-for-one
stock split. This means that for every share that you previously owned, you now own two
shares, giving you 200 shares. When the stock splits, the price will be cut in proportion to
the split ratio that was chosen by the corporation (in this case, to $50 a share). If you
compare the amount of your investment before the split and the amount after the split you
will notice that they are equal (100 shares x $100/share = $10,000; which is the same as
200 shares x $50/share = $10,000). So, in effect, nothing has changed from your
perspective.
But although technically nothing changes for the investor during a stock split, in reality
often times there are changes. Not only does the split tend to increase demand for shares
by making the shares more accessible to small investors, it also usually garners favorable
media attention. This tends to cause the price of a stock that has split to increase after the
split. The split is interpreted by some as a sign that the company's management is
confident that the stock's price will continue to rise. Of course, there is no guarantee that
this will happen.

Buybacks
A buyback is a corporation's repurchase of stocks or bonds that it has previously
issued. In the case of stocks, this reduces the number of shares outstanding, giving each
remaining shareholder a larger percentage ownership of the company. This is usually
considered a sign that the company's management is optimistic about the future and
believes that the current share price is undervalued.
Companies may decide to repurchase stock for many reasons. They may be attempting to
improve the price to earnings ratio by reducing market capitalization, or they may want to
offer the stock as an incentive to employees. It's important to note that when a company's
shareholders vote to authorize a buyback, they aren't obliged to actually undertake the
buyback. Some companies announce buyback plans as a sign of confidence, but it's
meaningless unless they actually go through with the repurchase.

Initial Public Offerings

Initial Public Offerings (IPOs) are the first time a company sells its stock to the public.
Sometimes IPOs are associated with huge first-day gains; other times, when the market is
cold, they flop. Its often difficult for an individual investor to realize the huge gains,
since in most cases only institutional investors have access to the stock at the offering
price. By the time the general public can trade the stock, most of its first-day gains have
already been made. However, a savvy and informed investor should still watch the IPO
market, because this is the first opportunity to buy these stocks.

Reasons for an IPO

When a privately held corporation needs to raise additional capital, it can either take on
debt or sell partial ownership. If the corporation chooses to sell ownership to the public, it
engages in an IPO. Corporations choose to go public instead of issuing debt securities
for several reasons. The most common reason is that capital raised through an IPO does
not have to be repaid, whereas debt securities such as bonds must be repaid with interest.
Despite this apparent benefit, there are also many drawbacks to an IPO. A large drawback
to going public is that the current owners of the privately held corporation lose a part of
their ownership. Corporations weigh the costs and benefits of an IPO carefully before
performing an IPO.

Going Public
If a corporation decides that it is going to perform an IPO, it will first hire an
investment bank to facilitate the sale of its shares to the public. This process is commonly
called "underwriting"; the banks role as the underwriter varies according to the method
of underwriting agreed upon, but its primary function remains the same.
In accordance with the Securities Act of 1933, the corporation will file a registration
statement with the Securities and Exchange Commission (SEC). The registration

statement must fully disclose all material information to the SEC, including a description
of the corporation, detailed financial statements, biographical information on insiders,
and the number of shares owned by each insider. After filing, the corporation must wait
for the SEC to investigate the registration statement and approve of the full disclosure.
During this period while the SEC investigates the corporations filings, the underwriter
will try to increase demand for the corporations stock. Many investment banks will print
"tombstone" advertisements that offer "bare-bones" information to prospective investors.
The underwriter will also issue a preliminary prospectus, or "red herring", to potential
investors. These red herrings include much of the information contained in the
registration statement, but are incomplete and subject to change. An official summary of
the corporation, or prospectus, must be issued either before or along with the actual stock
offering.
After the SEC approves of the corporations full disclosure, the corporation and the
underwriter decide on the price and date of the IPO; the IPO is then conducted on the
determined date. IPOs are sometimes postponed or even withdrawn in poor market
conditions.

Performance
The aftermarket performance of an IPO is how the stock price behaves after the day of
its offering on the secondary market (such as the NYSE or the Nasdaq). Investors can use
this information to judge the likelihood that an IPO in a specific industry or from a
specific lead underwriter will perform well in the days (or months) following its offering.
The first-day gains of some IPOs have made investors all too aware of the money to be
had in IPO investing. Unfortunately, for the small individual investor, realizing those
much-publicized gains is nearly impossible. The crux of the problem is that individual
investors are just too small to get in on the IPO market before the jump. Those large firstday returns are made over the offering price of the stock, at which only large, institutional
investors can buy in. The system is one of reciprocal back-scratching, in which the
underwriters offer the shares first to the clients who have brought them the most business
recently. By the time the average investor gets his hands on a hot IPO, its on the
secondary market, and the stock's price has already shot up.

Investor Research
Although it is difficult to get in on the ground floor of an IPO, there are still ways
individual investors can make money on the IPO market. For one, full-service and online
brokerages are increasingly offering IPO shares to their customers. Unfortunately, these
shares tend to be reserved for clients with the largest balances (usually $100,000 and up),
and are thus out of the reach of many investors. Furthermore, most brokerages will not
allow investors to sell IPO shares within a certain time period (generally 60-90 days),
which prevents any short-term gains.
The other, more-realistic way to profit from IPOs is to buy into some carefully chosen
stocks after they've become available to the broad market. In a suitably-hot IPO,

institutional investors will not get as many shares as they want before the stock becomes
available on the broad market; thus, an individual investor can buy the stock as soon as
its available, and count on the institutional investors to drive the price higher. And, of
course, the stock may rise purely because the share price is undervalued. We should point
out, though, that historically stocks tend to fall slightly in the first several months of
trading, so it's often best to not buy on the first day.
As with any investment, proper education and careful research are vital to profiting from
IPOs. Research should include a measure of the risks involved with investing in an IPO.
Business, financial, and market risk are several of the risks that should be included in the
evaluation process. Researching business risk involves examining the business model of
the corporation and the management team of the corporation. Researching financial risk
involves examining the corporations financial statements, capital structure, and other
financial data. Researching market risk involves examining the appeal of the corporation
to current and future market conditions
You should also inquire about the purpose of raising capital through an IPO. If the
corporation were issuing an IPO just to get out of financial problems, is investing in this
corporation a wise decision? Those previous problems could be indicative of other
problems, such as weak management. Similarly, if the company was having an IPO just
because the IPO market was hot and investors were currently paying too much for IPO
shares, then you would want to think twice before buying. On the other hand, if the
company has some smart plans for the money, then the IPO might be justified. The
investor must thoroughly investigate all available information to obtain an objective view
on an IPO.

DPOs
A direct public offering (DPO), like the more traditional IPO, is a stock's introduction
to the stock market. The stock is offered to the public for the first time. Unlike an IPO,
which utilizes an underwriter to sell shares to the public, DPO shares are purchased
directly from the issuing company. Individual investors have limited opportunities to
participate in IPOs, so DPOs give the average person a chance to invest in a public
offering. However, because DPOs are typically low-profile, it can be difficult to research
and locate these offerings. These are less common and more difficult to research than
IPOs.

Stock Exchanges
Introduction
Private companies initially sell their stock to the public through a process called an
initial public offering But what if you want to buy and sell shares of a company that is
already public? How would you go about finding someone who owns the stock that you
wish to buy? And when you're ready to sell, how would you find someone who wants to
buy the stock that you own? Obviously, buying and selling public stock would be very

difficult without a centralized system for buyers and sellers. Fortunately, there are stock
exchanges that provide just such a system, whether it be in a physical building or on a
virtual network. This paper takes at look at how some of these exchanges operate, how
they differ from one another, and the important characteristics of each.

NYSE
The New York Stock Exchange (also known by its initials, NYSE, or its nickname, the
Big Board) is the largest and oldest stock exchange in the United States. It traces its
origins back to 1792, when a group of brokers met under a tree at the tip of Manhattan
and signed an agreement to trade securities. Unlike some of the newer exchanges, the
NYSE still uses a large trading floor in order to conduct its transactions. It is here that the
representatives of buyers and sellers, professionals known as brokers, meet and shout out
prices at one another in order to strike a deal. This is called the open outcry system and
it usually produces fair market pricing. In order to facilitate the exchange of stocks, the
NYSE employs individuals called specialists who are assigned to manage the buying
and selling of specific stocks and to buy those stocks when no one else will. Specialists
and traders use a three-letter ticker symbol in order to identify and trade securities on the
exchange.
Of the exchanges, the NYSE has the most stringent set of requirements in place for the
companies whose stocks it lists. The NYSE requires that all of its companies meet certain
minimum listing requirements, including market capitalization, operating cash flow, and
earnings. Companies must also provide their shareholders with certain voting rights, and
they must have two or more outside directors plus an audit committee. It is important to
note, however, that meeting these requirements is by no means a guarantee that the
NYSE will list a company; it simply means that the NYSE will consider listing it. The
NYSE still examines each company individually to ensure that it is a stable business
before it decides to list it.

Amex
The American Stock Exchange (the "Amex") started as an alternative to the NYSE. It
originated when brokers began meeting on the curb outside the NYSE in order to trade
stocks that failed to meet the Big Boards stringent listing requirements (in fact, until the
1950s it was actually known as the Curb Exchange). Nowadays, of course, the Amex
has its own trading floor, just like the NYSE, and it operates in much the same way
except that it lists mostly small and mid cap stocks that don't meet the NYSE's
qualifications. In particular, it specializes in energy companies, start-ups, and biotech
firms, as well as in options and other derivatives In November of 1998 the parent
company of the NASDAQ purchased the Amex and combined their markets, although the
two continue to operate separately.

Nasdaq
Unlike the Amex and the NYSE, the NASDAQ (once an acronym for the National
Association of Securities Dealers Automated Quotation system) does not have a physical
trading floor that brings together buyers and sellers. Instead, all trading on the NASDAQ

exchange is done over a network of computers and telephones. The NASDAQ began
when brokers started informally trading via telephone; the network was later formalized
and linked by computer in the early 1970s. In the subsequent decades it has become a
serious rival to the NYSE, as certain big-name technology companies such as Microsoft
and Cisco have opted to list on the NASDAQ instead of the Big Board. In November
1998 the parent company of the NASDAQ purchased the Amex, although the two
continue to operate separately.
Orders for stock are sent out electronically on the NASDAQ, where so-called market
makers list their buy and sell prices. Once a price is agreed upon, the transaction is
executed electronically. Its important to note that the NASDAQ does not employ market
specialists to buy unfilled orders like the NYSE.

Over the Counter Exchanges

The term over the counter (OTC) has changed in meaning over the years. OTC used
to simply refer to any trading system that did not have a trading floor. Under this
definition, then, the NASDAQ would be considered OTC. As the NASDAQ has grown in
prestige during the last few decades, however, the term OTC has changed to refer instead
to those stocks that do not meet the listing requirements of any of the major exchanges,
including the NASDAQ. This means that todays OTC market primarily includes penny
stocks and other marginal stocks. Todays OTC market is sometimes referred to as the
pink sheets since that is the color of the paper on which the penny stock listings are
printed.
The OTC market presents the average investor with several problems. First, OTC stocks
are usually very risky since they are the stocks that are not considered large or stable
enough to trade on a major exchange. They also tend to trade infrequently, so it can be
difficult to find a buyer for a stock that you wish to sell. Making matters worse is the fact
that pricing information for these stocks are incredibly difficult to obtain. You will have
to rely on your broker to get the information for you, and you have no guarantee that it is
accurate.

Regional and Foreign

In addition to the exchanges mentioned above, there are also several regional
exchanges around the country, including the Boston Stock Exchange, the Philadelphia
Stock Exchange, the Pacific Stock Exchange, and the Chicago Stock Exchange. These
exchanges originally listed only regional companies but now list both regional and
national stocks.
There are also stock exchanges in foreign countries, such as the London Stock Exchange
and the Nikkei Exchange in Japan. These exchanges are usually similar to the ones found
in the United States, although there are differences depending upon the country in which
they are located.

The Stock Market

When people refer to "the stock market" or "the market" it can sometimes be confusing
to beginning investors as to what those terms actually mean. Are they talking about all the
stocks that trade on the NYSE, all the stocks that trade in the U.S., or all the stocks in the
world? Typically when people refer to the market they are talking about all the publicly
traded stocks in this country (they will usually say the global market if they mean the
entire world). Indeed, the concept of the market can be a difficult one at first, especially
since beginners tend to think of stocks as individual units.

Efficient Market
Proponents of the efficient market theory believe that there is perfect information in the
stock market. This means that whatever information is available about a stock to one
investor is available to all investors (except, of course, insiders, but insider trading is
illegal). Since everyone has the same information about a stock, the price of a stock
should reflect the knowledge and expectations of all investors. The bottom line is that you
should not be able to beat the market since there is no way for you to know something
about a stock that isnt already reflected in the stocks price. Thats not to say that
efficient market theory fans claim that all stocks are necessarily priced correctly; instead,
they claim that there is no way for you to know whether or not prices are too high or too
low. Proponents of this theory spend little time trying to pick stocks that are going to be
winners; instead, they simply try to match the markets performance. However, there is
ample evidence to dispute the basic claims of this theory, and most investors don't believe
it.

Random Walk
The random walk theory draws conclusions that are similar to the efficient market
theory, but it uses a different line of reasoning. The theory takes its name from a wellknown book by Burton Malkiel (although others pioneered the idea decades earlier)
which says that future stock prices are completely independent of past stock prices. In
other words, the path that a stocks price follows is a random walk that cannot be
determined from historical price information, especially in the short term. Much like
efficient market theory fans, the random walkers believe that it is impossible to pick
winning stocks and that your best bet is just to try to match the markets performance,
usually by using a long-term buy and hold strategy.

Behavioral Finance
Behavioral finance theory is very different from the random walk and the efficient
market theories. Proponents of behavioral finance believe that there are important
psychological and behavioral variables involved in investing in the stock market that
provide opportunities for smart investors to profit. For example, when a certain stock or
sector becomes hot and prices increase substantially without a change in the companys
fundamentals, behavioral finance theorists would attribute this to mass psychology (also

known as the follow the herd instinct). They therefore might short the stock in the long
term, knowing that eventually the psychological bubble will burst and they will profit[2].

Bull and Bear Markets

In addition to the three market theories mentioned above, there are other ways of
thinking about the market as a whole, that are less theoretical and more grounded in what
is actually happening to them. One way is to describe the overall trends in the market,
such as by defining them as bearish or bullish. A bull market, loosely defined, is a market
in which the major stock indexes have risen by over 20% over a substantial period of
time, usually measured in months or years. Bull markets can happen as a result of an
economic recovery, an economic boom, or simple investor psychology. The longest and
most famous of all bull markets is the one that began in the early 1990s in which the U.S.
equity markets grew at their fastest pace ever.
Bear markets are the exact opposite of bull markets: they are markets in which the major
indexes have declined by 20% or more over a period of at least two months (a decline
that large for any shorter time period is simply called a correction, especially if it
followed a substantial rise). Bear markets usually occur when the economy is in a
recession and unemployment is high, or when inflation is rising quickly. The most
famous bear market in U.S. history was, of course, the Great Depression of the 1930s.

Seasonal and Time-Related Market Factors

During certain times of the year or certain times of the month, the markets tend to
exhibit certain behaviors more often than would be predicted by chance. For example, the
early fall, October in particular, has historically been a time when the markets have
slumped, although the effect isn't extremely pronounced and there isn't a logical
explanation for it. Strong stock performance in January is another example of a seasonal
market trend. The so-called "January Effect" occurs because many investors choose to
sell some of their stock right before the end of the year in order to claim a capital loss for
tax purposes. Once the tax calendar rolls over to a new year on January 1st these same
investors quickly reinvest their money in the market, causing stock prices to rise. But
although the January effect has been observed numerous times throughout history, it is
difficult for investors to profit from it since the market as a whole expects it to happen
and therefore adjusts its prices accordingly.
In addition to the January effect and the October slump, there is also something called the
triple witching hour that occurs four times per year, during the final hour of trading on
the third Friday of March, June, September, and December. This is when the expirations
on stock index futures, options on the stock index, and options on stock index futures all
expire. When this happens, options and futures begin being bought and sold in vast
quantities, which causes large fluctuations in the value of their underlying stocks

Stock Regulations

Although it hasnt always been the case, the securities industry in the U.S. today is
subject to strict regulations. Its important for you to know about some of the regulatory
bodies and their rules in order to make sure you stay well within the limits of the law.
Penalties for not playing by the rules can be stiff and involve both hefty fines and time in
prison. Most of the time, it is individuals who work on Wall Street or who are insiders at
a company that run afoul of the law. Still, its a good idea for even the average investor to
know about the legal issues that exist in the securities world.

SEC
The Securities and Exchange Commission was established in 1934 in order to correct
some of the problems in the securities industry that had led to the Crash of 1929 and the
resulting Great Depression. Before this time, there was no central regulatory agency
responsible for enforcing securities legislation (granted, there was not much legislation to
enforce). The SEC of today, however, is responsible for enforcing a wide variety of
securities laws and ensuring that all market participants are playing by the rules.
The SEC is an independent, quasi-judiciary regulatory agency. It has five commissioners,
each appointed for a five year term that is staggered so that one new commissioner is
being replaced every year. In order to keep partisan politics to a minimum, no more than
three members of the commission can be of a single political party. The commissioners
are primarily responsible for enforcing the following pieces of securities legislation:

Securities Act of 1933: Prohibits fraud in the sale of securities and requires proper
disclosure of information about public securities to investors.
Securities Exchange Act of 1934: Extends the Securities Act of 1933 to include
securities traded on exchanges and over-the-counter markets
Investment Advisor Act of 1940: Requires that investment advisors and
investment advising firms register with the SEC and adhere to its standards.

Of course, there are other pieces of legislation that the SEC enforces; these are just
three of the most important ones. Recently, with the rash of accounting, mutual fund, and
analyst scandals, there has been a significant amount of new reform legislation aimed at
ensuring fair dealings. Eliot Spitzer, SEC watchdog, uncovered ample evidence in 2002
that analysts were doctoring their reports to win business for their banks' investment arms
or to downgrade companies that don't play ball. It is to be hoped that the new regulatory
crackdown on such activities will curb the publishing of misleading stock information,
but the individual investor should beware.
The job of enforcing regulations is divided between four basic divisions of the SEC. The
Division of Corporate Finance is in charge of making sure all publicly traded companies
disclose the required financial information to investors The Division of Market
Regulation oversees all legislation involving brokers and brokerage firms. The Division
of Investment Management regulates the mutual fund and investment advisor industries.
And finally, the Division of Enforcement enforces the securities legislation and
investigates possible violations.

NASD
The National Association of Securities Dealers (NASD) is a self-regulatory nongovernmental agency that regulates the sales of securities and oversees licenses for
brokers and brokerage firms. The NASD investigates complaints against member firms
and tries to ensure that all of its members adhere to both its own standards and those laid
out by the SEC. The NASD has the power to expel its members from an exchange in the
case of wrongdoing (it cannot, however, take legal action against a member other than by
reporting it to the SEC). The association is run by a Board that takes half of its
representatives from the securities industry and half of its representatives from the public.
In total, the NASD oversees more than 5,000 securities firms.

Illegal Insider Trading

Insider trading is illegal when insiders trade on the basis of information that has not
been disclosed to the public and that relates somehow to the companys stock. Insiders
are usually the officers of a company, but it can also include officers relatives or
employees of the firm. In fact, anyone who comes across inside information through any
means and then trades upon it can be found guilty of insider trading. The SEC, the
NASD, and the exchanges carefully regulate the trading activity of insiders in order to
curb these abuses.

Stock Indexes
Stock indices are benchmarks that are used to gauge the performance of a group of
stocks. There are many different types of indices and each of them is unique in its own
way. This paper covers the major stock indices that investors use and why they use them.

Dow Jones Industrial Average

The Dow Jones Industrial average is by far the most famous of all the stock indices. It
is composed of 30 widely traded blue chip stocks (large, well-established companies that
are leaders in their respective industries). The 30 stocks are chosen by the editors of the
Wall Street Journal (which is published by Dow Jones & Company), a practice that dates
back to the beginning of the century. The Dow was officially started by Charles Dow in
1896, at which time it consisted of only 11 stocks.
The Dow is computed using a price-weighted indexing system. Simply put, the editors at
WSJ add up the prices of all the stocks and then divide by the number of stocks in the
index. (In actuality, the divisor is much higher today in order to account for stock splits
that have occurred in the past.) The Dow is highly regarded for its simplicity and its
history.
However, there are some disadvantages in using the Dow as a benchmark. First of all, the
Dow only includes prices for 30 stocks, yet there are thousands of publicly traded stocks
on the market. Critics of the Dow therefore question whether or not the Dow is a

representative snapshot of the market as a whole. Another problem with the Dow is that it
is weighted by price, instead of market capitalization So, for example, a stock that trades
at $100 but has a market cap of only $1 billion will receive more weight than a stock that
trades at $50 but has a market cap of $5 billion. Most experts agree that market
capitalization-weighted indices better reflect the markets performance than priceweighted indexes.

NASDAQ Composite
Not surprisingly, the NASDAQ Composite tracks all of the stocks listed on the
NASDAQ exchange The index dates back to 1971, which is when the NASDAQ
exchange was first formalized. The index is used mainly to track technology stocks, and
thus it is not a good indicator of the market as a whole. Unlike the Dow, the NASDAQ is
market capitalization-weighted, so it takes into account the total market value of the
companies it tracks and not just their prices. Since the index tracks all of the 5000+
stocks listed on the NASDAQ, it includes more than just a representative sample of the
technology industry. Critics charge, however, that the index tracks too many small
companies whose performance increases the indexs volatility.

S&P 500
The S&P 500 index dates back to 1957 in its modern version (although it has been
extrapolated backwards to several decades earlier for performance comparison purposes).
This index provides a broad snapshot of the overall US equity market; in fact, over 70%
of all U.S. equity is tracked by the S&P 500. The index selects its companies based upon
their market size, liquidity, and sector. Most of the companies in the index are solid mid
cap or large cap corporations. Like the NASDAQ Composite, the S&P 500 is a marketweighted index, so it provides a fair assessment of the stocks that it tracks. Most experts
agree that the S&P 500 is one of the best benchmarks available to judge the market. Its
only possible fault is that it does not include foreign stocks (except for a handful that
have traditionally been included).

Wilshire 5000
If youre looking for an index that captures the state of the entire market, you need
look no further than the Wilshire 5000. Founded in 1974 by Wilshire Associates, the
Wilshire originally listed 5,000 stocks, although in subsequent decades it grew to include
considerably more. The Wilshire now tracks over 7,000 stocks (although the name kept
the 5,000 number in it for consistency). The index tracks every stock for every company
that is headquartered in the United States, leading some to call it the Total Stock Market
Index. Like the S&P 500 and the NASDAQ, the Wilshire 5000 index is a market
capitalization-weighted index.

Russell 2000
The Russell 2000 index is used to track the performance of 2,000 small-cap stocks.
These arent necessarily the smallest 2,000 companies in existence; instead the index is
composed of the 2,000 smallest companies in another related index, the Russell 3000,

which tracks the 3,000 largest companies in the U.S. So in that sense the Russell 2000
can be thought of as the smallest of the large companies. Even so, the Russell is a welldiversified index of small-cap stocks that is a useful benchmark for those interested in
only small companies.

Foreign Indexes
In addition to all the domestic indices mentioned above, there are a number of indexes
used around the world and in the U.S. that track foreign stocks. Morgan Stanley, for
example, has a Europe Australasia Far East (EAFE) index that is used to track stocks in
developed markets in those parts of the world. England has the FTSE 100 (pronounced
footsie), a British equivalent for the Dow. And Japan has the Nikkei 225, another index
similar to the Dow that dates back to 1949.

International Stocks
Stocks are obviously not unique to the United States. In fact, the U.S. equity market
makes up less than half of the global equity market, so there are indeed many
opportunities for investing in stocks abroad. You should note, however, that foreign
stocks, while similar to domestic stocks, are different in some important ways.

Diversification
The number one reason most financial experts cite when advising investors to consider
foreign securities is diversification. The logic behind this reasoning is simple enough: if
the U.S. happens to be suffering from an economic downturn or high inflation, there are
probably going to be better investment opportunities abroad. Those investments abroad
could help boost a portfolio weighted heavily in US equities when the U.S. stock market
is not performing well.
But not everyone agrees with this reasoning. Academic studies have shown that while
global diversification seemed to work quite well for many years, sometime during the late
1970s it stopped helping returns. A number of different reasons have been cited as to why
this might be the case, including an increasingly global marketplace that has reduced
economic differences among countries.

Risks
Whether or not these arguments are correct remains to be seen. There are, however, a
number of different risks associated with foreign stocks that are beyond doubt. There is,
for example, country risk. While U.S. markets have performed well over the very long
run, this is not necessarily the case with all foreign countries. Many countries suffer from
political, social, and/or economic instability that makes investing in those countries very
risky. Furthermore, foreign governments have different rules regarding the regulation and
taxation of securities that could be at odds with your investment objectives. Before
investing in any foreign country, learn about that countrys political, social and economic

conditions, as well as its tax laws and securities regulations.

In addition to country risk, there is also something called currency risk. Currency risk is
the risk that your investments abroad might decline in value because of fluctuating
currency rates. In general, the stronger the U.S. dollar becomes against a foreign
currency, the more you lose when investing in that country. This is because you must
convert your dollars into the foreign currency in order to purchase securities there and
later convert the foreign currency back into dollars when you sell the securities. If the
dollar is stronger against the other currency when you are exchanging the money for the
second time, you will lose some of its value. Of course, it also works the opposite way: a
weaker dollar can help to boost your returns.

Buying
Since purchasing foreign securities can be quite difficult due to the exchange of
currencies involved, the investment community has developed a few different ways for
you to purchase foreign securities more easily. Perhaps the easiest way for you to buy
foreign stocks is through a global or international mutual fund. Mutual funds bundle
together different securities from around the world in a number of different arrangements,
so you can probably find what you are looking for whether it's emerging market equities
or equities from around the world. Note that this wouldn't eliminate country or currency
risk, but these risks would be managed by a professional who has expertise in these areas.
Besides mutual funds, you can look into purchasing what are known as American
Depository Receipts (ADRs). ADRs were first created by U.S. banks in 1927 in order to
make it easier for investors to buy stocks from abroad. ADRs are created when a U.S.
bank purchases a large number of shares in a stock and then bundles them together and
reissues them on one of the major American stock exchanges. In other respects, ADRs
behave just like ordinary domestic stocks. They are a great way to invest in foreign
securities since they reduce administrative costs and the costs associated with exchanging
currencies. Foreign companies also benefit from having their stock converted into ADRs
because it gives them greater exposure to U.S. investors.

Types of Foreign Stocks

Of course, not all foreign stocks are the same. As mentioned previously, countries
across the globe vary greatly in their political, social and economic systems. This means
that you may want to invest in foreign stocks from one part of the globe but not from
another. In general, there is a distinction made between emerging markets stocks and
other foreign stocks. Emerging markets stocks are stocks from companies located in
countries that are undergoing significant economic transitions, such as developing Third
World nations or the nations of the former Eastern bloc. Because these countries are in
transition, the risks of investing in their stock is much greater than investing in the stock
of companies from, say, Japan or Western Europe.

Trading Stocks
Introduction and Types of Orders
Before you start trading stocks, it's a good idea to understand the process of trading. Most
buyers in this country are accustomed to retail shopping, where the prices are set
beforehand by the seller. The stock market operates more like an auction, in which both
buyers and sellers are actively setting the prices at the same time. I will discuss how
trading works, the different types of trading orders you can execute, and the different
systems that you can use to place your orders.
Both buyers and sellers actively set prices in the stock market. Not surprisingly, then,
there are two prices associated with every stock: the bid price and the ask price. The bid
price is the price at which buyers say they will purchase the security; the ask price is the
price at which sellers say they will sell the security. The bid and the ask prices are rarely,
if ever, the same: generally, the bid is slightly below the ask. The difference between the
two is what is known as the spreadthis is the amount that is taken by your broker as
profit. Specialists, who are in charge of the coordination of the buying and selling of a
certain stock, pair bids and asks together to streamline the process and keep the spread
small but positive
Since the bid and ask prices of a stock are in constant fluctuation, you need to be careful
about your sales and purchases. The price that you see quoted may or may not be the
price at which you actually buy/sell the stock. For instance, you may look on the internet
and see that your stock is selling for a certain price and decide that it's time for you to
sell. However, you might also get distracted by something immediately afterwards, so a
little bit of time elapses before you can contact your broker to tell him/her to sell your
stock. Then your broker has to relay the order down to his/her representatives on the
trading floor assuming the stock trades on the NYSE or Amex. By the time your trade is
actually executed, the price of the stock might have slipped from what you thought it
was, and you're left with less cash than you had anticipated.
Sound scary? Fortunately, trading does not have to work that way. The good news for you
is that you have many options regarding the method of execution for your trades. In the
above example, you would have been using what is known as a market order. Market
orders definitely have their uses, but you should be aware of all of the following types of
trades:

Market Orders: As mentioned above, you tell your broker to purchase or sell a
specified quantity of stock at the prevailing market price. These are often the
lowest-commission trades because they involve very little work on the broker's
part.
Limit Order: You tell your broker to buy a security at or below a specified price,
or to sell a security at or above a specified price. This ensures that you will never
pay more for the stock than whatever price you set as your "limit."

Stop Order: You tell your broker to buy a security at the market price once it
reaches a level higher than the current market price. The opposite would be true if
you were selling: you would tell your broker to sell your security once it reaches a
level below the current market price.
Fill or Kill: You tell your broker to execute the trade immediately; if the trade is
not filled right away then your broker does not execute the order.
Day Order: You tell your broker to execute the trade by the end of the day;
otherwise, he or she does not fill the order.

ECNs
If the thought of your broker making money off the bid/ask spread makes you less than
thrilled, you should be aware that there are alternatives for trading, such as Electronic
Communications Networks (ECNs). Electronic Communications Networks (ECNs)
represent orders in NASDAQ stocks; they internally match buy and sell orders or
represent the highest bid prices and lowest ask prices on the open market. The benefits
you get from trading with an ECN include after-hours trading, avoiding market makers
(and their spreads), and anonymity (which is often important for large trades).

Online Trading
You might also want to try trading online. Although trading online does not eliminate
the role of market makers and specialists, it can provide you with many other
conveniences, such as the ability to trade from your desk at work or at home. You should
be aware, however, that online trading is not instantaneous, so you still might find
yourself wanting to use limit orders instead of market orders. If there is a computer glitch
and you are not sure that the order went through, try to contact your broker or issue a
cancellation before re-submitting the order. You don't want to end up owning twice as
much stock as you had originally planned on buying.

After Hours
The stock markets in New York have traditionally been open for trading from 9:30 am
until 4 pm EST, every Monday through Friday (with the exception of certain holidays).
As interest in the stock market has grown, however, there has been greater and greater
demand for additional trading hours after the markets close. The markets actually do
allow trading after the closing bell -- it is known as "after hours" trading. For many years
after hours trading was limited to individuals with a high net worth and to institutional
investors such as pension funds, but it is becoming more common nowadays as systems
like electronic communications networks (ECNs) make it easier for individual investors
to access the after-hours market Before you decide to trade shares after hours, however,
you should be aware that trading stocks after hours can be a much different experience
than trading during normal hours. For one thing, volume after hours is extremely low,
since most investors do not trade after 4 pm. Low volume can lead to high volatility and
large bid/ask spreads, and often times there are larger than normal price fluctuations in
after hours trading.

Day Trading
Day traders are individuals who are trying to make a career out of buying and selling
stocks very quickly, often making dozens of trades in a single day and generally closing
all positions at the end of each day.
Day trading can be costly given the impact of commissions and the bid/ask spread. Day
traders will typically select a discount broker in order to mitigate the cost of commissions
on overall profits. Here are some tips for day trading:

Avoid the red-hot stocks and the household names. This is where the day trading
pros tend to hang out, so you'll be competing with the best traders if you focus on
these stocks.
Find stocks linked to indicators and trade based on movements in those indicators.
For example: bank stocks do well when interest rates fall; transportation stocks do
well when oil prices fall; export-oriented companies do well and import-oriented
companies do poorly when the dollar is weak. If you spot a stock which should be
moving due to an indicator but isn't, it could be a buying/selling opportunity.
Sell in the first hour of the day and buy in the last hour of the day. Day traders and
market makers often close out some of their positions at the end of the day. This
results in buying pressure in the morning and selling pressure in the afternoon,
which you may be able to capitalize on. However, this strategy may no longer
work with the advent of around-the-clock trading.
Don't overtrade. You'll be paddling upstream with each commission, so don't be
afraid to just sit at your computer and do nothing. Don't chase after bad trades
because you feel like you're wasting your time.
Set a limit to how much you're willing to lose and if you lose that much then get
out.
Learn more. The tips above aren't nearly enough to make you a successful day
trader. There are a large number of books on the subject, and you'll want to do a
lot of learning before putting any of your hard-earned money at risk.

Active Trading
Active traders buy and sell stocks frequently but havent pursued it as a full time job.
Unlike day traders, active traders trade once or twice a day, and don't close out all their
positions at the end of the day. While a day trader might only hold a given position for a
few minutes, active traders often hold onto their stocks for days, weeks or even months.
Also, while a day trader generally pays a large fee to their firm to use special trading
software as well as a commission, an active trader usually sticks with a deep discount
online broker or Level II NASDAQ quotes.
A few more tips about active trading:

You may be able to deduct some of the expenses incurred in the process of trading
(provided they exceed 2% of your AGI), including margin interest, real-time

quote costs, investment research costs, software costs, and internet access costs
associated with investing. If you do this, keep accurate records.
There is an IRS regulation called the Wash Sale Rule, regarding selling a security
at a loss and then buying back the same security or a very similar one within 30
days. When a wash sale occurs, you can't deduct the losses for tax purposes, but
instead must add the disallowed loss to the cost of the new security. This
postpones the loss deduction until the new security is sold. This is an unfortunate
but unavoidable problem that active traders must deal with but that buy-and-hold
investors don't have to worry about.

Brokerages
Introduction
The most common way for you to purchase a stock is through a broker. Actually, the
broker that you deal with is technically called a registered representative or an
account executive and the company that your account executive works for is called a
broker-dealer. For simplicitys sake, in this section we will just use the word broker in
the popular sense, to refer to the person that you tell to purchase or sell your securities.

Commissions and Fees

Brokers and brokerages (the companies that employ brokers) make money primarily
by charging commissions. A commission is a fee that you, the customer, pay a broker in
order to execute a transaction for you. The reason why you must go through a broker and
pay this fee in order to trade a stock is because you yourself do not have access to the
stock exchanges. Brokerages, however, have seats on the various exchanges and so they
will trade your stock for you in exchange for a small (or sometimes large, as the case may
be) commission. Brokerages also charge a number of other fees, such as for transferring
funds into and out of an account. Since fees and commission vary from broker to broker,
the best idea is for you to shop to around to see for what each brokerage charges.

Cash Accounts
The cash account is the most common type of account used at brokerages. As the name
suggests, cash accounts are accounts into which you place your money in order to make a
trade. You either must have enough money in your account to cover the trade at the time
of its execution (including both the price of the security and the commission), or you
must be able to pay for the trade within three days (this is called the settlement date).
Some brokerage firms are now beginning to accept credit cards to fund cash accounts, but
the overwhelming majority still require cash or a personal check.

Margin Accounts
Unlike a cash account, a margin account allows you to buy securities with money that
you dont have. How is that possible? You simply borrow the money from your broker.

The Federal Reserve limits margin borrowing to at most 50% of the amount invested (so,
for example, if you want to buy a share of stock for $100 you can borrow $50 at most on
margin and you must pay the other $50 yourself). Some brokerages have even stricter
requirements, especially for volatile stocks. People open margin accounts mostly to take
advantage of an opportunity to leverage their investment, not because they dont have the
money to make the full purchase By only putting up half the money for the purchase,
investors realize a higher return if the stock rises (for example, using the preceding
example, if the stock price doubles to $200 then the investor has actually quadrupled his
or her original $50 investment; if s/he had put up the full $100 the investment would only
have doubled in value). Brokerages charge a relatively low interest rate on margin loans
in order to entice investors into buying on margin.
As with any investment technique, there are downsides to buying securities on margin.
Although buying on margin can give you the opportunity to make more money than
normal, it can also lead to larger than normal losses, especially if the broker issues what
is known as a margin call. A margin call is basically a call for the investor to repay the
loan right away, within 24 hours. They are usually issued when the value of the
investment drops below the amount that has been borrowed. In this case, the broker will
want you to sell the security immediately in order to pay off your margin loan, which of
course would leave you with nothing from your original investment.

Discretionary Accounts
Discretionary accounts are a special type of brokerage account that permit the broker
to buy and sell shares for you without first contacting you for approval. You can also set
up a discretionary account with an investment advisor who can make the same
unauthorized transactions. If youre going to set up a discretionary account, its probably
a better idea to do so with your financial advisor as the authorized party since they (at
least in theory) are supposed to be trying to maximize your financial well-being. Brokers,
on the other hand, are not responsible for making you money; they are responsible for
making themselves money and so they might make frequent unnecessary transactions in
order to boost their commission.

Broker Research
Before sitting down to decide which broker you want to open an account with, you
should probably do a little bit of research about the person who will be handling your
transactions. One way to find out about a brokers background is to call the National
Association of Securities Dealers (NASD), a self-regulatory agency of brokers. The
NASD can tell you, for free, whether your broker has ever been convicted of a securitiesrelated crime or whether disciplinary action has been taken against him or her.
The other major resource that you can use to find out about your broker is the Central
Registration Depository (CRD) system, a computerized database that has information on
over 600,000 registered stockbrokers. The CRD can tell you about the brokers
employment history, his or her securities examination scores, licensing information, and
any record of disciplinary action. In order to access the CRD, simply ask your

prospective broker for his or her CRD number and then contact your state securities
commission or the NASD.

Choosing a Broker
When choosing a brokerage, be cautious of advertising, especially the advertisements
with comparisons of commission schedules. Instead, focus on objective ratings and use
the list of considerations below to help you make your decision:

Commission rates: especially for the types of trades you typically make.
Range of services: make sure they offer everything you need (for example, if you
will be trading foreign stocks, confirm that they are equipped for this).
Quality of service: check the Better Business Bureau, NASD Regulation or your
state attorney general's office for complaints.
Minimum to open an account
Account protection: confirm that they are SIPC insured. This will cover you for
up to $100,000 in cash and $500,000 in securities. If you need more, discuss it
with the broker.
Fees and investment options for IRAs
Margin rate (if you plan to buy on margin)
Money market account yield
Commissions on no-load mutual funds
Inactivity fees
How long you have to wait on hold when calling
Local offices
Other services (check writing privileges, credit cards, etc.)

When choosing an online broker, the following extra considerations are important:

Use of a secure server to handle all transactions.

Types of investment vehicles: stocks, options, bonds, futures, mutual funds,
foreign securities.
Types of orders that can be placed. Most allow market orders, stop orders, and
limit orders.
Order execution speed. Some brokers use "drop copy" trading, in which a live
broker reviews orders before they're executed, which can delay the trade by up to
ten minutes.
Order confirmation speed.
Support, preferably by both phone and email, and preferably 24-hour.
Amount of account information (and speed with which it's updated).
Free or cheap real time quotes.
Free or cheap research, market data and news, portfolio tracking, alerts, and
planning tools.

Its a good idea to narrow down your list of potential brokers to a few that seem to
meet your needs, and then to open demo accounts with each to see which you like best.

Discount versus Full Service

There are a few differences between full service brokerages and discount brokerages.
The major tradeoff is cost versus services. Full service brokers will help you make
decisions, whereas discount brokers won't. But the full service broker may not have your
best interests at heart when making these recommendations (since he or she works on
commission, there is always going to be a conflict of interest). Also, the full service
assistance does not come cheaply: commissions are significantly more expensive at the
full-service brokerages than at discounters. If you feel confident enough to select your
own stocks, it probably makes sense to go with a discount brokerage. Also, nearly all
discount brokers offer online trading.

Opening an Account
Opening a cash account is perhaps the simplest step involved in dealing with a broker.
You simply fill out an application form, sign it, and send in your initial deposit (minimum
deposit accounts vary from broker to broker but usually fall within the $500 to $2500
range, so make sure you have enough money first). Opening a margin account, however,
may be a bit more difficult if you have a poor credit history. You can also transfer an old
brokerage account to a new one. The key here is to open the new account first and then
ask your broker for the appropriate forms necessary to transfer the securities (if youre
transferring cash, then you can just ask your old broker to send you a check for your
balance and then use the money for your new account).

Stock Certificates
When you purchase a security through a brokerage, you have a couple of options as to
how you want to hold the actual security. You always have the option to request that the
actual stock certificate be mailed to you and that the issuer place your name upon its
registration list. Most often, however, people choose to hold stock in their brokerage's
street name. When you hold a stock "in street name", your ownership of the stock is
recorded at your brokerage but not by the issuer (they record your broker's name). You
also will not receive an actual stock certificate, although your broker will forward you all
relevant company correspondence, such as annual reports and proxies. Most people
choose to hold their stock in street name because it makes it easier for them to sell later
(since they don't have to mail in the certificate) and they don't have to keep track of the
certificates themselves (there are replacement fees if they are lost). Recently, some
companies have been allowing "direct registration" of stock that allows you to have the
security registered in your name without holding the actual certificate. You can check
with your broker or the company issuing the stock to see if this alternative is available.

Regulations and Fraud

In order to buy and sell securities for you, your stock broker must have passed two
examinations (called the Series 7 and the Series 63) and he or she must have a valid
broker's license issued by the National Association of Securities Dealers, a regulatory
agency for brokerages. Unfortunately, these regulations do not completely prevent ethical
violations from occurring in the brokerage industry. You can, however, take action against
your broker by contacting the NASD or the SEC for possible code violations if he or she
has done one of the following activities:

Churning: Your broker cannot trade excessively on your account in order to boost
his or her commissions.
Deception or manipulation when talking to you about your securities.
Unauthorized trading on your account.
Guaranteed that loss of investment will not occur.

SIPC
The Securities Investor Protection Corporation (SIPC) is a non-profit, non-government
corporation that insures brokerages in the case of a firm failure. The SIPC is funded by all
of its member securities broker-dealers, and it will replace up to $500,000 per customer
in the event that a brokerage runs out of funds to cover its claims. The SIPC does not,
however, insure you against losses to your investment.

Broker Recommendations
While stock picks from brokers can be useful information, they should not be relied on
too heavily. Brokers usually have significant conflicts of interest that affect their
recommendations, and so all information coming from them should be taken with a grain
of salt. After all, brokers are paid based upon how many times you trade, so some are
tempted to recommend that you trade more often than necessary. They may also have
other motives for getting you to buy a particular stock or to trade at a particular time. The
best idea is to usually use a broker for simply buying and selling securities and not for
advice. Doing so will also save you on commissions if you choose to use a discount
broker as opposed to a full service broker.

Analysts and Earnings Estimates

Analyst Reports and Recommendations
Wall Street investment firms employ thousands of analysts whose job is to issue
reports and recommendations on specific stocks. These analysts typically look at the
company's fundamentals and then build financial models in order to project future trends,
most notably future earnings They then use these projections as a basis for issuing
recommendations on whether or not they think the stock should be bought or sold.
Analyst recommendations vary from one firm to another, but usually they resemble

something along the lines of "strong buy," "buy," "hold," and "sell." Many investors take
these recommendations quite seriously, and you'll notice that often times when an analyst
changes his or her outlook on a stock the price will rise or fall immediately.
You should be careful when looking at analyst recommendations for several reasons. First
of all, many analysts suffer from a conflict of interest between the firm that employs them
and the company whose stock they track. Often times, an analyst will be responsible for
issuing reports on a company that is a current or potential client of their employer
(usually an investment bank). Since they know that their employer would like to keep the
client's business, the analyst may be tempted to issue a rosier outlook for the stock than
what it really deserves. You should also be careful regarding the actual recommendations
themselves. There are very few "sell" recommendations issued; "buy" and "strong buy"
are much more common, so much so that "buy" is sometimes interpreted to mean "not
good enough for a strong buy, so not worth buying". Again, analysts do not want to
offend any company that could be a potential client for their bank (which is every
company), so many analysts put a positive spin on even the gloomiest of stocks.

Earnings Estimates and Earnings Whispers

In addition to issuing buy, hold, and sell recommendations, analysts also issue earnings
estimates for companies. These earnings estimates are earnings per share numbers that
the analyst believes a particular company will report in its next quarterly statement
Earnings estimates have become increasingly important on Wall Street in recent years, as
companies that beat the estimates typically see their stock prices rise while those that
do not usually watch them fall.
But earnings estimates and reports are subject to conflicts of interest. In an all-toocommon practice, companies will guide analysts toward earnings numbers that are lower
than what the company actually expects to report. As a result, companies often exceed
expectations, which unsophisticated investors look at as a sign to buy. While the SEC is
trying to reduce such abuses, you should still garner whatever earnings information you
can from unbiased sources, such as the so-called earnings whispers or "whisper
numbers". Earnings whispers are intended to help investors avoid being duped by
misleading estimates. They are created using a variety of methods (such as polling
individual investors or enlisting the help of independent, unbiased analysts), and are often
more accurate than Wall Street's estimates.

Annual Reports
How you read an annual report depends upon your purpose. As an investor, your
purpose may be to assess profitability, survivability, growth, stability, dividends, potential
problems, risks or other factors which may affect your investment in that company. The
annual report provides a convenient way to monitor the progress of a company. If you
own shares in the company you should receive a copy of their annual report in the mail
from your broker; if you don't, you can request one or view it online at edgar.sec.gov.

Annual reports are a corporate "work of art" and should not be read like a normal book.
There is no need to read the report cover to cover. The first pages are a colorful, nontechnical overview of the company's objectives and how well it's meeting them. This
should be taken with a grain of salt, because it's marketing literature from the company,
designed to put their best foot forward. The pages in the back are for number-crunching
and heavy-duty research. Reading annual reports together year to year creates a kind of
timeline for the company. You can learn a lot by reading about how the company changed
their business model or carried out their desired plans from one year to the next.
There are nine sections in most annual reports. Not all reports will have all the sections or
the same type and amount of information. Here are the sections, what you'll find in each,
and questions you should ask yourself:

Chairman of the Board Letter: Should cover changing

conditions, previous objectives met or missed and upcoming
objectives, and actions taken or not to be taken. Is it well
written? Read between the lines; what is being apologized for?
Sales and Marketing: Should cover what the company sells,
how, where and when. Is it clear where it's making most of its
money presently? Is the scope of lines, divisions and operations
clear?
10 Year Summary of Financial Figures: Is this included?
Have revenues and profits increased each year?
Management Discussion and Analysis: Is it a clear discussion
of significant financial trends over the past few years? How
candid and accurate is it?
CPA Opinion Letter: Written by the CPA firm as an opinion
on the company's financials. Is it a well-respected firm? What
did they have to say about the company's numbers?
Financial Statements: Check sales, profits, R&D spending,
inventory and debt levels over time. Read the footnotes to
ferret out other information.
Subsidiaries, Brands and Addresses: Where is their
headquarters? Is it clear what lines, brand names the company
has and what their overseas distribution network is?
List of Directors and Officers: How many directors are
insiders and how many are outsiders (a good mix is ideal)? Are
the directors well-known and respected? Are there an unusual
number of directors (5 to 12 is typical)?
Stock Price History: General trend of price over time. Up or
down? On which exchange is the company listed? Do they
have a history of paying dividends?
Financial Statements: Most of the information youll be
concerned with in the annual report is located in the financial
statements (the balance sheets, the cash flow statements, and
the income statements),

Income Statements
The income statement (sometimes called the profit-and-loss
statement or P&L) is the first financial statement that youll
find in the annual report. It shows the revenue, expenses and
profit for the company during the past year. You can use the
income statement to figure out cash flow, profit margins, and
other financial metrics for the business. Most importantly,
though, the income statement contains the proverbial bottom
line: profits.
You should be careful when looking at the income statement
since companies can sometimes engage in gymnastics with
their accounting methods. The statements are audited by
outside firms, however, so there should be footnotes or other
markers whenever anything deviates from standard accounting
practices. The following list will teach you how to read an
income statement and use the information from them to make
some simple calculations regarding the firm's operations.

Revenues: The revenue section will tell you how much money
the company took in for a specified period of time. Sometimes
companies will break down revenues according to business
sector or geographic region, but usually there will just be one
number. Some companies, especially retailers and
manufacturers, use the term sales instead of revenues, but it's
the same idea.
Expenses: The expense section will show you how the
company spent its money. Companies spend their money on a
lot of different activities, so this section is usually broken down
into specific sub-sections. You might see expenses such as the
following:
o Cost of Sales: This number includes expenses directly
associated with creating revenue, such as labor and
materials.
o Operating Expenses: This number includes activities
such as marketing, research and development, and
administration. It usually also includes depreciation
expenses and any special non-recurring charges.
o Interest Expenses: This figure includes all the interest
the company paid out on its bonds (if any) and/or longterm debt.
o Taxes: The amount of money paid in taxes by the firm.
o Extraordinary Expenses: This figure shows any
unusual or one-time charges that the firm must pay (e.g.
a lawsuit settlement).

Profit: The profit section of the income report is the part to

which investors pay the most attention. It shows whether the
company made money or lost money. It usually includes these
specific sections:
o Net Income: This is the companys bottom-line profit
after all expenses and revenues have been accounted
for. If this number is positive, then the company turned
a profit for the period. If its negative, then the company
suffered a loss.
o Number of Shares: This is the average number of
shares outstanding during the specified time period; it is
used primarily in order to calculate earnings per share.
Two numbers are usually reported here: basic shares
and diluted shares. Basic shares include only actual
shares of stock outstanding, whereas diluted shares
include any securities that could possibly turn into stock
(such as convertible bonds or stock options).
o Earnings Per Share: This number is calculated by
taking net income and dividing by the number of shares
(both basic and diluted, so there are two earnings per
share figures).

Margins: You can find out how much a company is really

earning from its revenues on the income sheet by calculating its
margins, which are earnings expressed as a percentage of sales.
Here are a few margins that you might find useful:
o Gross Margins will tell you how much a company
earns taking into consideration the costs that it incurs
for producing its products and/or services. In other
words, gross margin is equal to gross income divided
by net sales, and is expressed as a percentage. Gross
margin is a good indication of how profitable a
company is at the most fundamental level. Companies
with high gross margins will have a lot of money left
over to spend on other business operations, such as
research and development or marketing.
o Net Margins are similar to gross margins, except they
take into account all of the expenses associated with the
business, including marketing expenses, administrative
expenses, etc. (so it is equal to net income divided by
net sales). Net margins provide an overall picture for
the company; this is what shareholders and investors
usually watch most carefully. Low (or negative) net
margins might indicate that the company is struggling
or is in a competitive industry in which it doesn't have
very much power to dictate its prices.

Balance Sheets
The second financial statement that you'll encounter in the annual report is the balance
sheet. The basic concept underlying a balance sheet is simple enough: total assets equals
total liabilities plus equity. A lot of investors tend to focus on the income statement, but
the balance sheet is just as important a source of information. You can use the balance
sheet to determine the firm's liquidity, to see how leveraged the company is, or just to see
all the specific assets and liabilities of the company. The following list will teach you
how to read a balance sheet and use the information from it to find out the company's
current financial standing.

Current Assets are the first numbers you'll encounter on the

balance sheet. Current assets are defined as assets that can or
will be converted into cash quickly (generally within one year).
Current assets include, of course, cash and cash equivalents
(money market accounts, etc.), but it also includes the
company's inventories (unsold stock) and its accounts
receivable (uncollected bills from its debtors).
Current Liabilities are the opposite of current assets. They are
the money that the company expects to pay out within the next
year. Current liabilities include accounts payables (bills the
company must pay), interest on long term debt, taxes, and
dividends.
Non-Current Assets and Liabilities are assets that cannot be
turned into cash quickly or liabilities that are not due for over a
year, respectively. This includes assets such as the company's
plants, property, and equipment, and liabilities like long-term
loans.
Ratios and Other Calculations can be calculated to analyze
the balance sheet, just like you can calculate several different
types of margins to help you analyze a company's income
statement.
o Debt/Asset Ratio: The debt/asset ratio can show you
what percentage of the company's assets are financed
through debt. You can calculate it by taking total
liabilities and dividing by total assets. If the ratio turns
out to be less than one, then that means that most of the
company's assets are financed through equity. If the
ratio turns out to be greater than one, then the company
is financing most of its assets through debt. Companies
that have high ratios are said to be "highly leveraged."
This means that they are carrying excessive amounts of
debt and could be in danger if creditors start to demand
repayment.
o Current Ratio: The current ratio is the opposite of the
debt/asset ratio: it takes the total number of current

assets owned by the company and divides by its total

current liabilities. If this number is greater than one,
then the company has enough current assets to cover its
short term liabilities. A number that is much higher than
one, however, might indicate that the company is
hoarding its assets instead of putting them to use. A
number less than one indicates that the company may
experience problems with liquidity.
Acid Test: The acid test ratio is similar to the current
ratio except that it subtracts out inventory from current
assets. To calculate this ratio, you take current assets
minus inventory and then divide by current liabilities.
The reason why the acid test disregards inventories is
because in many industries inventory is not easily
liquidated into cash; thus it can't be used to pay off
short term debt.
Shareholder Equity: Shareholder equity is equal to
total assets minus total liabilities. This number shows
you what part of the company is owned by the
shareholders after all of its obligations have been met.
Working Capital: Working capital is calculated by
subtracting the firm's current liabilities from its current
assets. This number shows you how much in liquid
assets the company has available to build its business.
The number can be positive or negative, depending on
how much debt the company is carrying. In general,
companies that have lots of working capital will be
more successful since they can expand and improve
upon their operations. Companies with negative
working capital may lack the funds necessary for
growth.
Turnover Ratio: The turnover ratio is used to
determine how many times a company "turns over" its
inventory in a given year. It is calculated by taking the
cost of goods sold and dividing by the average
inventory for the period. A high turnover ratio is looked
upon favorably because it is a sign that the company is
producing and selling its goods or services very
quickly. A low turnover ratio indicates that the company
has large warehouses of inventory going unsold for
long periods of time.
Leverage: Financial leverage is a measure of how
much debt the company has assumed in order to finance
its assets. It is calculated by dividing the amount of
long-term debt carried by the company by the
company's total equity. Companies that are highly

leveraged may be at risk of bankruptcy if they are

unable to make payments on their debt; they may also
be unable to find new lenders in the future. Leverage is
not always bad, however; it can increase the
shareholders' return on their investment and often there
are tax advantages associated with borrowing. The
important thing is to be able to differentiate between a
healthy amount of debt for good purposes and too much
debt for questionable purposes.
Cash Flow Statements
The cash flow statement is the newest of the three financial statements; companies have
only been required to furnish investors with it since 1988. The cash flow statement is
similar to the income statement, except that it dispenses with some of the abstract items
found on the income statement (such as depreciation) and focuses on actual cash. Most of
the information found on the cash flow statement is contained in either the income
statement or the balance sheet, but here it is organized in such a way that it is difficult for
companies to use accounting tricks to obscure the facts. The cash flow statement is
broken down into three parts:

Cash Flows from Operating Activities: Here you'll find how

much money the company received from its actual business
operations. This does not include cash received from other
sources, such as investments. To calculate the cash flow from
operating activities, the company starts with net income (from
the income statement), then adds back in any depreciation
expenses, deferred taxes, accounts payable and accounts
receivables, and one-time charges
Cash Flows from Investing Activities: This section shows
how much money the company has received (or lost) from its
investing activities. It includes money that the company has
made (or lost) by investing its excess cash in different
investments (stocks, bonds, etc), money the company has made
(or lost) from buying or selling subsidiaries, and all the money
the company has spent on its physical property, such as plants
and equipment.
Cash Flow from Financing Activities: This is where the
company reports the money that it took in and paid out in order
to finance its activities. In other words, it calculates how much
money the company spent or received from its stocks and
bonds. This includes any dividend payments that the company
made to its shareholders, any money that it made by selling
new shares of stock to the public, any money it spent buying
back shares of its stock from the public, any money it

borrowed, and any money it used to repay money it had

previously borrowed.
Free Cash Flow: While free cash flow doesn't receive as much
publicity as earnings do, it is considered by some experts to be
a better indicator of a company's bottom line. Free cash flow is
the amount of cash that a company has left over after it has
paid all of its expenses, including investments. Whereas
earnings reports are subject to a number of different accounting
tricks which can artificially boost the bottom line, free cash
flow is not. It is quite possible, for example, for a company to
have positive earnings and negative free cash flow. Negative
free cash flow is not necessarily an indication of a bad
company, however; many young companies tend to put a lot of
their cash into investments, which diminishes their free cash
flow. But if a company is spending so much cash, you should
probably be investigating why it is doing so and what sort of
returns it is earning on its investments.

10-K Reports
All publicly traded companies are required to file a 10-K report each year to the SEC.
The 10-K report is similar to the annual report, except that it contains more detailed
information about the companys business, finances, and management. It also includes
the bylaws of the company, other legal documents, and information about any lawsuits in
which the company is involved. If you are looking for information that you can't find in
the annual report, be sure to check out the 10-K.
10-Q Reports (Quarterly Reports)
You can think of quarterly reports (also called 10-Q reports) as abbreviated versions of
the annual report that are issued every three months instead of every year. Quarterly
reports contain financial statements, a discussion from the management, and a list of
"material events" that have occurred with the company (such as a stock split or
acquisition).
Form 8-K
Publicly traded companies must file Form 8-K with the SEC whenever any material
event occurs that might affect the companys financial condition. The list of material
events that must be reported includes stock splits, mergers, management changes, and
secondary stock offerings. This information will appear in the subsequent 10-Q, but the
8-K is a faster way to find out about such events.
Proxy Statements

Every year, each publicly traded company holds a meeting at which the companys
business is discussed and common shareholders cast their votes for the Board of
Directors. Shortly before each annual meeting, companies send out a document called a
proxy statement to each shareholder. The proxy statement contains a list of the business
concerns to be addressed at the meeting and a ballot for voting on company initiatives
and electing the new Board. This proxy ballot authorizes someone else at the meeting
(usually the management team) to vote on your behalf.

Fundamental Analysis
Fundamental analysis is a method used to determine the value of a stock by analyzing
the financial data that is fundamental to the company. That means that fundamental
analysis takes into consideration only those variables that are directly related to the
company itself, such as its earnings, its dividends, and its sales. Fundamental analysis
does not look at the overall state of the market nor does it include behavioral variables in
its methodology. It focuses exclusively on the company's business in order to determine
whether or not the stock should be bought or sold.
Critics of fundamental analysis often charge that the practice is either irrelevant or that it
is inherently flawed. The first group, made up largely of proponents of the efficient
market hypothesis, say that fundamental analysis is a useless practice since a stocks price
will always already take into account the companys financial data. In other words, they
argue that it is impossible to learn anything new about a company by analyzing its
fundamentals that the market as a whole does not already know, since everyone has
access to the same financial information. The other major argument against fundamental
analysis is more practical than theoretical. These critics charge that fundamental analysis
is too unscientific a process, and that it's difficult to get a clear picture of a company's
value when there are so many qualitative factors such as a company's management and its
competitive landscape.
However, such critics are in the minority. Most individual investors and investment
professionals believe that fundamental analysis is useful, either alone or in combination
with other techniques. If you decide that fundamental analysis is the method for you,
youll find that a companys financial statements (its income statement, its balance sheet
and its cash flow statement) will be indispensable resources for your analysis. And even
if youre not totally sold on the idea of fundamental analysis, its probably a good idea for
you to familiarize yourself with some of the valuation measures it uses since they are
often talked about in other types of stock valuation techniques as well.

Earnings
It is often said that earnings are the bottom line when it comes to valuing a
companys stock, and indeed fundamental analysis places much emphasis upon a
companys earnings. Simply put, earnings are how much profit (or loss) a company has
made after subtracting expenses. During a specific period of time, all public companies
are required to report their earnings on a quarterly basis through a 10-Q Report Earnings

are important to investors because they give an indication of the companys expected
dividends and its potential for growth and capital appreciation. That does not necessarily
mean, however, that low or negative earnings always indicate a bad stock; for example,
many young companies report negative earnings as they attempt to grow quickly enough
to capture a new market, at which point they'll be even more profitable than they
otherwise might have been. The key is to look at the data underlying a companys
earnings on its financial statements and to use the following profitability ratios to
determine whether or not the stock is a sound investment

Earnings Per Share

Comparing total net earnings for various companies is usually not a good idea, since
net earnings numbers dont take into account how many shares of stock are outstanding
(in other words, they dont take into account how many owners you have to divide the
earnings among). In order to make earnings comparisons more useful across companies,
fundamental analysts instead look at a companys earnings per share (EPS). EPS is
calculated by taking a companys net earnings and dividing by the number of outstanding
shares of stock the company has. For example, if a company reports $10 million in net
earnings for the previous year and has 5 million shares of stock outstanding, then that
company has an EPS of $2 per share. EPS can be calculated for the previous year
("trailing EPS"), for the current year ("current EPS"), or for the coming year ("forward
EPS"). Note that last year's EPS would be actual, while current year and forward year
EPS would be estimates.

P/E Ratio
EPS is a great way to compare earnings across companies, but it doesnt tell you
anything about how the market values the stock. Thats why fundamental analysts use the
price-to-earnings ratio, more commonly known as the P/E ratio, to figure out how much
the market is willing to pay for a companys earnings. You can calculate a stocks P/E
ratio by taking its price per share and dividing by its EPS. For instance, if a stock is
priced at $50 per share and it has an EPS of $5 per share, then it has a P/E ratio of 10. (Or
equivalently, you could calculate the P/E ratio by dividing the company's total market cap
by the company's total earnings; this would result in the same number.) P/E can be
calculated for the previous year ("trailing P/E"), for the current year ("current P/E"), or
for the coming year ("forward P/E"). The higher the P/E, the more the market is willing
to pay for each dollar of annual earnings. Note that last year's P/E would be actual, while
current year and forward year P/E would be estimates, but in each case, the "P" in the
equation is the current price. Companies that are not currently profitable (that is, ones
which have negative earnings) don't have a P/E ratio at all. For those companies you may
want to calculate the price-to-sales ratio

Projected Earnings Growth(PEG)

So is a stock with a high P/E ratio always overvalued? Not necessarily. The stock could
have a high P/E ratio because investors are convinced that it will have strong earnings
growth in the future and so they bid up the stocks price now. Fortunately, there is another
ratio that you can use that takes into consideration a stocks projected earnings growth:

its called the PEG. PEG is calculated by taking a stocks P/E ratio and dividing by its
expected percentage earnings growth for the next year. So, a stock with a P/E ratio of 40
that is expected to grow its earnings by 20% the next year would have a PEG of 2. In
general, the lower the PEG, the better the value, because you would be paying less for
each unit of earnings growth.

Dividend Yield
The dividend yield measures what percentage return a company pays out to its
shareholders in the form of dividends. It is calculated by taking the amount of dividends
paid per share over the course of a year and dividing by the stock's price. For example, if
a stock pays out $2 in dividends over the course of a year and trades at $40, then it has a
dividend yield of 5%. Mature, well-established companies tend to have higher dividend
yields, while young, growth-oriented companies tend to have lower ones, and most small
growing companies don't have a dividend yield at all because they don't pay out
dividends.

Dividend Payout Ratio

The dividend payout ratio shows what percentage of a companys earnings it is paying
out to investors in the form of dividends. It is calculated by taking the company's annual
dividends per share and dividing by its annual earnings per share (EPS). So, if a company
pays out $1 per share annually in dividends and it has an EPS of $2 for the year, then that
company has a dividend payout ratio of 50%; in other words, the company paid out 50%
of its earnings in dividends. Companies that distribute dividends typically use about 25%
to 50% of their earnings for dividend payments. The higher the payout ratio, the less
confidence the company has that it would've been able to find better uses for the money it
earned. This is not necessarily either good or bad; companies that are still growing will
tend to have lower dividend payout ratios than very large companies, because they are
more likely to have other productive uses for the earnings.

Book Value
The book value of a company is the company's net worth, as measured by its total
assets minus its total liabilities. This is how much the company would have left over in
assets if it went out of business immediately. Since companies are usually expected to
grow and generate more profits in the future, most companies end up being worth far
more in the marketplace than their book value would suggest. For this reason, book value
is of more interest to value investors than growth investors. In order to compare book
values across companies, you should use book value per share, which is simply the
company's last quarterly book value divided by the number of shares of stock it has
outstanding.

Price / Book
A company's price-to-book ratio (P/B ratio) is determined by taking the company's per
share stock price and dividing by the company's book value per share. For instance, if a
company currently trades at $100 and has a book value per share of $5, then that

company has a P/B ratio of 20. The higher the ratio, the higher the premium the market is
willing to pay for the company above its hard assets. Price-to-book ratio is of more
interest to value investors than growth investors.

Price / Sales Ratio

As with earnings and book value, you can find out how much the market is valuing a
company by comparing the company's price to its annual sales. This measure is known as
the price-to-sales ratio (P/S or PSR). You can calculate the P/S by taking the stock's
current price and dividing by the company's total sales per share for the past year (or
equivalently, by dividing the entire company's market cap by its total sales). That means
that a company whose stock trades at $1 per share and which had $2 per share in sales
last year will have a P/S of 0.5. Low P/S ratios (below one) are usually thought to be the
better investment since their sales are priced cheaply. However, P/S, like P/E ratios and
P/B ratios, are numbers that are subject to much interpretation and debate. Sales
obviously don't reveal the whole picture: a company could be selling dollar bills for 90
cents each, and have huge sales but be terribly unprofitable. Because of the limitations,
P/S ratios are usually used only for unprofitable companies, since such companies don't
have a P/E ratio.

Return on Equity (ROE)

Return on equity (ROE) shows you how much profit a company generates in
comparison to its book value. The ratio is calculated by taking a company's after-tax
income (after preferred stock dividends but before common stock dividends) and dividing
by its book value (which is equal to its assets minus its liabilities). It is used as a general
indication of the company's efficiency; in other words, how much profit it is able to
generate given the resources provided by its stockholders. Investors usually look for
companies with ROEs that are high and growing.

Technical Analysis
Technical analysis uses a variety of charts and calculations to spot trends in the market
and individual stocks and to try to predict what will happen next. Technical analysts don't
bother looking at any of the qualitative data about a company (for example, its
management team or the industry that it is in); instead, they believe that they can
accurately predict the future price of a stock by looking at its historical prices and other
trading variables. Technical analysis assumes that market psychology influences trading
in a way that lets them predict when a stock will rise or fall. For that reason, many
technical analysts are also market timers, who believe that technical analysis can be
applied just as easily to the market as a whole as to an individual stock
Critics of technical analysis, and there are many, say that the whole endeavor is a waste
of time and effort. They point to academic studies like Burton Malkiel's "A Random Walk
Down Wall Street" as evidence that there is no possible way to predict future prices using
historical prices. Others contend that if any such systems were found to be successful,

those who practiced them would be wealthy beyond their wildest dreams, and yet there
aren't any billionaire technical analysts (yet).
Technical analysts use dozens of different quantitative metrics in order to predict stock
prices. This paper introduce you to some of the most popular ones and explain to you
what they're all about, but first here are a few key terms you should know about:

Support Level: The level that the technical analyst believes a stock price will not
fall below (also sometimes called a "floor")
Resistance Level: The opposite of a support level, the level that the technical
analyst believes a stock price will not exceed.
Breakout: If a stock surpasses the resistance level or falls below the support level,
it is said to be a "breakout."
Advance-Decline Line: The total number of advancing issues minus the total
number of declining issues, added to a cumulative total.

Moving Averages
Perhaps the most commonly used variable in technical analysis, the moving average
for a stock is the average selling price for the stock over a set period of time (the most
common being 20, 30, 50, 100 and 200 days). Moving average data is used to create
charts that show whether or not a stock's price is trending up or down. They can be used
to track daily, weekly, or monthly patterns. Each new day's (or week's or month's)
numbers are added to the average and the oldest numbers are dropped; thus, the average
"moves" over time. In general, the shorter the time frame used, the more volatile the
prices will appear, so, for example, 20 day moving average lines tend to move up and
down more than 200 days moving average lines.

Relative Strength
Technical analysts use what is called relative strength in order to compare the price
performance of one stock to the entire market. The relative strength of a stock is
calculated by taking the percentage price change of a stock over a set period of time and
ranking it on a scale of 1 to 100 against all other stocks on the market. For example, a
stock with a relative strength of 90 has experienced a greater increase in its price over the
last year than the price increases experienced by 90% of all other stocks on the market.
Some technical analysts like stocks with high relative strength rankings, believing that
stocks which have recently gone up are more likely to continue going up. Other technical
analysts believe that a very high relative strength can be an indication that the stock is
overbought and is ready to fall. Relative strength is really a "rear view window" metric,
measuring only how the stock has done in the past, not how it will do in the future.

Momentum
Momentum investors seek to take advantage of upward or downward trends in stock
prices or earnings. They believe that these stocks will continue to head in the same
direction because of the momentum that is already behind them. The idea relies on the

belief that there are a large number of lemmings in the market who will buy whatever
stock is already hot. Momentum investors do not necessarily believe that momentum
stocks will do well in the long run, but they do think that in the short run people will
continue to buy them as they have in the immediate past. This therefore involves a lot of
market timing which of course entails a substantial amount of risk. Both moving averages
and relative strength can be used in order to determine momentum.

Charts
Charts are the main tool that technical analysts use in order to plot their data and
predict prices. Technical analysts may use several different types of charts in order to
conduct their tests, including line charts, bar charts, and candlestick charts. Most of the
time, analysts use these charts in order to look for patterns in the data. Some of the more
commonly used patterns include:

Cup and Handle: A pattern on a bar chart that is in the shape of the letter "U" over
a period of between 7 and 65 weeks. Once the stock price reaches the second peak
of the "U", technical analysts believe that the price will fall as investors who
bought at the previous peak start to unload their shares.
Head and Shoulders: A chart formation in which a price exhibits three successive
rallies, the second one being the highest. The name derives from the fact that on a
chart the first and third rallies look like shoulders and the second looks like a
head. Some technical analysts consider it a sign that the stock will fall further.
Double Bottom: A chart formation that looks like a "W". Technical analysts aim to
buy at one of the troughs and ride the stock higher.

Bollinger Bands
Bollinger bands on a chart have three lines in them: an upper band, a lower band, and a
band at the moving average. The upper and lower bands are placed precisely at two
standard deviations above the moving average and two standard deviations below the
moving average respectively (standard deviation is a mathematical measure of volatility).
Bollinger bands will expand and contract as the market for the stock becomes more or
less volatile. If the stock price reaches the upper band, then the stock is thought to be
overbought; if it reaches the lower band, then it is thought to be oversold.

Volume
Not all technical analysts focus exclusively on price. Many of them think that volume
is often times a better indication of where a stock is heading. Volume is simply the
number of shares of a stock that are traded over a particular period of time (e.g. 1 day or
30 days). Some technical analysts calculate moving averages for volume, the same way
others do for price. Volume is important because it tells how active the stock was during a
particular time, which can in turn affect a stock's price. For example, if a stock falls
precipitously but volume was exceptionally light that day, this is not necessarily an
indication that the stock has fallen out of favor with the market, since the move was
caused by a relatively small number of sellers.[2]

Stock Strategies
There are many different ways to approach investing in the stock market. This paper
will take you through some of the most common strategies for investing in equities.

Buy and Hold

The "buy and hold" approach to investing in stocks rests upon the assumption that in
the long term (over the course of, say, 10 or more years) stock prices will go up, but the
average investor doesn't know what will happen tomorrow. Historical data from the past
50 years supports this claim. The logic behind the idea is that in a capitalist society the
economy will keep expanding, so profits will keep growing and both stock prices and
stock dividends will increase as a result. There may be short term fluctuations, due to
business cycles or rising inflation, but in the long term these will be smoothed out and the
market as a whole will rise. Two additional benefits to the buy and hold strategy are that
trading commissions can be reduced and taxes can be reduced or deferred by buying and
selling less often and holding longer. Some proponents of the buy and hold strategy of
investing often believe in the Efficient Market Hypothesis or the Random Walk Theory.

Market Timing
Market timing is essentially the opposite of buying and holding. Market timers believe
that it is possible to predict when the market, or certain stocks, will rise and fall. It
therefore makes sense to buy when the markets are low and to sell when they are high in
order to maximize profits. Market timers can use any number of different methods for
timing the market technical analysis, fundamental analysis, or even intuition
Most experts agree that market timing is incredibly difficult if not downright impossible.
They also warn against it because:

It's hard to say when the market or a particular stock is "high" or "low"; often a
seemingly high stock will go higher, and a seemingly low stock will go lower.
Commissions eat away at your profits when you trade frequently, especially on
small transactions.
The bid/ask spread also eats away at your profits, especially for thinly traded
stocks.
In the long run, the market goes up. Unless you're a superb timer, you'll do better
staying fully invested at all times. For example, in the last 40 years, the market
returned about 11.3% annually. If you were fully invested the whole time, but got
out completely for the 40 best months, your annual return would've dropped to
2.7%. If you miss the big moves it hurts, and no one really knows when they're
coming. [2]

Growth
Growth investors focus on one aspect of a company: its potential for earnings growth.
They believe that companies with high earnings growth will see their stock price continue

to increase, since investors will want to own profitable companies that can pay large
dividends in the future. The number that they pay the most attention to is earnings per
share, especially how it changes from year to year, although they sometimes look at
revenue growth as well. Some investors also compare the price/earnings ratio with the
annual earnings growth, to get a feel for how much the market is willing to pay for a
given rate of earnings growth. Growth stocks tend to be from young companies, so they
are often riskier than the average security. They have the potential for large gains, but
they also have the potential for large losses. In the 1990s technology stocks were the most
commonly purchased stocks by growth investors, although growth stocks can exist in just
about any industry.

Value
Value investors look for stocks that are selling at an attractive price; in other words,
they are bargain hunters. This does not mean that value investors buy stocks because they
are "cheap" (such as penny stocks); value investing utilizes several measures of a
company's value to identify stocks that can be purchased for less money than they're
worth, regardless of whether they're worth $10 or $100. Although it's possible that a
growth stock could represent a good value, growth investing and value investing are
usually considered opposing strategies. This is because value investors tend to focus on
traditional valuation metrics such as the P/E ratio, looking for low ratios which are
typically not found in growth stocks Value stocks often are ones which have fallen out of
favor with the investment community for one reason or another, perhaps because they are
in a slumping industry or because they reported poor earnings.

GARP
If you're torn between the growth approach to investing in stocks and the value
approach, then you might want to consider trying the GARP approach. GARP stands for
"growth at a reasonable price" so, as you might expect, GARP investors look for
companies with growth potential whose stock price is undervalued. That can be a difficult
task since growth and value stocks tend to have opposing characteristics, but it's not
impossible. Most GARP investors look at the price-to-earnings-growth ratio (PEG) ratio
in order to find bargain stocks with growth potential that are selling at a reasonable price

Warren Buffett and Quality

Some investors prefer to consider themselves not 'value' or 'growth' but 'quality'. This
is a sort of hybrid approach in which the investor is searching not for questionable
companies at bargain prices or exceptional companies at outrageous prices, but good
companies at good prices. This strategy relies on a combination of quantitative and
qualitative factors.
Warren Buffett is often cited as a classic example of a quality investor. Buffett relies on a
fairly simple investment strategy that can benefit any investor interested in identifying
good values. He looks for great stocks, then buys them and holds them for several years
or more. Buffett is a long term investor who plans to hold onto stocks for many years

from the time of purchase. He thinks of his investment as buying a piece of a business,
not just shares of its stock. In this sense, the management of the underlying company is
an important criterion in the investment decision.
Buffett determines the value of a business by totaling the net cash flows he expects to
occur over the life of the company and discounting them by the appropriate interest rate.
He may add a premium based on the risk involved in the particular investment. He
focuses on return on equity, operating margins, debt levels and capital expenditures to
identify the best investments.
Interestingly, Buffett challenges some of traditional notions regarding diversification. He
believes that diversification is less necessary for those able to confidently choose a select
number of stocks they are confident will significantly outperform the market. For him,
identifying a few good values is far more important than spreading invested money
across a typical diverse portfolio.

Income
Income investors practice a very straightforward strategy: they buy stocks with the
highest dividends. Income investors focus primarily on securing a steady income stream,
instead of worrying about capital gains (although they obviously hope that the shares will
increase in value). The stocks of large, well-established companies usually qualify as
income stocks. Income investing is one of the more conservative stock strategies, yet
there are still the usual risks involved in investing in equities. In some respects, this
strategy is closer to bond investing than stock investing, even when stocks are used.

Dollar Cost Averaging

Dollar cost averaging is a good strategy for beginners that involves regular
contributions of a fixed dollar amount to a portfolio or specific investment. At each
interval, the chosen amount is invested, removing any emotional motivation to react to
short-term changes in the value of the investment. Of course, dollar cost averaging does
not guarantee a profit, but it does encourage consistent investing and prevents short-term
movement from leading investors to make emotion-based decisions that could harm their
long-term strategy.
Because the investment is purchased at a range of prices over time, fluctuations in price
are evened out and the initial price has a far smaller impact on the returns at the time the
investment is sold. The average price paid trends toward the current price at each interval.
As a result, the gap between the value of the money paid in and the current value of the
investment decreases. However, the average price does not move fast enough to
completely eliminate the possibility of profit or loss. Although dollar cost averaging can
prevent a large negative gap from growing between the price paid and the current price, it
limits the potential for a positive gap in the same way.
Essentially, dollar cost averaging is ideal for investors who wish to eliminate the risk
associated with timing the price of an investment and reacting to short-term results at the

expense of limiting themselves to a decidedly conservative strategy. Some investors

believe dollar-cost averaging is most effective when a stock is underperforming because
more shares can be acquired for the same regular investment amount. However, better
performance is not guaranteed and that aspect should not be the primary motivation for
adopting this strategy.

DRIPs and DSPs

Some stock strategies focus on reducing brokerage commissions in order to boost
overall returns. Direct Stock Purchase plans (DSPs) let you buy shares of stock directly
from the company, without the use of a brokerage (and without the commission they
charge). DSPs are a good way to invest since you don't even have to be a current
shareholder in order to purchase the shares. The company will not charge you a
commission, but they may charge you a small fee in order to set up a stock purchase
account.
Dividend Reinvestment Plans (DRIPs) are also a good way for you to bypass a broker
and save on commissions by investing your money directly with the company; however,
with DRIPs you must purchase the first share you buy in the company through a
brokerage. After that, though, you're free from the broker. The company will take
whatever dividends it would normally send to you as a check and instead it will reinvest
them to purchase more shares in the company for you, all without charging a
commission. The only drawback is that you have no control over when your money from
the dividends is used to purchase new stock in the company, which means you might be
buying new shares at sub optimal times.
Note that DSPs and DRIPs are only offered by some companies, although there are
hundreds of well-established blue chips offering such programs

Dogs of the Dow

This is a very simple strategy in which you find out which ten of the Dow Jones
Industrial companies currently have the highest dividend yield and then you purchase
those stocks. These stocks are called the dogs of the Dow because they tend to have
lower prices than the other Dow components, which means that they could experience
substantial price increases in the next year. If you decide to use this strategy, its
important for you to remember to reallocate your portfolio every year, since the dogs will
change over time. Historically this approach has been successful, but there's no
compelling reason to believe it will continue to be.

CANSLIM
CANSLIM is a strategy for investing that was pioneered by William J. ONeil, who
later went on to found Investors Business Daily. The strategy is a mixture of
fundamental analysis and technical analysis. Each of the letters in the acronym describes
a different metric used to pick a stock:

C Current Earnings: current earnings growth for the stock must be at least in the
20%-25% range
A Annual Earnings: average annual earnings growth for the stock over the past
five years should be substantial, around 25%.
N New Things: the company should be involved in developing new services or
products; this can sometimes even refer to new highs for the stock price.
S Shares Outstanding: the company should have less than 30 million shares
outstanding so that it has the potential for good growth.
L Leading Stocks: the company should be a leader in its industry.
I Institutional Ownership: the stock should have at least a couple of institutional
shareholders (e.g. pension funds, endowments, etc.).
M Market Conditions: the market should be moving upward or ready to move
upward.

Most of the principals involved in CANSLIM investing make sense to experts. Of

course, figuring out whether or not a company meets these seven criteria is a whole other
story.

Contrarian
Contrarian investing is a strategy that relies on behaving in opposition to the prevailing
wisdom; for example, buying when others are pessimistic and selling when they're
optimistic, or buying out-of-favor stocks and selling them when they're popular again. In
an extended bull market, the term contrarian can begin to mean someone who is bearish
or prefers value stocks to growth stocks, although this is really just a subset of contrarian
investing.

Insider Activity
Another strategy for investing involves looking out for what insiders at a company are
doing with their stock. Keeping an eye on insider trades can be useful because it allows
you to see what the people who have a large stake in a company are doing with their
stock. These insiders are often the ones who know what is going on at the top levels of
their company, and so they may have the best information about whether a company's
stock is actually worth more or less than the current price. Insiders can be either
individuals or corporations. They are required to report both direct holdings (which are
held in the name of the insider) and indirect holdings (which are controlled by the insider
but are held by a family member, trust, company plan, or corporation with which the
insider is affiliated). Note that we're not talking specifically about illegal insider trading
(that is, insiders who are trading based on privileged information), but instead about all
types of insider trades, including when no such privileged information exists, but the
insiders are just generally confident about the company's outlook.

Other Investing Strategies

Constant Ratio System: Unlike the constant dollar system, the same percentage of
funds is divided between different assets. When the balance is upset, it is periodically

restored by moving money from over performing assets to underperforming ones. This
system prevents one asset class from dominating the portfolio. This is one way to
maintain a desirable asset allocation.
Variable Ratio System: This is a variation on the constant ratio system that relies on
market timing to shift the proportions of the various asset classes contained in the
portfolio. Buying low and selling high is built into this strategy, but, like the constant
dollar system, prolonged movements in a given direction will harm returns.
Bottom-up Analysis: This is a name for an investing strategy that focuses on the
fundamentals of individual securities as opposed to the state of the overall economy.
Top-down Analysis: In contrast to bottom-up analysis, this investing strategy begins with
a look at the overall economic picture and then narrows it down to sectors, industries and
companies that are expected to perform well. Analysis of the fundamentals of a given
security is the final step.[2

Short Selling
Short selling (or "selling short") is a technique used by people who try to profit from
the falling price of a stock. Short selling is a very risky technique as it involves precise
timing and goes contrary to the overall direction of the market. Since the stock market
has historically tended to rise in value over time, short selling requires precise market
timing, which is a very difficult feat.

Application #3 Short Selling

Here's how short selling works. Assume you want to sell short 100 shares of a
company because you believe sales are slowing and its earnings will drop. Your broker
will borrow the shares from someone who owns them with the promise that you will
return them later. You immediately sell the borrowed shares at the current market price.
When the price of the shares drops (you hope), you "cover your short position" by buying
back the shares, and your broker returns them to the lender. Your profit is the difference
between the price at which you sold the stock and your cost to buy it back, minus
commissions and expenses for borrowing the stock. But if you're wrong, and the price of
the shares increase, your potential losses are unlimited. The companys shares may go up
and up, but at some point you have to replace the 100 shares you sold. In that case, your
losses can mount without limit until you cover your short position.
Here are a few reasons why short selling might make sense:

Some investors are better at identifying overpriced, bad companies than under
priced, good companies.
Brokers and analysts focus on what to buy, not what to sell, so the good news is
more widely known than the bad news. When an analyst issues a sell
recommendation on a stock, they find it much harder to get information from the

company's investor relations department, and the analyst's firm would never get
an opportunity to raise capital or float a bond for the company, so they focus more
on good news than bad. If you discover bad news, it might not yet be totally
factored in to the current price of the stock.
Many institutions just won't do short selling, leaving unexploited short selling
opportunities from which you can benefit.
A portfolio which includes both long and short positions in stocks which tend to
move together will generally have lower volatility than one which has only long
positions.

But short selling is not as easy and profitable as it may sound; there are a lot of
caveats:

As we mentioned, theres unlimited downside potential (i.e. if the stock price

keeps rising, you keep losing). Most short sellers set a limit to how much they're
willing to lose, but then they become vulnerable to a short 'squeeze', in which
long investors buy shares as the stock rises and demand delivery. As short sellers
buy to cover their losses, the price continues to rise, triggering more short sellers
to cover their losses, etc. This is a risk especially for small, illiquid companies.
The danger is that even if the stock is overpriced, it may become even more
overpriced, and you will have to buy it at some point to cover your position.
When you sell short, you're not just betting on what the stock is worth, you're
betting on what the market will be willing to pay for the stock in the future.
You're fighting the trend of the market, which is, in the long run, up. When you
buy a stock that you're confident is greatly undervalued, you should feel content
to wait as long as it takes for the dividends to start rolling in (provided you have a
sufficiently long investment horizon). When you're on the short side, however,
you will eventually need to buy the shares back, at whatever the market price
happens to be; and while you wait and wait for the speculative bubble to burst, the
rest of the market will probably continue on its upward trajectory.
SEC rules allow investors to sell short only on an uptick or a zero-plus tick. In
other words, you cannot sell a stock short if it is already going down. This rule is
in effect to prevent traders known as "pool operators" from driving down a stock
price through heavy short selling, then buying the shares for a large profit.
Money from a short sale isn't available to the seller, but is escrowed as collateral
for the owner of the borrowed shares. You aren't earning interest on the money
(although big institutions sometimes do, in the form of rebates).
You have to pay any dividends that are earned (since in effect you have a negative
number of shares).
You pay the (usually higher) short term capital gains tax on your profits,
regardless of how long you held the short position.
Another company could acquire the company youre shorting, possibly at a
significant premium, which would drive up the share price.
Sometimes shares aren't available to short.

While we dont recommend short selling for the above reasons, you may decide to
include it in your overall strategy. If you do, consider mitigating the risk by setting strict
quitting prices (say a 20% loss per investment). If it reaches that limit, resist the
temptation to hang on, thinking it's even more overpriced now. Successful short selling is
all about timing, which makes it more like technical analysis than fundamental analysis.
Some short-sellers target the following types of companies:

Small cap companies that have been driven up by momentum investors, especially
companies that are difficult to value.
Companies whose P/E ratios are much higher than can be justified by their growth
rates.
Companies with bad or useless products and services.
Companies riding the latest fad.
Companies that have new competition coming.
Companies with weak financials (bad balance sheet, negative cash flows, etc.).
Companies that depend too heavily on one product.

Stocks and Your Portfolio

The first thing you should know about stocks before adding them to your portfolio is
that they carry a certain amount of risk. This is because the returns on stock are not
guaranteed; not by the government, not by the company issuing the stock, and certainly
not by your broker. That means that there is a chance that your actual return will be
different than what you had expected. For instance, you might purchase stock under the
expectation that its price will rise steadily over time and that it will pay you annual
dividends. However, if the company experiences financial problems, you may not receive
the price appreciation or the dividends that you expected. In fact, the company could even
go out of business, in which case you could lose your entire investment. On the flip side,
however, there is always the chance that the stock will outperform your expectations. It
could double in price and start paying out hefty dividends, in which case you would enjoy
a gain greater than what you had expected. Because there is uncertainty regarding which
of the various possible outcomes will occur, you bear a certain amount of risk when
purchasing the equity.
How do the risks associated with stocks affect your overall portfolio? That depends upon
what other investments are in your portfolio. In general, the risks associated with
investing in stocks are greater than the risks associated with investing in bonds or money
markets. At the same time, however, the risks associated with investing in stocks are less
than the risks associated with investing in options or futures
Of course, not all stocks pose the same level of risk: some (such as internet stocks) are
much higher risk than others (such as utilities), so it's important to understand the amount
of risk you would be taking on with any given investment.
In order to manage the risks associated with investing in stocks, most investors turn to a

practice called diversification when building their stock portfolios. Diversification is a

method of risk reduction in which investors buy multiple securities instead of just one. As
a shareholder in several companies, the diversified investor knows that if one of his or her
stocks happens to fail then there is always the chance that another one could gain enough
to offset the loss. It's basically just a way for you to not put all your eggs in one basket,
which is also the concept underlying mutual funds There are two ways to increase your
diversification (and reduce your risk): increase the number of stocks you own or own
stocks that are fundamentally different from one another. Of course, you can't totally
eliminate all the risks involved in stock investing because there is still market risk, the
risk that the entire market will fall. In that case, no matter how well diversified you are,
your portfolio will suffer.
The other variable that will influence the amount of risk in your stock portfolio is your
time horizon. Over the long, long term (several decades), history has shown time and
again that stock prices outperform almost all other investments. However, in the short run
stock prices often go down (about half the time, if the time period is sufficiently short).
That means that if you are at a point in your life when you may need to sell your stocks in
the short run (such as if you're close to retirement), then you may want to think twice
about investing in stocks. There is a definite possibility that the stocks that you buy now
may be worth significantly less one or two years in the future. Most likely, however, they
will be worth significantly more ten or twenty years in the future. So before you invest in
stocks, you should sit down and examine both your own time horizons and those of the
market in order to see whether or not you can bear the risks associated with short term
stock investing.
Once you've thought about the risks associated with stock investing and figured out your
plans for diversification, the next issue to consider when adding stocks to your portfolio
is which stocks to add. You'll first want to take a look at your particular investing
objectives. If you're looking for steady income with low risk, you may want to consider
investing in income stocks On the other hand, if you're looking for opportunities that may
result in a big payoff and you're not too concerned about the risks involved, you might
want to try investing in growth stocks There are a number of different stock strategies
that you can use to try to meet your goals
Once you've decided on a strategy, the last step is to determine whether or not you should
buy the stocks you want given the prices at which they are selling. In order to do this, you
value the stocks you are interested in according to what you believe they are worth and
then compare them to their market prices. If you think your stocks are worth more than
what they are selling for, then they are good candidates for purchase. If you think they are
worth less than their price, then you might want to wait before purchasing them. The
method of determining a stock's worth is called valuation, and there are many different
approaches to it. Some investors look at a company's fundamentals while others look at
quantitative data regarding the stock's price and its trading patterns

Choosing a Stock

There are literally thousands of stocks available for purchase on the stock market. Here
are a few criteria worth considering (and of course there are many others):

Earnings growth
Recent earnings surprises
Price/earnings ratio
Dividends
Market cap or size
Industry
Relative strength

Stock Research
Once youve narrowed down the list of stocks that you are interested in, the next step
is to research the stocks. There are a ton of great resources available out there for
researching stocks, and fortunately most of them are free. Online research is becoming
more and more popular because of its convenience and ease of use. We recommend that
you try researching stocks using our handy Stock Research Tool which can give you all
of the different types of information you need with just one click of the mouse. You
should also take a look at the company's annual report and its financial statements for the
following
From the Income Statement:
o

o
o
o

Earnings growth (earnings acceleration is even better). Does the company

have a record of exceeding analysts' expectations? Earnings are considered
by many investors to be the most important single number, the assumption
being that earnings pave the way for future dividends.
Revenue growth.
Stable or increasing margins Stable or increasing R&D spending as a
percentage of sales (specifically for technology companies).
Tax abnormalities. For example, taxes below 25% usually mean the
company is using tax loss carry-forwards against income, which are only a
temporary earnings booster.
Number of common shares outstanding. Increases in the number of shares
negatively impact earnings per share (issuance of new shares isn't
necessarily bad; the important consideration is why they're doing it).

From the Cash Flow Statement:

o Cash flow. Ideally, cash flow should be positive, large, and increasing. In
any case, understand why the company's cash flow is what it is.

From the Balance Sheet:

o Debt. The debt to equity ratio (long term debt divided by stockholder's
equity) is the measure typically used. Lower is better, and zero is ideal.

o
o
o

Cash (relative to annual sales). Cash is always a good thing, but it's
especially important to companies that sometimes want or need to
temporarily go cash flow negative. Remember that when new shares are
issued, proceeds from the sale also appear here.
Return on equity. This is a measure of net income relative to stockholder's
equity. Higher is better.
Receivables and inventory. They should not be rising much faster than
sales are.
Current ratio. This is the ratio of current assets (cash, receivables and
inventory) to short-term liabilities The higher the better.

From the Management's Discussion and Analysis:

o What is the outlook for the future; are there any potential threats and
uncertainties they expect to encounter?
o What are the company's products and/or services? Do you see a continuing
need for them? Are the products and/or services things that customers buy
once or repeatedly? Do you see competitive offerings that are as good or
better?
o Can the company protect their position? If not, big margins can quickly
become small margins. Are there no close substitutes to the products and
services they offer? Are there barriers to entry? Do they have copyrights,
patents, innovative processes, economies of scale, de facto standards, or
anything else that will help them defend their niche? Is the product highly
differentiated? How do they compare with their competition?
o Are they generating significant earnings and revenues from products
introduced within the last few years?
o What's the outlook for the future, both for the company and for their
industry? Do they have lots of new products/services coming? Do they
have favorable long-term prospects? Where will they be in ten years?
Consider what the analysts and others expect for the future, but also make
your own determination. If possible, work out your own revenue and
earnings projections. Another technique is to assume that the analysts'
expectations are completely factored into the current price; if you think the
outlook is better than they do, the stock could be a bargain.
o Current dividends. This is more important for portfolios focusing on
income rather than capital appreciation, or for investors fearful of a broad
market downturn. Growth stock investors are willing to wait patiently for
earnings to turn into dividends.
o How's the management? What's the corporate culture? Are they able to
attract and keep highly skilled personnel?
o Insider ownership (more is better, especially by the CEO), and recent
insider activity.
o Do they have a global presence? U.S. companies that operate around the
world have outperformed the S&P 500 handily over the last 5 years, and
should continue to do so.
o How is their marketing?

Do they have a consistent operating history? Uncertainty is something to

be avoided, unless you are adequately compensated for it. Change,
difficult situations, product shifts, and big mergers all bring with them
uncertainty. If a company doesn't have experience with these things but
you see them coming, be careful.
Do they have a history of success? Past performance is no guarantee of
future results, to paraphrase the mutual fund mantra; but there's certainly a
positive correlation (on Wall Street and in life).
Is the stock expensive or cheap? Compare the P/E ratio (or book value, or
price to sales ratio, or price to earnings growth, or whatever measures you
use), relative to the company's historical average and relative to the
industry See if discrepancies are justified. Also, do their design,
manufacturing and distribution costs increase or decrease each year?

EDGAR
Perhaps the easiest way to access all of the statements available is through the SECs
EDGAR database (EDGAR stands for Electronic Data Gathering, Analysis and
Retrieval). The database contains required disclosure documents for public companies
and mutual funds, including annual 10K and quarterly 10Q reports, proxy statements for
all public companies, and prospectuses and semiannual reports for mutual fund
companies. You can access the EDGAR database directly, or there are other sites that reorganize the EDGAR data to make it easier to use. For a listing of EDGAR sites, use the
SEC filings page
Choosing a Stock
Once you've gathered the facts, you should then perform the analysis. Different investors
use different methods for determining what stocks to buy. Most investors prefer
fundamental analysis, although there are also a large number who focus on technical
analysis Whatever one you decide to use, here are a few final considerations to keep in
mind:

Focus on the market cap, not the per-share price. The market cap is the per-share
price times the number of shares outstanding. In essence, this is how much you
would have to pay to buy the whole company. Every company has a different
number of shares outstanding, making per-share price comparisons meaningless.
For this reason, a stock which is trading at $100 per share might actually be
cheaper than a stock trading at $2 per share. This doesn't mean that price per share
is completely unimportant; some technical analysts believe it can provide clues to
where the stock will go next but for fundamental analysis it's really not important.
There is no perfect stock screen, because every investor is looking for something
different. Some are looking for growth, others for value, still others for dividend
income. The screens you apply should be done with your unique goals in mind.
[2]

Five (5) Greatest Stock Myths

To a large degree, the investment community is their own worst enemy in scaring off
the individual investor. This is very unfortunate because stock investing is one of the best
avenues the average person has of accumulating substantial wealth.

MYTH #1: PRICE TO EARNINGS RATIOS TELL YOU WHETHER

STOCKS ARE CHEAP OR EXPENSIVE.
P/E ratios are easy to find. Just about every newspaper, magazine and stock report
publishes P/E ratios. Everybody seems to talk about them when discussing stocks. So P/E
ratios must be a great way to compare stocks.
Right? Wrong!
If you were told that Fly-By-Nite Industries had a P/E of 7, and Fantastic Plastics Inc. had
a P/E of 14, would you buy Fly-By-Nite Industries instead of Fantastic Plastics Inc.? You
might, but you wouldnt be comfortable making that decision. Why? Because you need
more information. Youd like to know a whole lot of things before you decide which
stock to buy. One of the most important things youd like to know is the worth of each
stock based upon its earnings, profitability and other key financial data. In other words,
youd like to have a sense of the stocks intrinsic value. P/E ratios dont say anything
about a stocks value!
What investors need is a Value to Price ratio. With a Value to Price ratio, investors would
know immediately whether a stock was cheap, expensive or fairly priced. But this means
we have to have a way of computing value. Of course there are theories and formulas for
computing intrinsic value. But they are complex, and some sophisticated investors even
say they are unfathomable. Consequently, most investors, even the Pros, dont begin to
look at stocks intrinsic value! They resort to trivial devices like comparing P/E ratios.[3]

MYTH #2: YOU MUST ASSUME HIGH RISKS TO MAKE GOOD

MONEY IN THE STOCK MARKET
The perception of high risk in stock investing is not totally without merit. Many
investors have lost substantial sums of money in the market. Visions of investors jumping
out of windows back in 1929 are graphic reminders of the risk inherent in stock investing.
Recent events on the market...the Great Crash of 87, the Friday the 13th Mini-meltdown,
the ills of Program Trading, insider trading, the Mercury Financial and Bre-X scandals,
have also contributed to the casino image associated with stock investing. This is very
unfortunate because stock investing is one of the best ways the average person has of
accumulating substantial wealth. It just requires a few simple techniques and some
discipline. In fact, it can be a lot safer than investing in real estate, collectibles, or your
own business.

Stocks with consistent, predictable earnings growth are the safest stocks you can buy.
They represent the best managed companies in America. A stock portfolio with an
average earnings growth rate of at least 14%/yr. has a high probability of doubling in five
years. In twenty years it will have increased by 1,500 percent.
If you bought 10 stocks, and limited your loss on any single stock to 10% by using StopSell orders, your total portfolio risk is only 10%. Your risk on any single stock is only 1%
of your total portfolio.
How many investments can you think of that have the upside potential of stocks with
such limited risk exposure?[3]

Here's how to make good money in stocks at low risk:

Buy stocks with consistent, predictable earnings growth

Buy stocks with earnings growth rates of at least equal to the sum of current
inflation and interest rates.

Do Not put more then 10% of your money into any single stock

Do Not own more then two stocks in the same industry.

Do Not plunge into the market. Spread the investments over time

Use Stop-Sell orders to limit risk[3]

MYTH #3: BUY STOCKS ON THE WAY DOWN AND SELL ON THE
WAY UP
Theres an old adage that says the way to make money in the stock market is to buy low
and to sell high. That, of course, is an irrefutable truth. The only problem is that many
investors confuse this bit of conventional wisdom with the assumption that if the price of
a stock is going down it is low, and if it is going up it is high. Consequently, they buy
stocks on the way down and sell on the way up. Theres hardly a worse thing an investor
could do.
Stocks are bought on the expectation that they will go up. If a stock is going up in price,
it is fulfilling that expectation. When the price is going down, it is denying that
expectation. Therefore, it is logical to buy a stock when its price is going up. Moreover,
one of the best times to buy a stock is when the price has broken above an old high. At
this point there are no unhappy holders who are waiting to dump the stock. If the stock is
fairly valued, there should be clear sailing ahead.[3]

MYTH #4: STOCKS ARE A HEDGE AGAINST INFLATION

For many years stockbrokers and mutual fund salesmen have been saying that stocks
are a hedge against inflation. Well, they are and they arent. It depends on how you look
at it. A true inflation hedge is one that goes up in value with higher inflation...like a
house, or gold, or collectibles. But, the fact is, inflation is the stock markets number one

enemy. When inflation goes up, interest rates go up and two things happen. For one thing,
investors say, "Golly, I can make all that money on high interest rate bonds so why should
I invest in stocks." So they take their money out of the stock market, and stock prices go
down. The second thing that happens is that the cost of doing business goes up. So
corporate earnings go down, and stock prices go down.
So why in the world would anybody say that stocks are a hedge against inflation? Its
because they can make money in stocks faster than inflation will eat it up. All they have
to do is invest in stocks which have earnings growth rates higher than the sum of inflation
and long-term interest rates. When they do that, the price of the stock will go up faster
than inflation. And they will be whipping inflation by staying ahead of it [3]

MYTH #5: YOUNG PEOPLE CAN AFFORD TO TAKE HIGH RISK

Of all the myths in the market, this may be the cruelest and the most foolish. Everyone
knows that the elderly are not supposed to take risks. They must be very conservative
because their earnings power is limited. They cant afford to lose their money! Well, who
decided that young people could afford to lose their money?
If any group needed to watch every penny, its the young. They need money to start a
family, buy a house, buy furniture, save for the future and on and on. Furthermore, young
people usually are at the low end of the earnings scale. They have precious little
disposable income.
Young people have an invaluable asset on their side, however. . They dont need to take
risk. They can invest in tried and true companies that make money year in and year out.
At 10%/year growth, their investments will double every seven years. By the time baby is
off to college, that initial safe investment has increased by a factor of eight.
When you have time, you can afford patience. Patience pays off in the market.[3]

Stock Valuation
Firms obtain their long-term sources of equity financing by issuing common and
preferred stock. The payments of the firm to the holders of these securities are in the form
of dividends. Unlike interest payments on debt which are tax deductible, dividends must
be paid out of after-tax income.
The common stockholders are the owners of the firm. They have the right to vote on
important matters to the firm such as the election of the Board of Directors. Preferred
stock, on the other hand, is a hybrid form of financing, sharing some features with debt
and some with common equity. For example, preferred dividends like interest payments
on debt are generally fixed. In addition, the claims against the assets of the firm of the
preferred stockholders, like those of the debt holders, are also fixed.

The common stockholders have a residual claim against the assets and cash flows of
the firm. That is, the common stockholders have a claim against whatever assets remain
after the debt holders and preferred stockholders have been paid. Moreover, the cash flow
that remains after interest and preferred dividends have been paid belongs to the common
stockholders.
The priority of the claims against the assets of the firm belonging to debt holders,
preferred stockholders, and common stockholders differ. The owners of the firm's debt
securities have the first claim against the assets of the firm. This means that the debt
holders must receive their scheduled interest and principal payments before any
dividends can be paid to the equity holders. If these claims are not paid, the debt holders
can force the firm into bankruptcy. The preferred stockholders have the next claim. They
must be paid the full amount of their scheduled dividends before any dividends may be
distributed to the common stockholders.
The value of these securities, as with other assets, is based upon the discounted value
of their expected future cash flows. In this paper, Time Value of Money principles are
applied to value common and preferred stock. Two approaches are presented for the
valuation of common stock. The first approach illustrates the valuation of a constant
growth stock, i.e., a stock whose dividends are growing at a rate which mirrors the longterm growth rate of the economy. The second approach is a more general approach
which can be applied to value stocks whose growth is not constant in the near term.[4]

Constant Growth Stock Valuation

Stock Valuation is more difficult than Bond Valuation because stocks do not have a
finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the
techniques used for stock valuation must make some assumptions regarding the structure
of the dividends.
A constant growth stock is a stock whose dividends are expected to grow at a constant
rate in the foreseeable future. This condition fits many established firms, which tend to
grow over the long run at the same rate as the economy, fairly well. The value of a
constant growth stock can be determined using the following equation:

Where

P0 = the stock price at time 0,

D0 = the current dividend,
D1 = the next dividend (i.e., at time 1),
g = the growth rate in dividends, and
r = the required return on the stock, and
g < r.

Application #4- Constant Growth Stock Valuation Example

Find the stock price given that the current dividend is $2 per share, dividends are
expected to grow at a rate of 6% in the foreseeable future, and the required return is 12%.
Solution:

Non-constant Growth Stock Valuation

Many firms enjoy periods of rapid growth. These periods may result from the
introduction of a new product, a new technology, or an innovative marketing strategy.
However, the period of rapid growth cannot continue indefinitely. Eventually,
competitors will enter the market and catch up with the firm.
These firms cannot be valued properly using the Constant Growth Stock Valuation
approach. I will now presents a more general approach which allows for the
dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes
that dividends will grow from that point on at a constant rate which reflects the long-term
growth rate in the economy.
Stocks which are experiencing the above pattern of growth are called non-constant,
supernormal, or erratic growth stocks.
The value of a non-constant growth stock can be determined using the following
equation:

where

P0 = the stock price at time 0,

Dt = the expected dividend at time t,
T = the number of years of non-constant growth,
gc = the long-term constant growth rate in dividends, and
r = the required return on the stock, and
gc < r. [4]

Application #5-Nonconstant Growth Stock Valuation Example

The current dividend on a stock is $2 per share and investors require a rate of return of
12%. Dividends are expected to grow at a rate of 20% per year over the next three years
and then at a rate of 5% per year from that point on. Find the price of the stock.
Solution:

There are 3 years of non-constant growth, thus, T = 3. Before substituting into the
formula given above it is necessary to calculate the expected dividends for years 1
through 4 using the provided growth rates.

Preferred Stock Valuation

Preferred stock is defined as equity with priority over common stock with respect to
the payment of dividends and the distribution of assets in liquidation. Preferred stock is a
hybrid security which shares features with both common stock and debt.
Preferred stock is similar to common stock in that it entitles its owners to receive
dividends which the firm must pay out of after-tax income. Moreover, the use of
preferred stock as a source of financing does not increase the probability of bankruptcy
for the firm.
However, like the coupon payments on debt, the dividends on preferred stock are
generally fixed. Also, the claims of the preferred stockholders against the assets of the
firm are fixed as are the claims of the debt holders.
Preferred stock has the following features:
Par Value
The par value represents the claim of the preferred stockholder against the value of the
firm.
Preferred Dividend / Preferred Dividend Rate
The preferred dividend rate is expressed as a percentage of the par value of the
preferred stock. The annual preferred dividend is determined by multiplying the preferred
dividend rate times the par value of the preferred stock. [4]
Since the preferred dividends are generally fixed, preferred stock can be valued as a
constant growth stock with a dividend growth rate equal to zero. Thus, the price of a
share of preferred stock can be determined using the following equation:

where

Pp = the preferred stock price,

Dp = the preferred dividend, and

r = the required return on the stock.

Application #6- Preferred stock valuation

Find the price of a share of preferred stock given that the par value is $100 per share,
the preferred dividend rate is 8%, and the required return is 10%.
Solution:

How to use P/E as a valuation tool

P/E is one of the more important fundamental valuation tools. P/E is a ratio of the
stocks price and the stocks earnings per share. To calculate a P/E, take the price of the
stock and divide it by it's earning per share.
Example: Stock Price $20, Earning Per share $2, gives a P/E 10.

Types of P/E, Individual and Collective

P/E can be calculated for an individual stock as well as for the overall market. To
calculate P/E for the overall market, investors typically use DJIA and the S&P 500.
To calculate the market P/E in the DJIA, the investor must use the value of the DJIA
divided by the earnings of its 30 components.

Trailing P/E
Trailing P/E, is when historical values are used, this does not give an indication of
future performance, but does give the investor an idea of the stocks historical value which
then can be compared to it's current P/E or projected P/E's. Trailing P/E ratio's are
commonly used in newspapers.

Projected P/E
Projected P/E uses the current stock price divided by the stocks projected earnings per
share. Projected earnings are generally provided in company research reports. Projected
P/E should be used with care, since it is based on estimated earnings.

Relative P/E
The relative P/E ratio is a ratio between the current P/E and historical P/E's. A relative
P/E has a numerical range of between 0- high (100%) P/E.
For example: if a stock has historically traded with a P/E range of 10-20, and the
current P/E is 20, than the relative P/E would be 100%. If the stock's P/E is 15, the
relative P/E would be 75% (15 / 20 = 0.75 or 75%0 ). Some investors believe that trading

in the high range of a stock's relative P/E is not considered safe since it could be
considered overvalued.
Historical P/E's are not always accurate since they do not account for large events, like
in 1992, which followed a large recession, when a large portion of companies wrote off
assets and went into restructuring.

P/E and company growth

Company growth is reflected in the stock's P/E. The higher the company growth rate,
the more expensive the stock, as measured by P/E. Growth stocks tend to have high P/E
ratios, in the range of 25 to 50 times the annual earnings per share.
Investors tend to invest when they believe the company growth will accelerate, thereby
increasing the price and the P/E. If the company is seen by the public to have a
decreasing growth, the price tends to fall as well as the P/E.
With growth stocks, it is important to compare the earnings growth rate with the stocks
P/E. Depending on the investors risk, one may consider a company with a growth rate of
20% and a P/E of 20 to be reasonably valued. A P/E which is as high as 25% above the
growth rate may considered reasonable in industries like high-tech. Conservative
approach would only consider stocks with a 20% growth rate if the P/E was less than
75% of the growth rate. (20 x 0.75 = 15, therefore the stock must have a P/E less than 15)
Analyzing P/E's and projected growth rates can help give the investor an indication of
valuation. For example a P/E of 50 may be considered quite high, yet if the company's
growth rate is estimated at 50%, then this stock would be at a discount in comparison to
it's future earnings. On the other hand a stock with a P/E of 10 and a growth rate of 5% is
considered overvalued.
If the company has a high P/E, the reasoning would be that it would have high growth
expectations. If these expectations are not met, the higher the P/E, the higher the potential
price fall. However stocks with low P/E's should not be so quickly considered based on
the P/E alone. A low P/E may be a results of competition, low growth, earnings
expectations and more.
Company's with low P/E's are generally considered more attractive because of two
main reasons, 1) the stock will rise in price if the P/E rises to that of the industry, and 2) it
can only go up. It is important when using a low P/E to always consider the companies
potential growth in earnings.

Forecasting with P/E

P/E by itself is not always a good predictor of future price movements, however it is
quite commonly used by investors to forecast future price level of stocks and the market.
Forecasted price = Current P/E * project annual earnings per share.

Example:
Current projected annual earnings per share is $2/share, the assumption will be that it will
maintain it's P/E of 10, the estimated price at year end should be $20 ($2 X 10 = 20).
It is unlikely that the P/E should remain constant throughout the year since it is based
on a moving price. The P/E will either rise or fall by the year end based on, if it the P/E is
higher, than a higher price should have been reached, or it the P/E is lower at year end,
than the price should be lower than projected.

Forecasted market price is calculated in the same way as

forecasted price.
Forecasted Market Price = Current market P/E X total projected annual earnings per
share of the market.
It should be understood by investors that forecasted prices are calculated from
assumptions made on company growth, and that they are not immune to
favorable/unfavorable news, competition, panic selling, business outlook and business
cycles, etc

Tips:

Current P/E has little meaning on forecasted price.

Positive P/E conditions are that the company P/E is higher than the market P/E at
the beginning of an up-trend.
P/E's should be compared to similar companies in the same market as well as
historical P/E values.
If institutional ownership is low, P/E tends to be low.
Companies with low P/E tend to be safer.
Do Not buy low P/E stocks just because they are low, Do Not buy stocks just
because the P/E is at a historical low and Do Not use P/E's as the only mean of
analysis.

Technical analysis provides an important

tool
Charts aren't the final solution to making smart investment decisions. They don't
provide all the answers but they are an important investment tool. If you are a serious
investor you need charts as much as a plumber needs a pipe wrench. Sure, he could do his
job without the proper tools but could he do it nearly as efficiently and effectively? And,
if the tools are readily available, isn't it foolhardy to continue working without them?
Charts, and technical analysis, will completely change your way of relating to
potential investments. They provide a filtering mechanism or framework for selecting
investments that provide a good potential for profit.

Let me show you how very quickly.

Within minutes of looking at a price chart you can decide whether you are interested in
further information on a particular market or not. This saves can you hours of wading
through miscellaneous reports, analyses, trading tips, and newsletters. Once you selected
potentially profitable investments you can plan your strategy according to sound
principles, including fundamental analysis.
This business-like approach to investing may not offer the thrills of buying and selling
on the spur of the moment but it does lead to greater profits and restful nights. You may
be thinking, "I don't know what all the fuss is about. Investing boils down to simply
knowing when to get in and when to get out."
You would be perfectly right; successful investing comes down to a matter of correctly
answering these two questions:
1. WHAT to buy and sell.
2. WHEN to buy and sell.
If you've lost money on some of your investments you already know what all the fuss
is about.

Price Charts
The price range and change in value of any - yes, ANY - item of trade can be graphed
over time to give you a picture of both historical and current prices. If you had your home
appraised once a month over a 5 year period, for example, you'd have the raw data for a
price chart which would be an accurate record of housing price trends in your
neighborhood for that time period.

Support and Resistance

Investments are bought and sold in the marketplace, most often through open bid.
Stocks, commodities, precious metals, etc. are being auctioned each and every business
day on a global scale. Buyers and sellers are competing to get the best price and make the
most profit (or get out with the smallest loss).

It's just like going to the grocery store and buying fresh chicken through open bid. If
there are only 5 chickens left and 12 interested purchasers (demand greater than supply)
the price will be relatively high. On the other hand, if there are 36 chickens and only 12
bidders (supply greater than demand) the purchase price will be relatively low.
In the first scenario prices will go up and up until buying resistance is met. Buyers
will simply not pay higher prices based on the current market in chicken. In the second
scenario prices will meet support when purchasers feel the price is so low that they want
to stock up their freezers thereby creating extra demand and supporting prices.
A price chart is a graphic record of this psychology of the marketplace with
respect to the price of a particular stock, commodity, fund, precious metal, etc.

Figure 2. A simple set of trend lines showing support and resistance. The up arrows
indicate troughs (points of support)and the down arrows indicate peaks (points of
resistance). It is often almost uncanny to see how perfectly the successive highs and lows
line up along a developing trend line.
Three Simple Rules
1. BUY only when the long term trend is UP.
2. SELL only when the long term trend is DOWN.
3. STAND ASIDE when the long term trend is SIDEWAYS.
Buy when the price is going up and sell when it is going down. Go with the trend. It
sounds so simple, doesn't it? Yet, how many times have you purchased an investment
without even considering the long term trend - the direction prices are headed? The price
of a stock or commodity, any market for that matter, acts like a fully loaded freight train.
Once a direction is established it becomes resistant to change. And the longer it heads in
one direction the greater the momentum.
Day traders are in a category all their own, of course! (And they're usually the first to
admit it!) The long term trend is relatively meaningless to a daytrader - however
daytraders must still anticipate the direction of the trend no matter how short-lived or
ephemeral. If you daytrade you just play by a different set of rules; the fundamental
actions of the market don't change.

Establishing Trends
How do you establish trends? By drawing lines on price charts which connect as many
highs as possible on one side and as many lows as possible on the other. These lines,
called trend lines, are actually zones which contain the price (see the section on Trend
lines).
When drawing trend lines try to make the line as meaningful as possible. In charting
practice and theory, a line based on one peak or one trough means nothing. You
require at least two points to draw a meaningful line - anything less is fantasy. Two highs
or two lows is the bare minimum. The more points you can connect the more
significant the resulting line (see Figure 2 above to see what I mean by connecting
points).

Technical Indicators
Technical indicators can be as straightforward as a simple moving average or as
complex as a Parabolic SAR. ChartHelp.com shows you how to apply some of the many
indicators available to your own specific needs and resources.
Martin Pring, a well known analyst, states the art of technical analysis is "to identify
trend changes at an early stage and to maintain an investment posture until the weight of
the evidence indicates that the trend has reversed." (Technical Analysis Explained by
Martin J. Pring, 1991)
Trend indicators such as trendlines, price patterns and moving averages identify a
change in trend after it has taken place. Momentum indicators, such as ROC, RSI and
MACD, can warn of strength or weakness in the market, often well ahead of the final
turning point.
Consider the popular MACD indicator, for example, in the charts below. The MACD
chart is shown underneath the price chart. As you can see from the example below
MACD can help catch a reversal in the overall price trend, providing very useful buy and
sell signals and alerts. Here we can see where the down trend was broken, providing the
first alert that a market reversal could be underway. When MACD broke through its
signal line we had a confirmation that the market had reversed. And a second
confirmation came when MACD broke upwards through the zero line. The market then
began a strong uptrend and MACD even proceeded to let us know when it was time to
sell! See the section on MACD for much more information on using this handy indicator.

Figure 3. The MACD indicator and some of its common signals.

There are dozens of technical indicators like MACD that are just as useful for timing
entry and exit points. Once you become familiar with a few of them, you will have a
much better set of tools available for making your investment decisions than the majority
of investors.

Steps to a Successful Trade

The steps involved in making a successful trade are generally as follows:
1. Ask yourself, "Which way is this particular market going?" Determine the long
term trend by drawing trendlines on the appropriate price chart. Consider buying
or selling only in the direction of this trend. (Unless you ride wild broncos, jump
out of airplanes, or daytrade).
2. Use the analytical tools at your disposal - indicators such as moving averages,
MACD, stochastics, RSI, etc, can provide you with excellent signals for
positioning your entry and exit points. ChartHelp.com has been designed to
provide you with the information you need to use these tools effectively and
profitably.
3. Decide on an entry signal. Based on business like rules for entering the market
determine the price you want to pay. Place orders in accordance with meaningful
signals such as breakouts in price.

4. How much are you willing to lose? Pre-calculate acceptable losses before you
enter the market. If the market turns against you get out when this loss is realized.
Don't hesitate.
5. When the long term trend line is broken it's time to take your profits.
6. Wait patiently for the next opportunity. Don't be in a big hurry to make a fortune.
Price charts and technical analysis can help you determine what to buy and sell and
when to enter and exit.

Let Your Profits Run

Have you heard the old market saying "Cut your losses short and let your profits run?"
There's a great deal of wisdom distilled into this one simple statement.
Cut your losses short by predetermining how much capital you are willing to risk on
any investment and getting out as soon as you've lost that much even if it's only on
paper. Paper losses are real losses. Don't let anyone kid you. You can't afford to hang
onto a loser because everyone else is telling you it will turn around. Going with the long
term trend should keep you out of losing situations but don't allow losses to
accumulate. When your pre-determined amount is lost get out!
Very honestly this is the best advice I can give you. Another old saying comes to mind,
"Look after your losses and the profits will look after themselves".
How do you let your profits run? By sticking with the long term trend. As long as the
price is on the right side of the long term trend hang in there. But as soon as the long
term trend is broken take your profits. It pays to keep checking your price charts after
you've entered a market so you know when to get out. If it is a long term investment
checking the price charts once a week should be enough.

Summary
Price charts and technical analysis can help you make investment decisions more easily
and in a more business-like manner. They should be considered an additional tool and not
the complete investment tool kit. The biggest benefit of using charts and technical
indicators is that they offer an objective framework for evaluating and profiting from an
investment. A price chart gives you an immediate graphic record of all factors
influencing the historic price of a commodity or security. Indicators can provide very
effective tools for determining the best time to buy and sell.

Breakout Signals
A breakout in price through a long established trend line is always significant.

Overview

When a price breaks out of a stable, established range, for whatever reason, the
odds are high that it will continue to move in the same direction
The longer the trend, the greater the potential move
An upward surge in trading activity, or volume, confirms the validity of the
breakout.
When the volume does not show a significant increase on the upside price
breakout, the price pattern should be questioned.

Interpretation
The breaking of an important trendline is often the first sign of an impending change in
trend, which is only sometimes a trend reversal. The breaking of a major upward
trendline might signal the beginning of a sideways price pattern, which would be
identified as a reversal or consolidation type later.
The stronger the trendline broken the more significant. Historically we know that if a
strong or "well-tested" trendline is broken and the price moves out of an established
range something important has happened to the psychology of the marketplace. We may
not know what it is; it will probably be a combination of influences or events. But,
whatever the reasons, any pull strong enough to break a long term trendline and carry the
price into new ground is usually strong enough to continue pulling the market in the new
direction to establish a new trendline.

The odds that a market will continue in the direction of a breakout are high but, of
course, there are no guarantees. Remember, this is not a golden rule; it is a pattern which
has been repeated many, many times in the past and will be repeated many more times in
the future. It gives us something tangible to look for when considering the hundreds and
thousands of potential trades we could enter into.

Breakout Validity
Not every move out of the price pattern constitutes a valid signal of a trend reversal, or
resumption if the price is in a narrow trading range. It's helpful to establish valid criteria
to minimize the possibility of misinterpreting moves such as whipsaws. A wait for a 3
percent penetration of the boundaries is traditionally necessary before determining that
the breakout is valid. The resulting signals are less timely, but a considerable number of
misleading moves are removed.
However, many short-term price movements barely exceed 3 percent in total. In short
term trades it will be difficult to make a profit if you wait for a 3 percent move to buy,
and an additional 3 percent decline for a breakdown to sell. The 3 percent rate works well
for longer-term price movements where the fluctuations are much greater. Deciding
whether a breakout is valid or not depends on the type of trend being monitored, volume,
momentum characteristics and your own experience.
An upward surge in trading activity, or volume, confirms the validity of the breakout. A
low volume breakout is suspicious and should be disregarded. Increasing volume is not as
essential for a valid signal with downside breakouts, as it is for an upside breakout. Prices
will often reverse and put on a small recovery, following the downside breakout. This
price increase is regularly accompanied by declining volume.

Dow Theory At a Glance

Overview
Dow Theory is based on the philosophy that the market prices reflect every significant
factor that affects supply and demand - volume of trade, fluctuations in exchange rates,
commodity prices, bank rates, and so on. In other words, the daily closing price reflects
the psychology of all players involved in a particular marketplace - or the combined
judgment of all market participants.
The goal of the theory is to determine changes in the major trends or movements of the
market. Markets tend to move in the direction of a trend once it becomes established,
until it demonstrates a reversal. Dow theory is interested in the direction of a trend and
doesn't offer any forecasting ability for determining the ultimate duration of a trend.
Much of today's technical analysis is based on Dow's original "trend following'
system

Classification of a trend

Principles of confirmation or divergence

Use of volume to confirm trends
Use of percentage retracement
Recognition of major bull and bear markets
Signaling the large central section of important market moves
Dow theory has been successful in identifying 68% the major trends over the
years

The three trends are:

Uptrend: successively higher peaks (highs) and higher troughs (lows)

Downtrend: successively lower peaks and troughs
Sideways Channel: peaks and troughs don't successively rise or fall

Each market trend has three parts compared to tides, waves and ripples.

The primary (major) trend or tide is a long term trend lasting from a year to
several years
The secondary trend (or mid-term trend) or wave lasts three weeks to three
months and represents corrections of one third to two thirds of the previous
movement - most often fifty percent of the movement.
The minor trends (short-term trends) or insignificant ripples last less than three
weeks and represent fluctuations in the secondary trend.

The major trend has three phases:

Accumulation phase: knowledgeable investors buy issues with good potential

Public Participation phase: Prices increasing rapidly and bullish markets are
reported
Distribution phase: Astute investors sell first, thereby leading the public

A Major or Long-term Stock Market Trend:

Must be confirmed by the Dow Averages, calculated on closing prices only, not
the daily high or low (this provides the overall stock market trend)
Should have volume increase/decrease in the direction of the trend
Stays in effect until it gives definite reversal signals

Shortcomings of the Dow Theory:

The major criticism of the Dow Theory is its slowness: It misses about 25% of a move
before giving a signal, primarily because it is a trend following system designed to
identify existing trends.

Trendlines
Trendlines illustrate the direction of the market movement and provide a primary
consideration in any analysis.

Overview

Uptrends consist of a series of successively higher highs and lows.

Downtrends consist of a series of successively lower highs and lows.

The first consideration when looking at any market is the direction of the long term
trend (with the exception of day traders).
Prices can only go in three directions; up, down, and sideways. A long line of past
price ranges together gives you a pattern. There will be plenty of dips and bumps along
the line but you should still be able to discern a general direction up, down, or sideways.
We can help spot this direction or trend by drawing in "trendlines".

Drawing trendlines during an up trending market: The trendlines above have been
drawn by connecting as many successive lows as possible (along the bottom of the price
range). An up trending trendline represents major support for prices as long as it is not
violated.

Trendlines connecting highs can also be drawn to indicate the top of the established
trend or channel (blue lines). These trendlines indicate the major zones of resistance. (See
below for a discussion of support& resistance).
Drawing trendlines in a down trending market. Down trending trendlines are drawn by
connecting the successive highs.

Trends can push and pull the price up or down. Markets can also enter a period of quiet
stability where the price forms a horizontal line sideways across the page. A sideways
trending market is normally a difficult market to trade for a profit. It can, however, set the
stage for a sharp move once the sideways trend is broken (signalled by a price break
through a well-established trendline).
A sideways pattern represents stability between supply and demand in the marketplace.
Trendlines in this type of market, often referred to as a narrow trading range or
congestive phase, are drawn by connecting both the highs and lows. Prices In this type of
market can break upward or downward so it is valuable to establish the top and bottom of
the range

Support and Resistance

An important concept in the use of trendlines is that of support and resistance. A
continued trend is based on underlying support for prices in the market, for whatever
reason. Similarly, theres resistance to higher prices built into the market. The trendline is
one way to capture and illustrate these zones of support and resistance.
As long as the market stays within these zones of support and resistance, as shown by a
trendline, the trend is sustained. Any penetration through a trendline warns of a possible
change in trend. We may not know the reason behind such a change, but we do know that
for some reason the support or resistance for a market is changing.
The Rhino Theory of Support and Resistance: The upper and lower trendlines contain
the price the way a barbed wire fence might contain a rhino. Think of the prices as the
rhino and the trendline as a barbed wire fence. If a rhino leans against the wire, the fence
will give a bit, offering more and more resistance until either the rhino eases off or the
wire snaps. If the rhino has wandered along and leaned against the fence in several places
without breaking through, we will have more faith in the strength of the fence.
If the rhino only leaned against the fence once before moving along, it is less
meaningful. In charting practice, a line based on one high or one low means nothing. Two
highs or lows is the bare minimum. The more points you can connect the more significant
the resulting line. And, the more significant the trendline, the more significant any
penetration will be. (I say will be because all trends eventually reverse some day!)

Round numbers
Another aspect of resistance and support concerns the round numbers associated with
price levels, such as 10, 20, 25, 50, 75 and 100. Since the price reflects the psychology of
the marketplace, these levels offer natural boundaries or targets. With resistance and
support common along these levels, it makes sense to avoid placing orders right at these
values. (If buying on a short term dip in an uptrend, youd place your order just above an
important round number). It also makes sense to place stop loss orders below the round
numbers on long positions, rather than exactly on the round number (i.e., $4.90 rather
than $5.00).

Duration of Trend
Short term trends are established over a few days. It may be in any direction and has
little potential over the long run (except if youre a daytrader). A strong thrust, however,
may indicate the beginning of a move into new ground. Particularly if it crosses a
medium or long term trend line. Think of it as an early warning system; a sign to be
prepared for a larger move.

Short term trend -- always the current trend. It may not necessarily be in the same
direction as the mid or longterm trend.
Medium term trend -- a trend that occurs over weeks to 2 or 3 months. All big moves
must start with a short term thrust building to a medium term trend.
Long term trend -- a trend over three months is considered a long term trend. Long
term trends show stability.
Any trend which has continued unbroken for over 3 months is considered to be a long
term trend, and of some significance. This is the trend to trade with in the majority of
cases. It can be thought of as the driving force behind the price and, until a fundamental
change occurs in the marketplace, it will continue to do so.

Signals
Signals are generated primarily when trendlines are broken. A particularly strong signal
is generated any time a long term trendline is broken.
Some traders also use the price bouncing off a trendline as a signal. If an upward
trendline holds, for example, you may have a buying opportunity at a relatively low
price. If the price is in a well-established channel, the other side of the channel can give
you an approximate price target.

Triangle Patterns
Triangles provide one of the most useful price pattern indicators. The odds favour a
continuation of the trend following a breakout from the triangle pattern.

Overview

When the top and bottom trendlines form a triangle a valuable indicator is formed,
often forecasting a sharp subsequent movement when the price breaks out.
The wider the price fluctuations within the triangle, and the longer the triangle
pattern holds, the greater the following price change.
Good triangles are an intermediate pattern, taking from one to three months to
form.

Triangle patterns usually form part way through a strongly trending move and
represent a congestive phase in the marketplace. These patterns are important because

they are typically followed by sharp increases or declines in price. An established triangle
pattern is a valuable signal prior to a relatively predictable price change.
The vertical line measuring the height of the pattern becomes the base of the triangle.
The apex is the point of intersection where the two lines meet. There are typically 3
common types of triangles - symmetrical, ascending, and descending:

Symmetrical Triangle
The symmetrical triangle is formed by two converging trendlines encompassing at
least two or more rallies and reactions with a breakout following the original trend. It is
also called a coil because fluctuation in price and volume decrease until both react
sharply, like an unsprung coil.
To complete the pattern, volume should pick up noticeably at the penetration of the
trendline

Ascending Triangle (Right Angle)

The symmetrical triangle is a neutral pattern, whereas the ascending right triangle is
bullish and the descending right triangle is bearish. The ascending triangle has a rising
lower line with a flat or horizontal upper line, indicating that buyers are more aggressive
than sellers. This bullish pattern usually results in an upward breakout.
This breakout should have a sharp increase in volume and the upper resistance line
should act as support on subsequent dips after the breakout. The minimum price target is
equal to the height of the base of the triangle measured upward from the breakout point.

The ascending triangle sometimes also appears as a bottoming pattern. Frequently, an

ascending triangle will develop toward the end of a downtrend .. Again, the pattern is
considered bullish. When demand remains weaker than supply, a bearish ascending
pattern may form and is confirmed with a breakout on the downside on good volume.

Descending Triangle (Right Angle)

The descending triangle is a flipped over ascending triangle with a flat bottom line and
a declining upper line. A close under the lower trendline, usually on increased volume,
resolves the pattern to the downside as bearish. Volume is less important on the downside
than on the upside.
If a rally occurs it usually meets resistance at the lower trendline. The descending
triangle can also be found at the top of a market.

Reversal Patterns (Tops And Bottoms)

Reversal patterns, or tops and bottoms, signify a fundamental change in the long term
trend.

Overview

Tops are usually less stable and shorter than bottoms.

Bottoms usually have smaller price variations and are slower to establish.
Volume is usually more important on the upside.
Confirmation of a top or bottom is in a double top or bottom (or a short channel.)

The most popular Reversal Patterns include: head and shoulders, double tops and
bottoms, triple tops and bottoms, and V-formations.

Interpretation & Signals

Head & Shoulders

The well known head and shoulders pattern is formed by three peaks; the center peak,
or head, is slightly higher than two lower, and not necessarily symmetrical, shoulders.
The line joining the bottoms of the two shoulders is called the neckline. Due to
fluctuations, the neckline is rarely symmetrical or perfectly horizontal.
The pattern isn't complete until the neckline is broken. It is often good to wait for
confirmation - for example, two successive closes below the neckline. Remember,
markets often bounce back to the Neckline after the breakout and this becomes a new
level of resistance.
Volume should be assessed to confirm the validity of these patterns. Volume is
normally heaviest during the formation of the left shoulder and also tends to be quite
heavy as prices approach the peak. The real confirmation of a developing Head and
Shoulders pattern comes with the formation of the right shoulder, which is invariably
accompanied by distinctly lower volume.
Some traders use the distance between the neckline and the top of the head to project a
"price objective." The price objective is determined by measuring from is the top of the
head to the neckline, and using this distance from the breakout point downwards.
An Inverted Head and Shoulders pattern is a mirror image of the Head & Shoulders
pattern (forming a market bottom).

Double Tops

Double Tops are another reliable and frequently used reversal pattern. This pattern
consists of two tops of approximately equal height. A line is drawn below and parallel to
the resistance line that connects the two tops. The neckline is a strong support for price
level but eventually fails.
As with a Head and Shoulders, after the two rallies and their respective reversals are
completed the double tops is confirmed only when the neckline is broken. The support
line then becomes a resistance line, which often holds a market rebound.
A Double Bottom pattern is a mirror image of a double top pattern: The average height
of the bottoms gives a good indication of the price objective.

Triple Top
A triple top is a cross between a head and shoulders and double top. This formation
consists of three tops of approximately equal height. A line is drawn below and parallel
to the resistance line that connects the three tops. The neckline is a strong support for
price level but eventually fails. The support line then becomes a resistance line, which
usually holds any market rebound.

Triple Bottom
A triple bottom pattern is a cross between an inverted head and shoulders and double
bottom pattern.

V- Pattern
The V pattern is an unusual pattern in that a sharp trend switches from one direction to
the other without warning and with high volume at or just after the turn around.

Further points
Trend reversals offer some of the most important opportunities for entering a market
with a good profit potential. They usually represent fundamental changes in the
underlying character of a particular market and often go on to yield big moves.
However, a market top or bottom is often difficult to identify. It is even more
difficult to choose appropriate entry and exit points. One problem is distinguishing
between an actual change in trend or merely a congestive phase in the middle of a move.
It is usually advisable to wait for prices to actually confirm a trend reversal by developing
one of these well-tested and reliable reversal patterns. The actual buy or sell signals are
based on a breakout in the direction of the new trend.
Here are some general observations about Reversal patterns:

A breakout through a trend line is used in conjunction with a price pattern to

yield signals in terms of both price level and timing.
The longer the time required to form a pattern and the greater the price
fluctuations within it, the more substantial the coming price movement is likely
to be. The time frame is normally from several days to several months - intraday
patterns are not considered reliable.

Candlestick Patterns
Overview
Candlestick charting has been in use in Japan for the last 300 years and has received
world wide recognition. Each candlestick is composed of four values, the high, low, open
and close. The advantage to this form of charting is that it provides more visual
information about the trading day as well as many trading signals to help decision
making.
The body of the candlestick (or jittai) is the open and the close of the trading day. The
high and the low of the day create the upper and lower shadows of the main candle body.

(Most charting programs will allow you to use other colors in the bar, typically green
for white candle and red for black candle)

Types of Candles
With candlestick charting, there is quite a lot of terminology to describe type of
candles.

A marabozu, or "shaved head", is a candlestick with no shadows. This is where the

open and close prices are similar to the high and low.
An opening bozu in a white candlestick is when there is no lower shadow (opens at
the low) and in the case of the black candlestick an opening bozu has no upper shadow
(opens at the high).
A closing buzo in a white candlestick is when there is no upper shadow (it closes at the
high) and in a black candle a closing buzo is when there is no lower shadow (it closes at
the low).

Bullish Candlestick Patterns

Single day bullish signals
The easiest type of signal is the single white candlestick (yo-sen). The longer the body
(jittai) the more bullish is the candle.

Two day bullish signals

Kirikomi or Kirihaeshi candlestick
This two day candlestick opens with a black marubozu candlestick and is followed by
a kirikomi candlestick ( a kirikomi candlestick is a marubozu candlestick which has
opened lower than the previous low and closes above the 50% level, but below the black
marubozu's opening price.)

The first candle shows a down. On the second

day, the candle opens lower than the previous day's
low. This creates an "overnight price gap". Typically
the pattern does not weaken further (if it does it's
marginal), the market then fills the gap.
By closing above the 50% level, the kirikomi
candlestick is considered a stong bullish signal.

Bullish Tasuki Candlestick

The bullish tasuki candlestick comprises of "a long black candlestick that opens within
the range of the previous day's long white body, and closes marginally below the previous
day's low". (Candlesticks do not have to have long bodies if the two days ranges are
about the same size). The second day of the formation, the candle opens lower than the
previous close. (This black candle occurs in an otherwise uptrending market). This move
can be interpreted as profit taking. At this point, the profit taking during an uptrend where
the bullish tasuki occurs

Upside Gap Tasuki Candlestick

The upside gap tasuki is "a second day black candle that closes an overnight gap
opened on the preious day by a white candle."

The pattern is similar to a

common gap. It provides a
short term opportunity to sell
to fill the gap. The filling of
the upside gap is an indication
that the uptrend will resume.

Bullish Engulfing Pattern (Bullish Tsutsumi)

This pattern composes of "a second day long white candlestick that opens lower and
closes higher than the preceding small black body."

The name comes from the idea that the white

candle "engulfs" the black candle. This can also
be know as a "bullish key reversal" and is a
signal to reverse and go bullish.
It is common to see a neutral period follow
this pattern since it takes

Bearish Candlestick Patterns

Single day bearish signals
The easiest type of signal is the single black candlestick (in-sen). The longer the body
(jittai) the more bullish is the candle.

Two day bearish signals

Dark Cloud Cover (Kabuse Candlestick)
The dark cloud cover (Kabuse candlestick) has an white candle followed on the second
day by a black candlestick that opens at a higher price. The black candlestick should open
approximately half way up the white candle's body. It is the black candle which negates
the previous day's movement that gives the pattern it's name, a dark cloud cover (or
kabuse candlestick). This pattern is considered a bearish reversal (sell).

Atekubi (Ate) Candlestick

The atkubi candlestick's second day small white candle which has opened lowed than
the previous day's low and then closes at a high. Typically the volume is lower and the
current close at the high is only equal to the previous day's low. This signal is seen most
often in a down trend and the appearance of this signal indicates the down trend will
continue.

Irikubi Candlestick
The irikubi candlestick is a modified atekubi candlestick, the difference is that the
white candlestick's high can be marginally higher than the black candlestick low. This
pattern is bearish an indicates futher selling ahead.

Sashikomi Candlestick
The sashikomi candlestick is a alteration of the irikubi candlestick. This is where the
white candle opens lower than the black candle's low, and closes at the daily high. This is
considered a bearish signal.

Bearish Engulfing Pattern (Bearish Tsutsumi)

This pattern is pretty much the opposite of the bullish engulfing pattern. The first day
white candle is engulfed by the second day black candle. Volume tends to be high during
this signal and indicates a change in sentiment.

Bearish Tasuki Candlestick

The tasuki pattern has a second day white candle that has opened within the body of
the first day black candle's body. The white candle then closes slightly above the black
candle's low. Either candle can have varying body sizes as long as the range of both

candles are of similar size. This pattern is found in down trends and is viewed as a period
of profit taking. This is a bearish signal.

Downside Gap Tasuki Candlestick

This pattern has a second day white candle that closes an overnight gap from a black
candle. This provides a very short term opportunity to buy to fill the gap, however, it has
no other significance. It is typical for the down trend to continue after this pattern occurs.

Reversal Candlestick Patterns

Daily Reversal Patterns
For the most part, daily candlestick reversal patterns are quite subjective with the
exception of the "long-legged shadows' Doji" and the "hangman and hammer" which are
more commonly used and provide more significance to the trader.

Komas or spinning top

This pattern refers to the idea that "the trend is not quite sure where to go".

Tonbo or dragonfly
This indicates a sign of trend reversal, yet it still may move either way.

Long-legged shadows' doji candlestick

This candle has no body, the open and the close is identical. This signal shows that the
trend has run it's course and it will reverse. The trend will reverse quickly after this signal
occurs. It is considered a reliable signal.

The Hangman and Hammer

The hangman and hammer (karakasa, or paper umbrella), consists of a small body
(either color) with a very long lower shadow. This pattern is typically found at the top or
bottoms of trends. When the pattern occurs at the top of a up trend it is called a hangman,
when it is found at the bottom of a down trend it is called a hammer.

The hangman and hammer can be

either a black or a white candle.

Example hangman and hammer

Complex Candlestick Patterns

Sanzan or Three Mountains
Similar to a triple top formation, the Sanzan (or three mountains) have three peaks of
all similar height.

Buddha top formation

The buddha top is similar to the sanzan except that the middle mountain is highter than
the other two (head and shoulders pattern).

Sansen / Three Rivers / The Three River Evening Star

The sansen is a three day pattern. The first day consists of a long white candle,
followed by a small gapped white candle and ends with a long black candle. This pattern
is considered a bearish reversal.

Other variations of the sansen are

Three River Morning Star

The three river morning star is the opposite of the three river evening star, this is it's
bullish equivalent.

Bullish Sanpei (three parallel candlesticks / three soldiers)

This pattern is intented to singal either a trend reversal or the trend continuation. It
consists of three white candlesticks of similar increments and size. It signifies a
continuation of the trend.

If the second and third day candlesticks open at or above the midrange of the previous
day, this signifies that the trend will continue.

If the second and third day show decreasing higher high's following a long white
marubozu, the trend is reaching it's end and signifies a sell. This sell pattern is also
known as a red three candlestick advance block or skizumari.

If the sanpei is started by a small white candle, followed by a long white marubozu and
then a small bodied white candle, this indicates uncertainty and it would be advised to
assume the trend will break.

Bearish Sanpei (three crows)

This pattern is intented to singal either a trend reversal or the trend continuation. It
consists of three black candlesticks of similar increments and size. It signifies a
continuation of the trend.

If the second day gap is lower followed by a third candlestick which opens above the
midrange of the second day, this is also considered bearish. (also known as a "down gap
three wings").

In the last variation, each black candlestick opens at the close of the previous day. This
pattern is extremely bearish and suggests a strong down trend.

Sanpo (three methods)

The idea behind the sanpo pattern is that no price movement moves straight up or
down, there always exists some retracement before the movement makes a new high or
low. Therefore this pattern is to indicate whether a trader should "pause" during the trend
(a short term consolidation will occur with a direction opposite to that of the major trend).
Bullish Formation (rising three methods)

Bearish Formation (falling three methods)

"Wait and See" Candlestick Patterns

These signals tell the trader that the market is indecisive, by avoiding these situations,
it can avoid a traders exposure until a clear trend has formed.

Harami candlestick
The harami is a two day candle pattern. The first day of the pattern consists of a long
bodied candle either black or white. On the second day a short opposite candle is formed.
This generates a "wait and see" signal since it appears that the market is focused on the
first large day, and on the second is waiting for more information. This is also seen since
there should be lower trading volume on the second day.

Haramiyose candlestick
This two day pattern is similar to the harami, except it indicates a reverse in trend. The
first day opens with a tall candle of either color, the second day a doji candlestick
appears. The doji in this case opens at a different price from the previous day's close.

Hoshi (star) candlestick

The hoshi pattern has the same candlesticks as the Harami pattern, except that the
second candle gaps up.

Shooting Star
In the case of a shooting star, it is identical to the hoshi except it has a long upper
shadow. It also signifies a "wait and see" situation.

Point and Figure Patterns

Overview
Point and Figure charting differs from other charting techniques by the fact that it only
requires price for analysis, not time. It is also plotted differently by using columns and
rows using price movement only.
Point and Figure was developed towards the end of the nineteenth century. This new
form of charting was referred to as the "book method". The book method was applied by
entering the actually prices into the rows and columns however this proved to be not very
popular since it was time consuming to enter the entire price. It was upgraded by the
early twentieth century into point and figure. Unlike the book method, point and figure
uses the symbol X or O to describe the price movement rather than writing the entire
price into the field.
There is also a significance given to the number three in point and figure charting.
When movements hit the support or resistance line, extra attention should be spent on the
third collision. There is also quite a few patterns where the third hit is when the signal is
generated.
Due to the accuracy of the signals provided by point and figure charting, interest in this
form of analysis is continuously growing.
Point and Figure patterns can be categorized by "bearish", "bullish", "reversal", and
"wait and see" (trend continuation).

Bullish Point and Figure Patterns

Triple Top
The pattern is formed by three rallies (1,2,3),
on the third rally it pushes past the resistance
line formed by the first two.
The third column will rise past the resistance
line an equal distance to that of the bottoms.

Breakout of a Spread Triple Top

This pattern is a variation to the triple top

except that on the third rally it fails to reach the
resistance line. On the fourth move it breaks
past the resistance line and should rise an equal
amount to that of it's bottoms.

Ascending Triple Top

Another variation of the triple top except in

this case each consecutive top is higher than
the last. However this pattern does not give a
price objective like the triple top. The signal in
this variation is to buy on the breakout.

Upward Breakout of a Bullish Resistance Line.

A variation of the ascending triple top except

in this case there is a fourth consecutive top is
higher than the last. The signal in this variation
is to buy on the breakout.

Upward Breakout of a Bearish Resistance Line.

This pattern consists of a consecutive series

of lower highs. When the price breaks through
the resistance line a buy signal is given.

Bullish Trend Reversal Patterns

Inverted Head and Shoulders Pattern
The inverted head and
shoulders pattern is found in
candlestick, point and figure,
and chart patterns and is
considered one of the most
reliable reversal patterns.
The price forms a low on
column one, followed by a
period of consolidation. A
second low is created
followed by another period of
consolidation, the right
shoulder is then formed
followed by a buy signal as it
crosses the neckline.
Parralel support and
resistance lines can be drawn
as well as a visible neckline.
The height of the lowest
low should give a projection
of the strength of the upward
move.

Triple Bottom

The triple bottom is a

variation of the inverted head
and shoulders pattern. This
pattern consists of three lows
of similar height. After the
third low is formed and the
price movement breaks the
neckline, a bullish signal is
given. The expected rise
should be of similar height as
from the neckline to the low.

Double Bottom
The double bottom is a
variation of the triple bottom
pattern. This pattern consists
of two lows of similar height.
After the second low is
formed and the price
movement breaks the
neckline, a bullish signal is
given. The expected rise
should be of similar height as
from the neckline to the tops.
It is important to note that
before the breakout, the trend
line is broken.

Bullish Rectangle Reversal

The downtrend forms a

clear period of consolidation,
the resistance line is then
broken on a heavy volume
day, it is at this point where
the bullish signal occurs.

Bearish Point and Figure Patterns

Triple Bottom
The pattern is formed by three downs
(1,2,3), on the third drop it pushes past
the support line formed by the first two.
The third column will drop past the
support line an equal distance to that of
the tops.

Breakout of a Spread Triple Bottom

This pattern is a variation to the triple

bottom except that on the third rally it fails to
breach the support line. On the fourth move it
breaks past the support line and should drop an
equal amount to that of it's tops.

Descending Triple Bottom

Another variation of the triple bottom except

in this case each consecutive low is lower than
the last. When the price drops below the
support line this generates a clear selling
signal.

Downward Breakout of a Bearish Support Line.

A variation of the descending triple bottom

except in this case there is an upward bias. The
signal is to sell on the support line breakout.

Downward Breakout of a Bullish Support Line.

This pattern consists of a consecutive series

of higher lows. When the price breaks through
the support line a sell signal is given.

Bearish Trend Reversals

Head and Shoulders
The head and shoulders
pattern is found in
candlestick, point and figure,
and chart patterns and is
considered one of the most
reliable reversal patterns.
The price forms a high on
column one, followed by a
period of consolidation. A
second high is created
followed by another period of
consolidation, the right
shoulder is then formed
followed by a sell off. High
volume should be seen on the
last downward move.
Parralel support and
resistance lines can be drawn
as well as a visible neckline.
The height of the highest
high should give a projection
of the drop of the final
downward move.

Triple Top
The triple top is a variation
of the head and shoulders
pattern. This pattern consists
of three peaks of similar
height. After the third peak is
formed and the price
movement breaks the
neckline, a bearish signal is
given. The expected drop
should be of similar height as
from the neckline to the tops.

Double Top
The double top is a
variation of the triple top
pattern. This pattern consists
of two peaks of similar height.
After the second peak is
formed and the price
movement breaks the
neckline, a bearish signal is
given. The expected drop
should be of similar height as
from the neckline to the tops.
It is important to note that
before the price drop, the
trend line is broken.

Bearish Rectangle Reversal

The uptrend forms a clear
period of consolidation, the
support line is then broken on
a heavy volume day, it is at
this point where the bearish
signal occurs.

Point and Figure Patterns

Trend Reversal Patterns
Head and Shoulders
The head and
shoulders pattern
is found in
candlestick, point
and figure, and
chart patterns and
is considered one
of the most
reliable reversal
patterns.
The price forms
a high on column
one, followed by a
period of
consolidation. A
second high is
created followed
by another period
of consolidation,
the right shoulder
is then formed
followed by a sell
off. High volume
should be seen on
the last downward
move.
Parralel support
and resistance
lines can be drawn
as well as a visible
neckline.
The height of
the highest high
should give a
projection of the
drop of the final
downward move.

Inverted Head and Shoulders Pattern

The inverted head and
shoulders pattern is found in
candlestick, point and figure,
and chart patterns and is
considered one of the most
reliable reversal patterns.
The price forms a low on
column one, followed by a
period of consolidation. A
second low is created
followed by another period of
consolidation, the right
shoulder is then formed
followed by a buy signal as it
crosses the neckline.
Parralel support and
resistance lines can be drawn
as well as a visible neckline.
The height of the lowest
low should give a projection
of the strength of the upward
move.
Triple Top

The triple top is a variation

of the head and shoulders
pattern. This pattern consists
of three peaks of similar
height. After the third peak is
formed and the price
movement breaks the
neckline, a bearish signal is
given. The expected drop
should be of similar height as
from the neckline to the tops.

Triple Bottom

The triple bottom is a

variation of the inverted head
and shoulders pattern. This
pattern consists of three lows
of similar height. After the
third low is formed and the
price movement breaks the
neckline, a bullish signal is
given. The expected rise
should be of similar height as
from the neckline to the low.

Double Top
The double top is a
variation of the triple top
pattern. This pattern consists
of two peaks of similar height.
After the second peak is
formed and the price
movement breaks the
neckline, a bearish signal is
given. The expected drop
should be of similar height as
from the neckline to the tops.
It is important to note that
before the price drop, the
trend line is broken.
Double Bottom

The double bottom is a

variation of the triple bottom
pattern. This pattern consists
of two lows of similar height.
After the second low is
formed and the price
movement breaks the
neckline, a bullish signal is
given. The expected rise
should be of similar height as
from the neckline to the tops.
It is important to note that
before the breakout, the trend
line is broken.
Bearish Rectangle Reversal

The uptrend forms a clear

period of consolidation, the
support line is then broken on
a heavy volume day, it is at
this point where the bearish
signal occurs.

Bullish Rectangle Reversal

The downtrend forms a

clear period of consolidation,
the resistance line is then
broken on a heavy volume
day, it is at this point where
the bullish signal occurs.

Point and Figure Patterns

"Wait and See" Patterns

Flag
This pattern shows a large
gain, followed by a period of
consolidation. It then breaks
past the resistance line. The
height of the new breakout
should be similar to that of the
opening move in the pattern.

Inverted Flag
This pattern shows a large
drop, followed by a period of
consolidation. It then breaks
past the support line. The
height of the new fall should
be similar to that of the
opening drop in the pattern.

Pennant Pattern

This is a variation of the

Flag pattern except for the
structure of the consolidation.
In this case it is triangular.
The breakout should also have
large volume and the height of
the new breakout should be
similar to that of the opening
move in the pattern.

Inverted Pennant Pattern

This is a variation of the
Inverted Flag pattern except
for the structure of the
consolidation. In this case it is
triangular. The downward
breakout should also have
large volume and the height of
the downward breakout
should be similar to that of the
opening move in the pattern.

Bullish Breakout of a Symmetrical Triangle

This pattern is similar the pennant
pattern except it does not have a
"pole". This pattern is rather unreliable
and there is real bias to the direction it
may actually take. False breakout's in
this case may also occur so look for
large volume to accompany the
breakout.

Bearish Breakout of a Symmetrical Triangle

This pattern is similar the inverted
pennant pattern except it does not have
a "pole". This pattern is rather
unreliable and there is real bias to the
direction it may actually take. False
breakout's in this case may also occur
so look for large volume to accompany
the move..

Andrews' Pitchfork
The lines formed by Andrews' Pitchfork can help predict channels of support and
resistance in a trending market.

Overview

Andrews' Pitchfork is a method of channel identification in a trending market.

This technique, in effect, splits a major channel into two minor equidistant
channels.
The lines in the Pitchfork tend to delineate lines of support and resistance.

Andrews' Pitchfork was developed by Dr. Alan Andrews, based on what he called his
"Action/Reaction" techniques. Originally called the "Median Line Study," this pattern is
based on a set of lines drawn from peaks and valleys on a price chart. When linked
together, the arrangement of lines closely resembles a farmer's pitchfork.
Dr. Andrews' median lines, and the pitchfork pattern, often indicate lines of support or
resistance where prices tend to stall out or reverse.

Interpretation
Andrews' Pitchfork is plotted on a price chart as follows:
1. First, identify a significant reversal point (high or low) and this becomes Pt. A.
2. Draw a line (shown in red) from this point to the next significant reversal point; at
Pt. B.
3. Then plot a line from a significant point early in the trend (Pt. C) bisecting the
first line (in red) half way between Pts. A and B. This is the Median Line or
"handle" of the Pitchfork.
4. Now, draw two lines parallel to the Median Line, one starting from Pt. A and the
other from Pt. B. These form the "tines" of the Pitchfork.

5. Presto! Andrews' Pitchfork.

This is a quick introduction to the Pitchfork technique; Dr. Andrews' price study
methods were typically much more complex than what I've shown here. He also counted
waves using what he called the "0-3/4 pivot count rule" and the "5 count probability
rule."

Signals
Watch for reversals when the price approaches or penetrates the lines of the Pitchfork.
As with any trendline, the more often support or resistance is confirmed the more reliable
the line can be considered. In the example above, the lower channel managed to contain
most of the price activity - not perfectly - but enough to indicate that the channel was
indeed providing important support and resistance.

Bollinger Bands
Bollinger Bands provide several useful signals, including confirmation of trend and an
indication of volatility.

Overview
Bollinger Bands can provide an indication of:

whether prices are relatively high or low

whether current trends are likely to continue or reverse
the volatility of a market, based on the width of the band .

Developed by John Bollinger, this technique is one of the most popular forms of
envelope or channel indicator. Two winding parallel lines above and below a central

moving average (MA) create a band that contains the majority of price movements within
a channel. This is similar to moving average envelopes. The difference is that Bollinger
Bands are also sensitive to volatility in the market. The bands spread further apart during
volatile markets and come closer together during calmer markets.
Technically speaking, moving average envelopes are plotted at a fixed percentage
above and below a moving average, whereas Bollinger Bands are placed two standard
deviations above and below the moving average, which is usually 20 days. Using two
standard deviations ensures that 95% of the price data will fall between the two outside
bands.

Interpretation
John Bollinger has written that, "Trading bands are one of the most powerful concepts
available to the technically based investor, but they do not, as is commonly believed, give
absolute buy and sell signals based on price touching the bands. What they do answer is
the perennial question of whether prices are high or low on a relative basis." He goes on
to say, "It is the action of prices near the edges of the envelope that we are particularly
interested in."
As with most indicators, signals generated by Bollinger Bands should be confirmed
using complimentary indicators. According to Bollinger, one of the biggest mistakes in
technical analysis is the multiple counting of the same information. For example, using
different indicators all derived from the same series of closing prices to confirm one
another.
The indicators he recommends to complement Bollinger Bands are:

RSI or MACD -- based on price alone

On-Balance Volume (OBV) -- combining closing prices and volume
Money Flow -- combining price range and volume
He recommends against using the Commodity Channel Index (CCI) for the reason
above

Signals
Bollinger Bands provide the following useful signals:
Trend: when prices move outside the bands, a continuation of the current trend is
implied. Strongly trending markets will often stay touching and occasionally penetrating
the band for long periods. Watch for initial penetrations of a band, particularly if other
indicators confirm a potential move. When the bands are unusually far apart, the current
trend may be ending. When the two bands are very tight, the market may be about to
initiate a new trend.
Price targets: a move that originates at one band tends to go all the way to the other
band. This observation can be used projecting price targets. For example, if prices bounce
off the lower band and cross above the 20 day moving average, the upper band becomes

the upper price target. A crossing below the 20 day average would establish the lower
band as a price target.
Volatility (width of bands): sharp price changes tend to occur after the bands tighten,
as volatility lessens.
Momentum: when the price moves above or below the Bollinger band then, on a
subsequent move, fails to reach the band, you can interpret this as a loss of momentum
and a reversal is possible. Many times the subsequent move will reach a higher or lower
price but the loss of momentum is still indicated.

Fibonacci arcs & retracements

Fibonacci Arcs & Retracements help anticipate support and resistance levels along
with price targets.

Overview
After making long sustained moves in one direction, many markets retrace a part of the
move before continuing on further. The Fibonacci indicator, popularized by Ralph Nelson
Elliot, is used to try and forecast potential support levels and price targets, based on the
height of the overall move and any wave patterns.
For example, if a stock increased from $5 to $10 and then slipped back 50%, this
retracement would take it to $7.50 before it continued upwards again.
This indicator uses mathematical ratios discovered by Leonardo Fibonacci's in the 12th
century. The Fibonacci summation series is 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and
so on to infinity. Interestingly, these numbers have the following constant relationships:

The sum of any two consecutive numbers equals the next higher number.
The ratio between any number and the next higher number approaches 0.618 after
the first four calculations.
The ratio between any number and the next lower number is approximately 1.618
(the inverse of 0.618).

The number 1.618 is commonly referred to as the Golden Mean or the Golden Section.
The real value of this number series is that it is "the most important mathematical
presentation of natural phenomena ever discovered" (R. Fischer). It keeps popping up in
everything from the proportions of the Egyptian pyramids the number of florets in
flower headsthe double helix of the DNA molecule to the logarithmic spiral of the
nautilus shell.
(The well-known Elliot Wave Principle is also based on the application of Fibonacci
numbers to the waves evident in any price chart.)

Interpretation
The most commonly used numbers in this analysis are 61.8% (usually rounded off to
62%), 38% and 50%. This means that, in a strong trend, the minimum retracement is
usually close to the 38% level and may go as far as the 62% level.
Constance Brown, a well known technical analyst, has written, "If the market has
shown respect in the past to a Fibonacci grid drawn on the chart, the chances are much
higher that it will also respect those levels in the future market action."

FibonacciRetracements

Fibonacci Retracements are based on a trendline drawn between a significant

trough and peak.
If the trend is rising, the retracement lines will descend from 100% to 0%
If the trendline is falling, the retracement lines will ascend from 0% to 100%
Horizontal lines are drawn at the common Fibonacci levels of 38%, 50%, & 62%
As the price retraces, support and resistance often occur at or near the Fibonacci
Retracement levels.

Fibonacci Arcs Fibonacci arcs can be added to the same chart, or they can be charted
alone. The arcs are drawn centered on the last peak or trough, crossing the original
trendline at the points where the retracement lines intersect. The price will tend to "react"
to both the arcs and the retracement levels, as they provide support and resistance.

Price Targets
More advanced studies can also be undertaken, based on the Fibonacci numbers, to
develop price targets. One such approach is to add a second copy of the original
Fibonacci grid above or below the first (depending on which way the market is trending).
This will give you potential price targets based on adding a new set of 38%, 50% and
62% lines.

Keltner Channel
The Keltner Channel is based on the Average True Range and is sensitive to volatility.
It may be used in place of standard deviation (Bollinger) bands or percentage envelopes.

Overview

The Keltner Channel is made up of two bands plotted around an Exponential

Moving Average (EMA), usually the 20-day EMA.
Prices breaking through the bands often produce buy and sell signals. The
indicator was originally developed by Chester Keltner and later modified by
Linda Raschke to use an average true range (ATR) calculated over 10 periods.

Interpretation
As with all envelope or band systems, the probability is that price will remain within
the envelope. When price breaks though the envelope, it can be taken as a signal to either
buy or sell.
When prices close above the top band, this often means a breakout in upward
volatility to be followed by higher prices. When prices close below the bottom band,
prices are expected to move lower.
In a rising market the middle line, or 20 period EMA, should provide support.
Conversely, in a falling market it tends to provide resistance.
As with all trend following systems, the Keltner Channel works well in up trends or
down trends, but doesn't work well in a sideways channel. As a trend following system it
is not meant to catch tops or bottoms.
Keltner channels should be used in combination with other indicators, such as RSI or
MACD, to provide confirmation of the strength of a market. An exit strategy utilizing
trendlines and other indicators can be particularly important, as can be seen from the
example above. Waiting for the price to close below the lower band often erodes much of
the potential profits from a good move.
The calculation for Keltner Channel, based on ATR, is as follows:

For the top or Plus Band, the ATR is calculated over 10 periods, doubled and
added to a 20 period exponential moving average
For the bottom or Minus Band, the ATR is calculated over 10 periods, doubles and
subtracted from a 20 period exponential moving average

Signals

When prices close above the plus band, it is a signal of strength and rising prices
When prices close below the negative band, a signal that prices will drop is
indicated
Signals stay in effect until the prices close across the opposite band. This should
often be tempered, however, with the use of other indicators to provide better exit
opportunities.

Moving Averages
Moving Averages (MAs) provide a set of very useful indicators for tracking trends and
trend reversals.

Overview

The Moving Average is a lagging indicator, or trend following formula, that

smoothes the volatile swings in a market.
MAs are used to track the progress of a trend and to signal when a trend has
ended or reversed.
There are 4 common types of moving averages: simple, linearly weighted,
exponential and variable.( See Table below for Types of Moving Averages)

The Moving Average (MA) is one of the simplest, yet most versatile and widely used
of all technical indicators. The MA attempts to tone down the fluctuations of market
prices to a smoothed trend, so that distortions are reduced to a minimum. MAs help in
tracking trends and signalling reversals. You could think of the MA as a curved trendline,
fitting itself to the market.

Interpretation
Signals to buy or sell are generated when the price crosses the MA or when one MA
crosses another, in the case of multiple MAs. As with trendlines, the MA often provides
an area of support and resistance. The more times an MA has been touched (i.e., acts as
support or resistance) the greater the significance when it is crossed.
Since the MA is a lagging indicator, a crossover will usually signal a trend reversal
well after a new trend has begun and is used largely for confirmation. Generally
speaking, the longer the time span covered by an MA, the greater the significance of a
crossover signal. For example, the crossover of a 100 or 200-day MA is significantly
more important then the crossover of a 20-day MA.
Moving averages differ according to the weight assigned to the most recent data.
Simple moving averages apply equal weight to all prices. Exponential and weighted
averages apply more weight to recent prices. Variable moving averages change the
weighting based on the volatility of prices.
When prices fluctuate up and down in a broad sideways pattern for an extended period
(trading-range market), longer term MAs are slow to react to reversals in trend, and when
prices move sideways in a narrow range shorter term MAs often produce false signals.

Flat and conflicting MAs generally indicate a trading-range market and one to avoid,
unless there is pronounced rounding that suggests a possible new trend.
Type of MA

Simple
(This is the
most
commonly
used MA)

Description
Use of multiple MAs can provide
good signals

Useful periods
Short term 10-30 day
Mid term 30-100-day
Long term 100-200+day

Methods Used

Crossover of short term

through long term
Convergence/ Divergence
Crossover of MA by price

There is no perfect time span

Linearly
Weighted

Exponential
(EMA)

Variable

With this MA, data is weighted in

favour of most recent observations.
Has the ability to turn or reverse
more quickly than simple MA.
An exponential (or exponentially
weighted) moving average is
calculated by applying a percentage
of today's closing price to yesterday's
moving average value. Exponential
moving averages place more weight
on recent prices.

An automatically adjusting
exponential moving average based
on the volatility of the data.

Warning of trend reversal

given by change in direction of
the average rather than crossover.

Crossover of short term

through long term
Convergence/ Divergence
Crossover of MA by price

The more volatile the data, the

greater the weight given to the
current data and the more
smoothing used in the moving
average calculation.

The variable MA is able to compensate for trading-range versus trending markets.

This MA automatically adjusts the smoothing constant to adjust its sensitivity, often
allowing it to outperform the other moving averages in these difficult markets.
MAs should always be used in conjunction with other indicators because of the
potential for false signals (whipsawing) and, particularly during sideways channels. MAs
can be calculated on a security's open, high, low, close, volume, or on any other indicator.

Indicators which are especially well-suited for being used with moving averages include
MACD, Price ROC, Momentum, and Stochastics. A moving average of another moving
average is also common.
Moving averages are helpful in keeping you in line with the price trend by providing
buy signals shortly after the market bottoms out and sell signals shortly after it tops,
rather than trying to catch the exact bottom or top.

Signals
Moving Average Price crossover
A price break upwards through an MA is generally a buy signal, and a price break
downwards through an MA is generally a sell signal. As we have seen, the longer the time
span or period covered by an MA, the greater the significance of a crossover signal.
If the MA is flat or has already changed direction, its violation is fairly conclusive
proof that the previous trend has reversed.
False signals can be avoided by using a filtering mechanism. Many traders, for
example, recommend waiting for one period - that is one day for daily data and one week
for weekly data.
Whenever possible try to use a combination of signals. MA crossovers that take place
at the same time as trendline violations or price pattern signals often provide strong
confirmation.

Multiple Moving Averages

It is usually advantageous to employ more than one moving average. Double and triple
MAs often provide useful signals.
With two MAs the double crossover is used; a buy signal is produced when the shorter
average crosses above the longer, and vice versa for the sell signal. For example, two
popular combinations are the 5 and 20-day averages and the 20 and 100-day averages.

The technique of using two averages together lags the market a bit more than a single
moving average but produces fewer whipsaws.

The triple crossover method is also popular, using three moving averages. The most
widely used triple crossover system is the popular 4-9-18-day MA combination. A buy
signal is generated when the shortest (and most sensitive) average - the 4 day - crosses
first the 9-day and then the 18-day averages, each crossover confirming the change in
trend.
Additional Points:

The 200-day MA(or 40-week MA), should be carefully watched as a pivotal level
of support or resistance for the long-term trend. Many people watch carefully
when the 200-day MA is approached by the price. The relationship between the
price and its 200-day MA can often provide excellent buy or sell signals.
The 200-day MA is also particularly significant for the various indexes, such as
the Dow Jones or NASDAQ. A crossover of this MA has often signalled a
correction or period of consolidation.
Moving averages can also be calculated and plotted for other indicators, not just
the price. A continued upward movement by the indicator is signified by the
indicator rising above its moving average. A continued downward movement is
signified by the indicator falling below its moving average.

Price Channel
The Price Channel or Donchian's Four Week Rule is a simple and effective trend
following, channel breakout system.

Overview
Channel breakout systems were shown by research to be one of the top trading systems
to generate significant profits

Developed as the 4 Week Rule by Richard Donchian, originally for commodity

trading
Can be used on daily, weekly and monthly charts

Louis Lukac's research from 1975 to 1986 compared 23 trading systems. Moving
averages and channel breaklouts came out as the top performers and Lukac suggested a
channel breakout as the best starting point for technical trading. (Lukac, Louis; The
Financial Review, November 1990).

Interpretation
The Price Channel is a simple breakout system. As with all trend following systems,
the Price Channel works well in up trends or down trends, but doesn't work well in a
sideways channel. The signals derived from the Price Channel are based on the following
basic rules:

When the price is at its highest in a four week period, buy long and cover short
positions
When the price falls below the lows of a four week period, sell short and liquidate
long positions

As a trend following system the Price Channel indicator is not meant to catch tops or
bottoms. Trend traders may want to extend the period to eight weeks to wait for
significant trend signals. Similarly, some traders shorten the time period to a more
sensitive 1 or 2 weeks for liquidation purposes.

Signals
The following signals are offered by the Price Channel indicator:

A buy signal is generated when prices penetrate and close above the upper
channel.

A sell signal is generated when prices penetrate and close below the lower
channel.

These signals should, of course, be combined with the use of other indicators to
provide confirmation. For example, a relatively simple, yet effective, approach to exiting
a trade based on a price channel would be to watch for a break in the long-term trend.
Some Ideas for Applying Shorter Time Periods:

Can be used to identify trend reversals

When prices are trending sharply higher, shorten the time span for needed
sensitivity
Use a four week rule for entry and one or two weeks to signal exit points.
A two week price breakout in the same direction as a moving average crossover
signal, makes an exceptional filter on which to base a market decision
A stop-loss could trail with a one week lag

Interpretation
Andrews' Pitchfork is plotted on a price chart as follows:
1. First, identify a significant reversal point (high or low) and this becomes Pt. A.
2. Draw a line (shown in red) from this point to the next significant reversal point; at
Pt. B.
3. Then plot a line from a significant point early in the trend (Pt. C) bisecting the
first line (in red) half way between Pts. A and B. This is the Median Line or
"handle" of the Pitchfork.
4. Now, draw two lines parallel to the Median Line, one starting from Pt. A and the
other from Pt. B. These form the "tines" of the Pitchfork.
5. Presto! Andrews' Pitchfork.
This is a quick introduction to the Pitchfork technique; Dr. Andrews' price study
methods were typically much more complex than what I've shown here. He also counted
waves using what he called the "0-3/4 pivot count rule" and the "5 count probability
rule."

Signals
Watch for reversals when the price approaches or penetrates the lines of the Pitchfork.
As with any trendline, the more often support or resistance is confirmed the more reliable
the line can be considered. In the example above, the lower channel managed to contain
most of the price activity - not perfectly - but enough to indicate that the channel was
indeed providing important support and resistance.

Speed Resistance Lines

Speed Resistance, or Speedlines, are a combination of percentage retracements and

trend lines that change with the trend.

Overview
Speedlines, developed by Edson Gould, are a variation on the idea of dividing the trend
into thirds. The main difference from the percentage retracement is that speedlines
measure the rate of ascent or descent - or "speed" - of a trend as it develops.
In an uptrend the speedlines are drawn by:

Drawing a line vertically from the base to the highest peak (shown as a blue line)
dividing this vertical line into thirds
drawing speedlines (shown as red lines) from the beginning of the trend through
the 1/3 and 2/3 points
The upper line is often referred to as the 2/3 speed line and the lower line as the
1/3 speedline

As the trend develops and new peaks (or valleys in the case of a downtrend) are
formed the vertical line is redrawn and new speedlines are added.

Signals
Uptrend: If a correction is underway in an uptrend, the price will usually stop at the
upper speedline. If the price penetrates the upper speedline, however, this is often a good
indication of a trend reversal and can be used a sell signal.
Downtrend: In a downtrend, a penetration through the lower speedline signals a likely
rally to the upper line; and if the upper line is broken this usually indicates a continued
rally.

TD ARCS
Developed and trade marked by Tom DeMark, TD Arcs combine a percentage
retracement with the time period.

Downtrend (Upside Arc)

1. Connect the most recent low to the previous highest peak.
2. Draw the Fibonacci retracement levels (38.2% and 61.8%) on this line, pivoting at
the recent low price

Uptrend (Downside Arc)

1. Connect recent high to previous lowest low
2. Draw the Fibonacci retracement levels on this line, pivoting at the recent high
price

Interpretation

Find the highest high (A) between the current low (B) and the last time the price
exceeded this low, draw a line connecting A and B.
Mark the .382 and .618 Fibonacci percentage reversal figures on this line and
swing forward. TD Arcs are the retracement levels marked on the straight line
A time filter is used to test the retracement strength.

Signals
If the price retraces 38 percentage points of the previous move in less than 38% of the
period that generated the last move, the price has a greater chance of retracing further to
the 62% level.
The key to TD Arcs is the speed with which the first retracement level is reached and
broken (or not) by the price. If the 38% level is reached and broken before the 38% Arc,
there's a strong tendency for the momentum to carry the price up through the next
retracement level at 62%. As the example above demonstrates, however, if this doesn't
occur quickly enough (before the price reaches the 38% Arc) the momentum tends to lag,
the retracement becomes exhausted, and the market once again follows the overall longterm trend.

Accumulative Swing Index (ASI)

The Accumulative Swing Index, based on the Swing Index, is a swing or wave system
used to capitalize on breakout patterns. ASI is commonly used to confirm trendline
breakouts on price charts.

Overview
ASI was developed by Welles Wilder, Jr. as a simple swing system (even though the
calculation itself is relatively complex), with signals generated by breakouts past previous
highs or lows in the index. Trendlines drawn on the ASI chart are also used to confirm or
deny trendline breakouts on a price chart. Any divergence between the Index and price
should also be noted.

Interpretation
In his book New Concepts in Technical Trading Systems, Wilder summarizes the
usefulness of ASI as follows:
"When the Index is plotted on the same chart as the daily bar chart, trend lines drawn
on the ASI can be compared to trend lines drawn on the bar chart. For those who know
how to draw meaningful trend lines, the ASI can be a good tool to confirm trend-line
breakouts. Often erroneous breaking of trend lines drawn on bar charts will not be
confirmed by the trend lines drawn on the ASI. Since the ASI is heavily weighted in favor
of the close price, a quick run up or down during a day's trading does not adversely
affect the index."
Wilder uses the following terminology in explaining the use of the ASI indicator:

>High Swing Point (HSP) is any day with an ASI that is higher than the previous
day and following day.
Low Swing Point (LSP) is any day with an ASI that is lower than the previous
day and following day

Wilder also designed a system of trailing stop loss points for the Index which he refers
to as the Index SAR (Stop and Reverse). For complete details on using this system you
should refer to his book New Concepts in Technical Trading Systems.

Signals
These rules apply only to the ASI and must be correlated with the price action point.
Buy Signal: Upside Breakout -- ASI exceeds a previously significant High Swing
Point
Sell Signal: Downside Breakout -- ASI drops below a previously significant Low
Swing Point

Advance-Decline Line
The popular Advance-Decline (AD) Line is a market breadth indicator, providing a
very good measure of overall market strength

Overview
The Advance-Decline line measures the broad market strength represented by the New
York Stock Exchange (NYSE). Historically, the AD Line peaks out well ahead of the
more widely followed market indices and averages. It provides such useful information
as:

Overall market strength

Rising or falling trends
Whether the trend is intact, and
The length of the current trend

The AD Line is calculated by taking the difference between the advancing and
declining issues each day (usually on the NYSE). This positive or negative number is
added to the cumulative AD line.

When the AD line is positive, more stocks are advancing than declining and the
A/D Line moves up
When the AD line is negative, more stocks are declining than advancing and the
A/D Line moves down

Interpretation
The AD Line is a good indicator of overall market strength; and many feel it is more
revealing than popular indices such as the Dow Jones or the NASDAQ Composite Index.
This is because the AD line is usually calculated on the NYSE, which represents the
largest equities marketplace in the world with over 3,025 listed companies (see the
Sidebar below).
In using the AD Line, keep an eye on the Trend and watch for Divergence from other
indices or sectors:
Trend: By studying the trend of the AD Line you can see if the market is in a rising or
falling trend, if the trend is still intact, and how long the current trend has prevailed.
Divergence: The AD line should trend in the same direction with the market averages.
When the AD line peaks out ahead of the market, as it often does, investors are alerted to
poor market breadth.
Typically, the daily AD Line is used to watch for short to intermediate trends. A weekly
AD Line is considered more useful for trend comparisons that span several years.

Overbought/Oversold Indicator
The Overbought/Oversold Indicator (OB/OS) is simply a smoothed AD Line. The
smoothing is done by taking the 10-day exponential moving average of the A/D Line.
Smoothing the A/D Line makes it fluctuate within a narrower range with heavier
weighting given to past data.

The OB/OS indicator generally fluctuates in a range of +400 to -400. A level above
+200 suggests an overbought market while a level below -200 suggests an oversold
market.

Further Information
There are a number of other useful indicators for measuring market breadth. See also
the McClellan Oscillator, McClellan Summation Index, Upside-Downside Volume, and
the Arms Index.

Sidebar on the NYSE

The New York Stock Exchange (NYSE) is the largest equities marketplace in the world
and is home to 3,025 companies worth more than $16 trillion in global market
capitalization. As of year-end 1999, the NYSE had 280.9 billion shares listed and
available for trading worth approximately $12.3 trillion.
Over two-thirds of the roster of NYSE companies have listed here within the last 12
years. These companies include a cross-section of leading U.S. companies, midsize and
small capitalization companies. Non-U.S. issuers play an increasingly important role on
the NYSE. As of July 1999, 382 non-U.S. companies were listed here - more than triple
the number 5 years ago. [6]

ADX Directional Movement Index

DMI indicates when a trend is present and the overall strength of a market.

Overview

The higher the DMI (on a scale of 0-100) the better the trend potential of a move.
The DMI system is made up of three lines; ADX and +DI & -DI.
DMI can be used either as a system on its own or as a filter for a trend-following
indicator (i.e., Parabolic SAR).

The Directional Movement Index, DMI, is an effective and frequently used trend
indicator. This system was designed by Welles Wilder Jr. and is made up of three lines:
1. The +DI indicates the up average.
2. The -DI indicates the down average.
3. The ADX, average directional movement index, shows whether a trend is in effect
by smoothing the difference between the +DI and -DI.

In the example above two clear buy signals have been generated. The first could have
been ignored because ADX was very close to 25 - a potential danger signal. The second
was perhaps more significant, even though ADX was trending downwards. It did provide
a clear indication of the beginning of a very strong move in this market.
Buy and sell signals are given when +DI and -DI cross. The time periods most
commonly used in the complex formula are 10 or 14 days.
According to Wilder the DMI should be used with the ADX as a filter.

A rising ADX line means the market is trending and a better candidate for a
trend-following system.
A falling ADX line indicates a non-trending market.
Some traders also look for an ADX greater than 20 or 25 to confirm that the
market is trending. When the ADX line starts to drop from above the 40 level,
that is an early sign that the trend is weakening. A rise back above 20 is often a
sign of the start of a new trend.

Signals
Generally speaking, the two main buy and sell signals generated by DMI are as
follows:

A buy signal is given when +DI crosses above the -DI line.
A sell signal is given when +DI crosses below the -DI line.

However, some refinements are suggested by experienced traders:

The crossing of DI lines only provides an early warning signal; other criteria must
be fulfilled for the actual signal.
The ADX should be between the upper DI line and the lower one.
An ADX below 25 is a strong warning to avoid trading.

Wilder himself developed a refinement to take care of whipsawing (when the DI lines
cross back and forth over a short period, providing unreliable signals). He called it his
Extreme Point Rule.
The Extreme Point Rule is derived by noting the high or low point on the day when
the +DI and the -DI cross one another. +DI determines the high or low point (if +DI is
above -DI the Extreme Point is the high of the day, if +DI is below -DI, the Extreme Point
is the low for the day).
The extreme point is then used for the actual buy or sell signal. For example, if the
price once again rises above the Extreme Point price level you have a buy signal. If the
price fails to rise above the extreme point, you should continue to stand aside. The
converse holds true for sell signals.

ADXR
An additional indicator, the average directional movement index rating (ADXR), was
created by Wilder as a measuring tool for the strength of ADX. ADXR is the average of
the current ADX and the ADX 14 days ago. ADXR is typically plotted alongside ADX on
the same chart.

Arms Index (TRIN)

The Arms Index is a short term breadth indicator showing whether volume is flowing
into advancing or declining issues.

Overview

The Arms Index is named after its developer, Richard Arms.

It represents the relationship between advancing and declining stocks and the
volume in these issues.
Ten days is the normal time period.

The Arms Index has also been called the Short-term Trading Index and TRIN (an
acronym for TRading INdex).

Interpretation
The Arms Index is used mainly as a short-term trading tool, not as an indicator of
long-term trends. It is interpreted in the same way as any other breadth oscillator, except
for the inverse relationship between price and TRIN (it may be plotted on an inverted
scale to compensate).
TRIN represents the relationship between advancing and declining stocks and the
volume in these issues. If there's more volume in advancing stocks, TRIN is less than 1.0;
if there's more volume in declining stocks, it's greater than 1.0.
TRIN is usually smoothed with a moving average, 10 days being considered the norm.
In some cases two or three averages are shown together, such as the 10-, 20- and 30-day
averages.

Signals
The Arms Index offers the following signals:

Trend

A rising TRIN represents more volume flowing into declining issues and is a
bearish indicator
A falling TRIN represents more volume flowing into advancing issues and is
bullish

Overbought/Oversold Levels

TRIN is often used as an overbought/oversold indicator. When the index drops below
0.8, it can be taken as a potential opportunity to buy. When it rises above 1.2, it can be
taken as a potential opportunity to sell. These signals should, of course, be confirmed by
referring to other indicators (such as MACD or Parabolic SAR).

Interpretation
In his book New Concepts in Technical Trading Systems, Wilder summarizes the
usefulness of ASI as follows:
"When the Index is plotted on the same chart as the daily bar chart, trend lines drawn
on the ASI can be compared to trend lines drawn on the bar chart. For those who know
how to draw meaningful trend lines, the ASI can be a good tool to confirm trend-line
breakouts. Often erroneous breaking of trend lines drawn on bar charts will not be
confirmed by the trend lines drawn on the ASI. Since the ASI is heavily weighted in favor
of the close price, a quick run up or down during a day's trading does not adversely
affect the index."
Wilder uses the following terminology in explaining the use of the ASI indicator:

High Swing Point(HSP) is any day with an ASI that is higher than the previous
day and following day.
Low Swing Point (LSP) is any day with an ASI that is lower than the previous
day and following day

Wilder also designed a system of trailing stop loss points for the Index which he refers
to as the Index SAR (Stop and Reverse). For complete details on using this system you
should refer to his book New Concepts in Technical Trading Systems.

Signals
These rules apply only to the ASI and must be correlated with the price action point.
Buy Signal: Upside Breakout -- ASI exceeds a previously significant High Swing
Point
Sell Signal: Downside Breakout -- ASI drops below a previously significant Low
Swing Point

Average True Range

Average True Range (ATR) is a volatility indicator. It is also used as part of other
trading systems such as Starc Bands and Keltner Channels.

Overview

ATR provides a measure of volatility.

ATR is calculated as the moving average of true price ranges over a given period.
Developed by Welles Wilder and first described in his 1978 book New Concepts
in Technical Trading Systems [7]

Interpretation Average True Range is a moving average of the True Range over "X"
periods, usually 14-days. True Range is the greatest difference from the following
choices:

Today's high and today's low.

Today's high and yesterday's close, or
Today's low and yesterday's close.

True range is always a positive number (negative numbers from the calculation above
are Major tops are typically accompanied by high volatility during the blow-off phase of
a market, as investors become more and more nervous and ready to take profits. Major
bottoms are usually calmer, with low volatility, as the hopes for quick profits have faded.

Signals
High ATR values are often correlated with high volatility as prices bottom and there is
a sell off.
Low ATR values are often correlated with low volatility as prices stabilize or move
intoa sideways channel prior to a possible breakout.

Interpretation
The Swing Index alone doesn't provide much in the way of signals. It should be used in
conjunction with the Accumulative Swing Index.

BETA
Beta is a risk measure comparing the volatility of a stock's price movement to the
general market.

Overview

Beta is derived from a formula that measures the volatility of a stock compared to
the volatility of the market in general (as measured by a market index such as the
S&P 500, DJIA, etc). Beta's companion measure for volatility is alpha.
The Beta for a stock may vary in up- versus down-markets.
Monthly data is preferred.

Beta provides a good idea of a stock's inherent risk or sensitivity to general market
fluctuations.

Signals
High beta stocks react strongly to variations in the market, and low beta stocks are less
affected by market variations.

If Beta is 1, then an issue has the same volatility as the general market. It is either
growing at the same rate or declining at the same rate.
If Beta is greater than 1, then an issue is more volatile. At 1.25 it will probably
move 25% more than the market. If the market is in an up trend, then the security
will gain 25% more than the general market.
If Beta is less than 1, then an issue is less volatile. At 0.5 it probably will move
only 50% or a half of the market. If the market is In a downtrend, it will only lose
50% of what the general market loses.
If beta is less than 0, then the stock is moving in a reverse pattern to the index.
When the index moves up the stock declines and vice versa.

Calculating Beta
To calculate the 200-day Beta for a stock (in comparison to the S&P index), you would
compute the 200 one-day percentage changes in S&P and the 200 one-day percentage
changes in the stock. These calculations produce 200 ordered pairs that are then charted
as a scatter graph, and the slope of the least-squares-fit line is the value for beta. (Alpha is
the y-intercept of the least-squares-fit line.)

Commodity Channel Index

CCI is an oscillator that provides an indication of overbought or oversold markets.

Overview

CCI is usually used as an overbought/oversold indicator

CCI can also be used for timing buy/sell signals

The Commodity Channel Index, CCI, was designed to identify the beginning and the
end of commodity market cycles by Donald Lambert. It has also proven effective for
other markets. CCI compares the current mean price with the average mean price over a
period of usually 20 days.

Interpretation
The CCI indicates the price is increasingly high compared to average prices as it
moves towards +100. As the CCI drops towards -100, it indicates that the price is
increasingly low compared to average prices.

Signals
1. CCI provides a warning of overbought and oversold markets when the line
crosses the +100 or the -100 levels. The actual buy or sell signal is usually
provided, however, when the line then crosses back over the +/-100 level.
2. Divergence from the price is also a good warning of a possible correction or trend
reversal.
3. Zero-line crossings can often provide a confirmation buy/sell signal or a
complimentary warning of a change in trend.

Demand Index
Demand Index, DI, incorporates price and volume to give a ratio of buying pressure to
selling pressure.

DI is often a leading indicator of price change, based on the general observation

that volume tends to peak before prices do.
DI can be used with both daily and weekly data

DI is charted on an open scale and fluctuates above and below a zero line. When
buying pressure is greater than selling pressure, the DI is above the zero line and vice
versa. DI is one of the early volume indicators, developed in the 1970s by James Sibbet.

Interpretation
Several levels of interpretation can be used to help analyze the underlying trend.
Thomas Aspray, an experienced trader, suggests using DI in three formats:
1. Plotting buying pressure (BP) and selling pressure (SP) as separate lines.
2. Deriving an oscillator of the BP/SP which he calls the Demand Oscillator (charted
as an histogram), and,
3. The DI line itself (which can be charted as a line or as an histogram - although
trendlines are more easily drawn on DI as a line)
Many experienced traders feel that weekly studies can be particularly important in
identifying the predominant trend, and DI is often assessed using weekly data.

Signals
DI offers the following types of signals:

Divergences between DI and price. A divergence between the DI and prices

suggests an approaching change in the price trend.
Trendline analysis of DI showing levels of support/resistance, can help
determine changes in trend. As a leading indicator DI trendlines are often broken
ahead of price trendlines
Zero-line crossings can confirm previous signals as a lagging indicator.

Mass Index
The Mass Index is a range oscillator that uses changes in daily trading price and
provides unique market reversal forecasts that other indicators may miss.

Overview
Donald Dorsey's mass index is used to signal an approaching trend reversal. The index
is a 25 day moving sum of two moving averages. The first moving average is an
exponentially smoothed moving average of the daily close and the second is the first
average smoothed a second time. Values over 25 indicate a widening range and those less
than 25 indicate a narrowing range.

Interpretation
The Mass Index is designed to identify reversals in trend by measuring the narrowing
and widening of the average range between the high and low prices. As the range widens
the Mass Index increases. As the range narrows the Mass Index decreases.
The most significant pattern to watch for is called the "reversal bulge." A reversal
bulge occurs when a 25 period Mass Index rises above 27 and subsequently falls below
26.5. A reversal in price is likely once the Mass Index falls below 26.5. The overall
direction of prices is not important.
A 9-period exponential moving average is often used to determine whether the reversal
bulge indicates a "buy" or "sell" signal. The moving average can provide confirmation if
it also reverses trend.

Signals
A signal is given when the Mass Index line:
1.

rises up through the 27 level, and,

2.

then crosses back down through 26.5, creating a bulge above these levels.

The Mass Index signal should normally be confirmed using other indicators, such as
Moving Averages and breakout patterns from congestive phases.

MACD
MACD is a useful indicator for spotting major changes in trend.

Overview

MACD stands for Moving Average Convergence/Divergence.

MACD is a trend following momentum indicator used to signal trend changes and
to indicate trend direction.
Signals are generated by crossovers and divergence from price.

The MACD method, developed by Gerald Appel, is a trending indicator, telling us

whether a stock is in an uptrend or a downtrend. The direction of the long-term trend is
the first assessment you should make of any market. If it is trending up, you want to
be long (buying). If it is trending down, you want be short (selling). (This wouldn't
necessarily hold true for to day traders, of course).
The simplest version of this indicator is composed of two lines: the MACD line, which
is the difference between two exponential moving averages (EMAs) and a signal line,
which is an EMA of the MACD line itself. The signal or trigger line is plotted on top of
the MACD to show buy/sell opportunities. Gerald Appel's MACD method uses a 26-day
and 12-day EMA, based on the daily close, and a 9-day EMA for the signal line.

Interpretation
The MACD proves most effective in trending markets rather than choppy, sideways
markets. There are two main sets of signals generated by the MACD: crossovers and
divergences.

Crossovers
There are two main MACD crossover signals:
1. Signal Line Crossovers: MACD crosses above or below the signal line
2. Zero Line Crossovers: MACD crosses above or below the zero line

Signal Line Crossovers

The basic MACD trading rule is to buy when the MACD rises above its signal line.
Similarly, a sell signal occurs when the MACD crosses below its signal line. The
crossing of the MACD line above the signal line can denote the beginning of a trend.
An uptrend typically pauses or stops when the MACD line crosses and falls below the
signal line.
The location relative to the zero line is also important in indicating how strong a
trend might be. A crossover above the zero line is considered more bullish than one
below the zero line. The higher above the zero line it crosses, the stronger the uptrend. If
the crossover occurs below the zero line, the uptrend is likely not very strong.

When the bullish crossover occurs above the zero line, the uptrend gains more
momentum, and the price rises with more intensity.
Bullish MACD crossovers are probably the most common signals and as such can be
less reliable. If not used in conjunction with other technical analysis tools, these
crossovers can lead to whipsaws and many false signals.
One way to try and counteract false signals is to apply a price filter to the crossover to
see if a trend will hold. An example of a price filter would be to buy if the MACD breaks
above the signal line and remains above for three days. The buy signal would then
commence at the end of the third day.

Zero Line Crossovers

The zero line can also be used to produce a signal. It is popular to buy/sell when the
MACD crosses above/below the zero line.
A bullish zero line crossover occurs when MACD moves above the zero line and into
positive territory. This is a clear indication that momentum has changed from negative to
positive, or from bearish to bullish. After a positive divergence and bullish MACD
crossover, the zero line crossover can act as a confirmation signal.

Divergence
MACD can provide forewarning of important market turns through divergence.
When the MACD trend diverges from the price trend, it can provide a signal that a
trending market may slow or reverse. A negative, or bearish, divergence occurs when the
MACD is making new lows while prices fail to reach new lows. A positive, or bullish,
divergence occurs when the MACD is making new highs while prices fail to reach new
highs. Both of these divergences are most significant when they occur at relatively
high/low levels.A positive divergence is shown when MACD begins to advance and the
market is still in a downtrend and makes a new low. MACD can either form as a series of
higher lows or a second low that is higher than the previous low. Positive divergences are
not very common, but are usually reliable and can lead to good moves.

Combinations
Probably the best way to use the basic MACD is to use a combination of signals to
confirm one another. In addition, a fast MACD line can be added to enhance the signals
generated and to often provide early warning of changes in trends. An example of a three
line MACD is shown below, with the signal line, the fast MACD line and the slow
MACD line. The MACD Histogram is also commonly used to clarify the relationship
between the two MACD lines.

Weaknesses of MACD
MACD is a trend following indicator, and as such, sacrifices early signals in exchange
for keeping you in line with the trend. When a significant trend develops, MACD is often
able to capture the majority of the move. When the trend is short lived, however, MACD
often proves unreliable.
This is because moving averages themselves are lagging indicators. Even though
MACD represents the difference between two moving averages, there is still some lag in
the indicator itself. This is more likely to be the case with weekly charts than daily charts.
One solution to this problem is the use of the MACD-Histogram.

MACD Histogram
The MACD Histogram is useful for anticipating changes in trend.

Overview

The MACD Histogram (MACD-H) consists of vertical bars showing the

difference between the MACD line and its signal line
A change in the MACD-H will usually precede any changes in MACD

Signals are generated by direction, zero line crossovers and divergence from
MACD
As an indicator of an indicator, MACD-H should be compared with MACD
rather than with the price action of the underlying market. MACD-H is used with
MACD as a complementary indicator.

Thomas Aspray found that MACD signals often lagged important market moves,
especially when applied to weekly charts. He first experimented with changing the
moving averages and found that shorter moving averages did indeed speed up the signals.
However, he was looking for a means to anticipate MACD crossovers and came up with
the MACD Histogram.

Interpretation
The MACD Histogram represents the difference between MACD and it's signal line
(usually the 9-day Exponential Moving Average (EMA) of the MACD). Whenever
MACD crosses the signal line, MACD-H crosses the zero line.

If the MACD line is above the signal line, the histogram is positive, and the bars
are drawn above the zero line.
If the MACD line is below the signal line, histogram is negative, and the bars are
drawn below the zero line.

Sharp increases in the MACD-H indicate that MACD is rising faster than its 9-day
EMA and upward momentum is strengthening. Sharp declines in the MACD-H indicate
that MACD is falling faster than its moving average and downward momentum is
increasing.
Divergences between MACD and MACD-H are the main tool used to anticipate
crossovers. A positive divergence in the MACD-H indicates that MACD is strengthening
and could be on the verge of a bullish moving average crossover. A negative divergence
in the MACD-H indicates that MACD is weakening and can act to foreshadow a bearish
moving average crossover in MACD.

Signals
The main signal generated by the MACD-Histogram is a divergence from MACD
followed by a zero-line crossover.

A bullish signal is generated when a positive divergence forms and there is an

upward zero line crossover.
A bearish signal is generated when there is a negative divergence and a
downward zero line crossover.

In Technical Analysis of the Financial Markets, John Murphy states that the real value
of the MACD-H is spotting when the spread between the two lines is widening or
narrowing. When the histogram is above its zero line (positive) but starts to fall, the
uptrend is weakening. Conversely, when the histogram is below its zero line (negative)
and starts to rise, the downtrend is losing momentum. These turns of the histogram
provide early warnings that the current trend is losing momentum, and the buy or sell
signal is given when the histogram crosses the zero line.[8]
Murphy also advocates a two-tiered approach in order to avoid making trades against
the major trend. The weekly MACD-H can be used to generate long-term signals. Then
only short-term signals that agree with the major trend are used.

If the long-term trend is up, only positive divergences with upward zero line
crossovers are considered valid for the MACD-H.

If the long-term trend is down, only negative divergences with downward zero
line crossovers are considered valid.

Used this way, the weekly signals become trend filters for daily signals. This prevents
using daily signals to trade against the overall trend.

McClellan Oscillator & McClellan

Summation Index
A short to mid-term leading indicator, based on a market Index (NYSE, etc), showing
overbought and oversold markets and providing a valuable timing tool.

Overview
Comprised of the daily advances minus declines of an Exchange, usually the New York
Stock Exchange, with the weighted 20 and 40 day moving averages

Indicates overbought markets above +125 and oversold below -125

Used as an important timing tool based on bullish and bearish signals.

The McClellan Oscillator is calculated by subtracting a 39-day exponential moving

average of the difference between the advancing issues and the declining issues from a
19-day exponential moving average of the difference between the advancing issues and
the number of the declining issues in the Exchange.

Interpretation
The McClellan Oscillator is based on the movements of an Exchange, usually the New
York Stock Exchange, not on any one particular stock. It is a short to mid-term "market
breadth" indicator designed to determine the strength of a market trend. Market breadth is
a measure of the percentage of stocks participating in a particular market move; if twothirds of the stocks listed on an exchange move in the same direction during a trading
session analysts say there was significant breadth.
The Oscillator produces three general types of signals:
1. Divergence between the Index line and the indicator line 2.
2. Overbought and oversold indications when the oscillator crosses the +125 and
-125 levels 3.
3. Zero line crossovers as the oscillator moves between positive and negative
territory.

Signals
The McClellan Oscillator offers the following specific signals and alerts:

Divergence
The oscillator leads the index; so if it fails to confirm a new index high or low, the
index may be forming a top or bottom. The example chart shows divergence between the
index and the oscillator, with the oscillator indicating weakness. The Index subsequently
plunged leaving behind a market top. Divergence can provide a warning, and should be
combined with the other signals to produce definite entry and exit points.

Oversold/Overbought indications

An overbought market is indicated when the oscillator enters territory above the
+100 to +125 range. A bearish signal is provided when the oscillator forms a
peak above +125 and then crosses back below this level.
An oversold market is indicated when the oscillator enters territory below the
-100 to -125 range. A bullish signal is provided when the oscillator forms a
bottom below -125 and then crosses back above this level.

Zero-line Crossovers

Bullish signal: upward movement through the zero line.

Bearish signal: downward movement through the zero line.

McClellan Summation Index

The McClellan Summation Index (MSI) is a cumulative total of the McClellan
Oscillator, useful for intermediate to long term trading. Both are based on the movements
of a market Index (i.e., NYSE) rather than an individual stock. Major tops tend to occur
when the MSI goes above +1500. Major bottoms tend to occur when the MSI dips below
-1500 (the -2000 level may provide more reliable signals - see example below).

Money Flow Index

A divergence between the Money Flow Index and price trend can warn of a possible
trend reversal.

Overview

The Money Flow Index (MFI) tracks the flow of money into or out of a market.
Price typically follows MFI and will eventually move in the same direction.

If a stock trades up 1 cent on 100 shares, and the next trade is down 1 cent on 10,000
shares, it shows that large sellers are more aggressive, and vice versa. Given that largevolume single trades are more significant than smaller-share trades, the Money Flow
Index reflects this comparing today's average price with yesterday's and weighs the
average price by volume. The volume of shares traded on upward moves is added up and
then the volume of shares traded on downward moves is subtracted. The cumulative total
for the day of every trade's volume is then plotted against a 0 - 100 scale. MFI is usually
calculated over a 14 day period.
The Money Flow Index was developed by Laszlo Birinyi, Jr. as a real-time variation on
the On-Balance Volume indicator. Instead of using each day as a reference point (as OBV
does), MFI analyzes each trade. And instead of ignoring the price or the amount that the
market is up or down, MFI weights each trade by price.
MFI is based on Money Flow but the two are not the same.

Interpretation
Money flow analysis is a volume weighted relative strength index. It is effective for
both stock and company selection because it gives a view of a market's essential strength
or weakness. Normally, MFI shows the same trends as the price pattern; indicating that,

in an uptrend, money is flowing into the market, and when prices fall, money is flowing
out of the market.

Since Price - MFI divergences can exist for a fairly long period, other indicators
should be used as confirmation and to select entry points
Different time spans should be considered; often the longer the better.

Signals

A divergence between price and MFI often signals an imminent reversal of the
trend.
Readings below 20 on the scale are considered oversold (bullish).
Readings above 80 on the scale are considered overbought (bearish).

Momentum
Momentum measures the speed of price change and provides a leading indicator of
changes in trend.

Overview

The Momentum line leads price action frequently enough to signal a potential
trend reversal in the market.

Momentum indicators can warn of dormant strength or weakness in the price well
ahead of the turning point.
At extreme positive values, momentum implies an overbought position; at
extreme negative values, an oversold position.

Interpretation
A strongly trending market acts like a pendulum; the move begins at a fast pace, with
strong momentum. It gradually slows down, or loses momentum, stops, and reverses
course.
The momentum line is always a step ahead of the price movement. It leads the advance
or decline in prices and levels off while the current price trend is still in effect. It then
begins to move in the opposite direction as prices begin to level off.
The 10 day momentum line fluctuates on an open scale around a zero line. When the
latest closing price is higher than that of 10 days ago, a positive value is plotted above the
zero line. If the latest close is lower than 10 days previous, a negative value is plotted.
Ten days or periods are usually used in calculating momentum, but any time period can
be employed. The shorter the time frame used the more sensitive momentum becomes to
short term fluctuations with more marked oscillations. Oscillator swings are smoother
and more stable when a longer number of days are used.

Upward Momentum
When an uptrending momentum line begins to flatten out it means that the new gains
being achieved by the latest closing prices are the same as the gains 10 days earlier. The
rate of upward momentum has leveled off even though prices may still be advancing.
When the momentum line begins to drop further, below the zero line, the uptrend in
prices could still be in force, but the last price gains are less than those of 10 days ago.
The uptrend is losing momentum.

Downward momentum
When the momentum line moves below the zero line, the latest close is now under the
close of 10 days ago and a short term downtrend is in effect. As momentum continues to
drop farther below the zero line, the downtrend gains momentum. The downtrend
decelerates when the line begins to turn around.
If loss of momentum is experienced in a market at the same time as selling resistance is
met or when buying power is temporarily exhausted, momentum and price peak
simultaneously.

Signals
Momentum is a basic application of oscillator analysis, designedto measure the rate of
price change, not the actual price level.
Three common signals are generated by the momentum oscillator: zero-line crossings,
trendline violations, and extreme values.

Zero-line crossings
Although the long-term price trend is still the overriding consideration, a crossing
above the zero line could be a buy signal if the price trend is up and a crossing below the
zero line, a sell signal, if the price trend is down.

Using Trendlines
The trendlines on the momentum chart are broken sooner than those on the price chart.
The value of the momentum indicator is that it turns sooner than the market itself, making
it a leading indicator.

ExtremeValues
One of the benefits of oscillator analysis is being able to determine when markets are
in extreme areas. At extreme positive values, momentum implies an overbought position;
at extreme negative values, an oversold position
The absence of a fixed upper and lower boundary presents a difficulty with the
momentum line. To help solve this problem look at the long-term history of the

momentum line and draw horizontal lines along its upper and lower boundaries. Adjust
these lines periodically, especially after important trend changes.

On Balance Volume
On Balance Volume can be used to either confirm the current price trend or warn of a
possible reversal.

Overview

It is the trend of the OBV line that is important, not the actual numbers
themselves.
OBV is a momentum indicator that helps quantify buying or selling pressure.
OBV changes often precede price changes.

On Balance Volume was developed by Joe Granville. See his book New Strategy of
Daily Stock Market Timing for Maximum Profits for more detailed information.

Interpretation
It is the direction of the OBV line (its trend) that is important and not the actual
numbers themselves. The actual OBV values will differ depending on how far back you
chart.
The OBV line should follow in the same direction as the price trend. If prices are in an
uptrend, the OBV line should do the same. If prices are trending lower, the OBV line
should do the same. If the OBV line shows a divergence from the price trend, you have a
warning of a possible trend reversal. OBV changes usually precede price changes.
OBV shows if volume is flowing into or out of a security, or the buying and selling
pressure. When there's strong and increasing buying pressure, the price is almost certain
to continue going up. The theory is that money from knowledgeable traders, or "smart
money," can be seen flowing into the security by a rising OBV. When the public then
moves into the security, both the security and the OBV will surge ahead.
Also watch for OBV line breakouts, when the OBV breaks its established trend (see
Breakout Signals). Since OBV breakouts normally precede price breakouts, an OBV
upside breakout is a buy signal. Likewise, an OBV downside breakout is a sell signal.
On Balance Volume is well-suited to trading short-term cycles, however, Granville
advises that investors must act quickly and decisively if they wish to profit from shortterm OBV analysis. Traders also recommend that the daily, weekly and monthly charts
should be consulted for OBV to confirm the buy and sell signals. Signals OBV offers the
following signals:

Divergence between price and the OBV line

Trendline breakouts that forewarn of impending price trend reversals.
MA crossovers, when the OBV is plotted with its Moving Average.

Drawbacks
One of the weaknesses of the OBV indicator is that an entire day's volume is assigned
a plus or minus value. Many experimental variations of OBV have been developed in
trying to discover a more accurate measure for the flow of volume. One of the more
advanced, and useful, is the Money Flow Index .

Parabolic SAR
Parabolic SAR provides a useful tool for catching new trends early, offering excellent
buy and sell signals.

Overview

The Parabolic SAR (stop and reverse) is a trend-following system that sets "stoplosses."
It works well in trending markets, but tends to whipsaw during non-trending,
sideways phases.
A parabola below the price is generally bullish.
A parabola above the price is generally bearish.

The Parabolic System, developed by Welles Wilder who also developed the Relative
Strength Index (RSI), is usually referred to as the Parabolic "SAR" (stop-and-reverse).
Mr Wilder designed this indicator to supplement the other trend-following systems.
The Parabolic SAR is a "stop-loss" system used to set trailing price stops. The name of
the system is derived from its parabolic shape, which follows the price movements in the
form of a dotted line. When the parabola follows along below the price, the trader should
be buying or going long. A parabola above the price suggests selling or going short.
The particular value of the Parabolic SAR is that it allows traders to catch new trends
relatively early. If the new trend fails, the parabola quickly switches from one side of the
price to the other, thus generating the stop and reverse signal.
Mr. Wilder built an acceleration factor into the Parabolic system. To allow the trend
time to become established, the movement of the indicator starts off slowly - with the
dots close together. As acceleration increases, the parabola move faster (with the dots
further apart) until it catches up to the price action.
As with most indicators, Parabolic SAR performs best in trending markets, and is less
reliable during sideways or congestive phases.

Signals
The Parabolic SAR is an outstanding indicator for providing exit points - offering sell
signals when the parabola moves above the price. Buy signals are generated when the
parabola falls below the price. Of course, these signals need to be confirmed by the price
action itself and other, complementary indicators.

It is always useful to examine different time periods; using daily, weekly and monthly
charts.

Combining Parabolic SAR with DMI

John Murphy, author of Technical Analysis of the Financial Markets, recommends
using a filter to complement the Parabolic system. He suggests using the Directional
Movement Index (DMI) to help eliminate whipsaws and false signals in the more
sensitive Parabolic system. As a simple rule of thumb, he observes that the DMI and
Parabolic SAR indicators can complement one another as follows: "When the +DI line is
above the -DI line, all Parabolic sell signals can be ignored." We can see the
effectiveness of this strategy below. (The ADX line is essentially the smoothed difference
between the +DI and -DI lines.)[10]

Price and Volume trend

The Price and Volume Trend (PVT) is a cumulative total of volume adjusted according
to relative changes in closing prices. It is similar to On Balance Volume (OBV).

Overview
PVT is calculated by adding a percentage of the volume when prices close up and
subtracting a percentage of volume when the prices close down. (OBV adds all volume
when prices close higher and subtracts all volume when prices close lower.) The amount
of volume added or subtracted to the PVT is relative to the amount that prices rose or fell
compared to the previous day's close (see note on calculation below).

When the price changes by a small percentage, PVT adds only a small portion of
volume to the indicator
When the price changes by a large percentage. PVT adds a large portion of
volume to the indicator

Interpretation

When the PVT falls money is flowing out of this market (falling prices
accompanied by increased volume).
When the PVT rises money is flowing into this market (prices and volume are
increasing together).

PVT is a leading indicator for future price movements. Although interpretation of PVT
is similar to the OBV and the Accumulation/Distribution indicators, PVT more accurately
demonstrates the flow of money. PVT adds only a proportional amount of volume to the
indicator, whereas OBV adds the same amount of volume not considering whether the
market closes up a fraction of a point or triples in price.
1. Rising PVT means new money, sometimes referred to as "smart money, " is
flowing into the marketplace. The result will be that the present trend will
continue. Accelerating PVT rise indicates that "the masses" are joining the new
price trend.
2. If the PVT then levels off, it is often an early warning that the trend is finishing.
3. Declining PVT indicates that the smart money is liquidating.
4. If the PVT moves sideways or falls while the price is rising, the increase in price
is not confirmed and a market top or bottom may be indicated.

Signals
The main signal offered by the PVT indicator is divergence from price.
In the example charted above, bullish divergence was seen on two separate occasions
-- with the PVT trending higher while prices trended lower -- followed by strong price
increases in both cases.

Calculation
PVT is calculated by multiplying the day's volume by the percentage change from
yesterday's close and adding this value to a cumulative total. For example, if a stock
closed up 0.5% and volume was 10,000 shares, you would add 50 (i.e., 0.005 X 10,000 =
50) to the PVT. If the stock had closed down 0.5 %, you would subtract 50 from the PVT.

Range Expansion Index (REI)

The Range Expansion Index is an arithmetically calculated market-timing oscillator designed to
overcome problems with exponentially calculated oscillators.

Overview
Developed by Tom DeMark, this is a more precise indicator of trends and trading signals than
exponential oscillators, such as MACD.

REI eliminates short term irregularities by comparing current prices with the prices two days
previous
REI works only in trending periods
DeMark included conditions to eliminate premature signals

Interpretation
The REI oscillator typically produces values of -100 to +100 with 45 or higher indicating
overbought conditions and -45 or lower indicating oversold conditions. DeMark advises against
trading in extreme overbought or oversold conditions indicated by six or more bars above or below
the +/-45 thresholds.
When conditions aren't met, the day's value is zero.

REI values range from -100 to + 100

If the REI is in the overbought or oversold area for less than five consecutive periods, you can
expect at least a minor reversal
The signal is unreliable if it stays above or below these levels for more than five periods. REI
must then return to the neutral zone (between +45/-45) before giving a reversal signal outside
the zone.

Signals

Overbought - REI greater than + 45

Oversold - REI below -45

Trading should be avoided when:

Overbought for six or more periods above +45

Oversold for six or more periods below - 45.

Rate of Change
ROC is a momentum indicator that measures velocity and also leads the price action.

Overview
Rate of Change, ROC, can be very useful, because it is a leading indicator (ROC
changes direction before the underlying price). ROC is sometimes also referred to as
Price Rate of Change (PROC).

ROC is a price momentum or velocity indicator.

A rising ROC indicates a bullish increasing momentum
A falling ROC indicates a bearish decreasing momentum
ROC should always be used in conjunction with reversal signals on the price
chart.

Whereas the Momentum indicator provides the difference between the current price
and the price from a past period as a ratio, ROC displays the same information as a
percentage on an open scale.. The zero-line, or equilibrium line, represents the level
where the price is the same as the reading for the past period (e.g., 10 days for the 10-day
ROC).

Interpretation
The ROC displays the amount prices have changed over the given time period as an
oscillator. When the wave is above the equilibrium line, the market price is higher than it
was at the start of the ROC time period. The higher the wave, the greater the change.
When the wave sinks below the equilibrium line into a trough, the lower it goes, the
lower the market is in comparison to the previous price. As the wave starts coming up
from the bottom of a trough, in a rising ROC, this indicates expanding momentum
(considered bullish). Conversely, a falling ROC is considered bearish.
Comparing the ROC's of different time spans improves the accuracy of the analysis. A
12 month period is usually the most reliable for long term trends and 3 or 6 month period
works well for intermediate trends. As mentioned previously, a 10 or 12-day ROC is a
good short term indicator, oscillating in a fairly regular cycle.
The lower the ROC, the more undersold the market and the more likely a recovery.
Although the opposite may hold true in that the higher the ROC, the more overbought the
market, both extremes can indicate the formation of a sideways channel.

Signals
Overbought/ Oversold Levels
Overbought and oversold lines can be drawn on the ROC chart, generally along
previous highs and lows. There are no hard and fast rules about where these lines should
be drawn. Like trend lines they should be drawn in response to the previous actions of the
price and ROC indicator itself. Overbought levels can only be relied on to indicate a
coming market reversal when a bull market has matured, or during bearish phases.
You can filter out a many premature buy and sell signals by waiting for:

the ROC to come back through the overbought or oversold line the second time,
and
a confirmation of a trend reversal from the price itself.

Divergences
Divergences can provide warnings or alerts of weaknesses in market trends, but do not
represent actual buy or sell signals. It is essential to wait for a confirmation from the price
itself that the overall trend has reversed.
Zero-line crossings
Although the long-term price trend is still the overriding consideration, a crossing
upward through the zero line can confirm a buy signal and a crossing downward through
the zero line, a sell signal.
Trendline Violations
The trendlines on the ROC chart are broken sooner than those on the price chart. The
value of the momentum indicators is that it turns sooner than the market itself, making it
a leading indicator.

Relative Strength Index

The Relative Strength Index (RSI) can provide an early warning of an opportunity to
buy or sell.

Overview

The RSI is a momentum indicator, or oscillator, that measures the relative

internal strength of a market (not against another market or index).
As with all oscillators, RSI can provide early warning signals but should be used
in conjunction with other indicators.
Divergences are the most important signal provided by RSI.

The Relative Strength Index (RSI) is a popular oscillator developed by Welles Wilder,
Jr (see his book, New Concepts in Technical Trading Systems). RSI measures the relative
changes between higher and lower closing prices, and provides an indication of
overbought and oversold conditions.
The term "Relative Strength" is slightly misleading and often causes some confusion.
Relative strength generally means a comparison between two different markets or
indices. RSI, on the other hand, looks at the internal strength of a single market.

Interpretation
RSI is plotted on a vertical scale of 0 to 100. The 70% and 30% levels are used as
warning signals. An RSI above 70% is considered overbought and below 30% is
considered oversold. The 80% and 20% levels are preferred by some traders. The
significance depends upon the time frame being considered. An overbought reading in a
9-day RSI is not nearly as significant as an RSI for a 12-month period.
An overbought or oversold condition merely indicates that there is a high probability
of a counter reaction. It is an indication that there may be an opportunity to buy or sell,
but does not provide the final signal. RSI signals should always be used in conjunction
with trend-reversal signals offered by the price itself.
RSI can be plotted for any time span. Wilder originally recommended using a 14-day
RSI. Since then, the 9, 10 and 25-day RSIs have also become popular. The shorter the
time period, the more sensitive the oscillator becomes. If the user is trading short-term

moves, the time period can be shortened. Lengthening the time period makes the
oscillator smoother and narrower in amplitude.
In using RSI, a crossover above the 70% level is a warning signal to prepare to sell
and, conversely, when the RSI falls below 30% you have a notice to prepare to buy. The
actual buy and sell signals are given when the RSI reverses (see below). RSI crossings
through the 50% level are also used as buy and sell signals by some traders.

Signals
Tops & Bottoms, Failure Swings, Divergence
Traders watch for double tops or what Wilder referred to as "failure swings." If the RSI
makes a double top formation, with the first top above 70% and the second top below the
first, you get a sell signal when the RSI falls below the level of the dip. Conversely, a
double bottom at or below 30% (with the first low below 30% and the second at or above
the same level) gives you a buy signal when the RSI breaks above the previous peak.
These failure swings can lead to divergences between the price action and the RSI. For
example, a divergence occurs when a market makes a new high or low, but the RSI fails
to set a matching new high or low. A divergence can be an indication of an impending
reversal. In Wilder's opinion, divergences are the most important signal provided by
RSI.

Trendlines
RSI trendlines can provide good signals, particularly when used in conjunction with
price patterns. When both price and RSI trendlines are violated within a short period you
could have an important buy or sell signal

Sequential Analysis
An indicator designed to identify market exhaustion using price patterns. It can help to
anticipate trend reversals.

Overview

Developed and trade marked by Tom DeMark, this indicator helps identify market
exhaustion (based on the premise that price reversals are the result of market
exhaustion).

Interpretation
Sequential Analysis involves a three step process of counting the daily bars on a bar
chart:
1. Set Up
1. Buy set up: count nine consecutive daily price closes which are lower
than the close four days earlier.
2. Sell set up: count nine consecutive daily price closes which are higher
than the close four days earlier.
2. Requisite filter (Intersection):
This step is designed to filter-out false expectations of a reversal when the trend is
strong.
1. To confirm a buy set up the highs of day 8 or 9 must intersect the lows of
three or four days previous.
2. To confirm a sell set up the lows of day 8 or 9 must intersect the highs of
three or four days previous.
3. Countdown:
1. A buy set up is 13 closes lower than or equal to the close 2 periods earlier
(unlikely that these will be consecutive)
2. A sell set up is 13 closes higher than or equal to the close 2 periods earlier
(unlikely to be consecutive).

Signals
Only after the entire three-step process has unfolded, would you enter the market.

Stochastic Oscillator

The stochastic indicator can help determine when a market is overbought or oversold.

Overview
The stochastic indicator is:

a momentum oscillator that can warn of strength or weakness in the market, often
well ahead of the final turning point.
based on the assumption that when a stock is rising it tends to close near the high
and when a stock is falling it tends to close near its lows.

The original stochastic oscillator, developed by Dr. George Lane, is plotted as two lines
called %K, a fast line and %D, a slow line.

%K line is more sensitive than %D

%D line is a moving average of %K.
%D line triggers the trading signals.

Although this sounds complex, it is similar to the plotting of moving averages. Think
of %K as a fast moving average and %D as a slow moving average. The lines are
plotted on a 1 to 100-scale. "Trigger" lines are normally drawn on stochastics charts at the

80% and 20% levels. A signal is generated when these lines are crossed. The zones above
and below these two lines can be referred to as the stochastic bands.

Slow Stochastics
The original stochastic is sometimes referred to as the "fast" stochastic to differentiate
it from the "slow" stochastic. Some traders feel the fast stochastic %K line is too sensitive
and, to improve their analysis, they replace the original %D line with a new slow %K
line. The new slow %D line formula is then calculated from the new %K line. The result
is a pair of smoothed oscillators that some traders believe provide more accurate signals.

Interpretation
The 80% value is used as an overbought warning signal, and the 20% is used as an
oversold warning signal. The signals are most reliable if you wait until the %K and
%D lines turn upward below 5% before buying, and the lines turn downward above
95% before selling.
An overbought or oversold level indicates that a market may be vulnerable to a
retracement

These signals are particularly important with monthly charts. Buying into a
market with an overbought %K or selling into one that is oversold may involve
above-average risk, particularly if the market is pressing against previous levels of
support or resistance.

Signals
The Stochastic Oscillator generates signals in three main ways:
1. Extreme values when the 20% and 80% trigger lines are crossed. Buy when the
stochastic falls below 20% and then rises above that level. Sell when the
stochastic rises above 80% and then falls below that level.
The pattern of the stochastic is also important; when it stays below 40-50% for a
period and then swings above, the market is shifting from overbought and
offering a buy signal. And vice versa when it stays above 50-60% for a period of
time.
2. Crossovers between the %D and %K lines. Buy when the %K line rises above
the %D line and sell when the %K line falls below the %D line. Beware of shortterm crossovers. The preferred crossover is when the %K line intersects after the
peak of the %D line (right-hand crossover). Crossovers often provide choppy
signals that need to be filtered through the use of other indicators.
3. Divergences between the stochastic and the underlying price. For example, if
prices are making a series of new highs and the stochastic is trending lower, you
may have a warning signal of weakness in the market.

Swing Index

This momentum indicator is used primarily as a component of the Accumulative Swing

Index.

Overview
Welles Wilder developed the Swing Index to provide a line "which cuts through the
maze of high, low and close prices and indicates the real strength and direction of the
market." (For a detailed description refer to Wilder's book New Concepts in Technical
Trading Systems.)
The Swing Index is used primarily as a basis for Wilder's Accumulative Swing Index
(ASI) indicator.
Mr. Wilder summarizes the significance of the Swing Index as follows:

Swing Index gives one numerical value that always falls between +100 and -100,
while incorporating current and previous opening and closing prices and true
range in its complex calculation.
Swing Index provides a line which gives definitive short-term swing points.

Interpretation
The Swing Index alone doesn't provide much in the way of signals. It should be used in
conjunction with the Accumulative Swing Index.

TRIX - Triple Exponential Smoothing

Oscillator
As a momentum indicator, this oscillator is based on smoothed moving averages and
their momentum to avoid insignificant daily price movements and to aid timing.

Overview
TRIX, developed by John Hutson, displays the percent rate-of-change of a triple
exponentially smoothed moving average using an equity's closing price.

TRIX swings on an open scale around a zero line

A buy signal is generated by extreme negative levels
A sell signal is generated by extreme positive levels
Divergences between TRIX and the equity can aid in timing turning points.

Interpretation

TRIX is best used in conjunction with CCI or Parabolic SAR.

Depending on the number of periods chosen, TRIX keeps an investor in trends
shorter than specified.

Signals
Similar to the use of the MACD indicator, a 9-period moving average of the TRIX can
be used to create a signal line.

A buy signal is given when the TRIX rises above its signal line.
A sell signal is given when it falls below the signal line.

Ultimate Oscillator
The Ultimate Oscillator i sensitive to buying and selling pressure and offers reliable signals.

Larry Williams developed the Ultimate Oscillator to address the problems experienced with
most oscillators when used over different lengths of time.
Signals are based on divergence and a breakout in the Oscillator's trend, as well as
overbought and oversold levels.

Williams noted that the value of oscillators can vary greatly depending on the number of time
periods used during the calculation. The Ultimate Oscillator, therefore, uses weighted sums of three
oscillators which represent short, intermediate, and long term market cycles (7, 14, & 28-period). It is

plotted as a single line on a vertical scale of 0 to 100.

The three oscillators are based on Williams's definitions of buying and selling "pressure."
Williams recommends that you initiate a trade following a divergence and a breakout in the
Ultimate Oscillator's trend.

Signals
A Buy signal is offered when:
1. A positive or bullish divergence occurs between the Oscillator and the price.
2. The Oscillator falls below 30 and then rises above the previous high established during the
divergence (the actual buy signal).
A Sell Signal is offered when:
1. A negative or bearish divergence occurs between the Oscillator and the price.
2. The Oscillator rises above 70 and then falls below the previous low established during the
divergence (the actual sell signal).
Closing existing positions:
1. Close long positions when the oscillator exceeds 70.

2. Close short positions when the oscillator goes below 30.

Please remember that, as with most indicators, these signals should be confirmed by other
indicators before being acted upon.

Upside/Downside
Measures of Upside/Downside separate the volumes for rising markets from those in falling
markets. Since volume is independent of price, it makes a valuable tool for measuring the quality of a
price trend.
There are two common measures for Upside/Downside:
1. The Upside/Downside Ratio, and
2. Upside/Downside Volume Line Index

The Upside/Downside Ratio

Overview

The Upside/Downside Ratio is calculated by dividing the daily volume of advancing stocks
on a particular exchange by the daily volume of declining stocks. The NYSE
Upside/Downside Ratio, for example, shows the relationship between rising and falling
volume on the New York Stock Exchange.
A U/D Ratio greater than 1 shows there is more volume with rising price stocks than with
falling price stocks.

Signals
The higher the U/D ratio, the more bullish the signal: high readings above 4 are considered bullish
signals, and low readings below .75 are considered bearish signals.
Martin Zweig wrote in Winning on Wall Street, "Every bull market in history, and many good
intermediate advances, have been launched with a buying stampede that included one or more 9-to-1
days" ("9-to-1" refers to a day were the Upside/Downside Ratio is greater than nine). He goes on to
say, "the 9-to-1 up day is a most encouraging sign, and having two of them within a reasonably short
span is very bullish. I call it a "double 9-to-1" when two such days occur with three months of one
another."

Overview

The Upside/Downside Volume (U/DV) Line is constructed by keeping a running total for the
difference between the daily volume in advancing and declining issues.
Since the indicator starts with an arbitrary number, it is usually wise to choose a relatively
large number (five thousand works well).

A moving average can be constructed from weekly and monthly figures and plotted alongside
the U/DV line.

Signals

Normally, the U/DV line will move up and down with the price, and trend lines drawn on the
U/DV and price lines will correspond.
When the U/DV line doesn't confirm a price move (divergence), a signal is given for a
possible trend reversal. For example, upside volume may fail to expand to support increased
prices.

Signals are also provided when the U/DV line crosses its moving average.

Volume
Volume is the number of shares or contracts traded during a given time frame. The
time frame is usually one day, but can also be a week.

Overview

The analysis of volume is basic and essential in technical analysis.

Volume provides evidence of intensity with a given price move.
As volume often leads price, it is a valuable indicator, especially for price peaks.

Volume Accumulation Oscillator (Chaikin

Oscillator)
Volume analysis is important for identifying internal strengths and weaknesses in a
market. Very often, a divergence between volume and price movements can offer clues to
an impending reversal.

Overview
The Volume Accumulation Oscillator (VAO) -- also called the Chaikin Oscillator after
its designer Marc Chaikin -- is more sensitive to volume versus price than the On Balance
Volume indicator.
VAO assigns a proportional amount of volume to the price according to the
relationship between the closing price and the average price for the day.

A close above the mean price is given a positive value and a close below the mean
a negative value.

When the market closes at either the high or low of the day, the volume is given
full value.

In general, volume oscillators are designed based on the following premises:

1. Volume and price normally rise and fall together, and when this relationship
changes it can provide an early indication of a coming change in trend.
2. The more a market is controlled by buyers (accumulation), the closer it will close
to its high. If a market is controlled by sellers (distribution), it will close below its
midpoint for the day.
3. Lagging volume on an upward move is often a forewarning of a weakening
market. A declining market is more complex; usually there's a pickup in volume
followed by reduced volume and a period of accumulation before a valid bottom
develops.

Interpretation
Divergence between volume and price movement is often the sign that a reversal is
about to take place. In the short and intermediate term, the VAO helps to identify market
tops and bottoms by sensitively comparing volume to price action.
Most indicators are most effective when used in conjunction with other, complimentary
indicators. An effective short and intermediate-term combination of indicators, for
example, might include VAO, along with a 21-day moving average and an
overbought/oversold oscillator (e.g., Momentum, ROC, CCI).
The VAO is most valuable when:

in an overbought/sold position, prices reach a new high or low and the oscillator
fails to exceed its previous high/low reading and then reverses direction.

Signals
Buy or sell signals are considered reliable only when they are in keeping with the
overall (long-term) trend.

A buy signal would be generated if an up-trending market is above its

intermediate (100-day) moving average, and a negative VAO turns upwards (from
a trough).
A sell signal would generated if a stock is below its 100-day moving average and
a positive VAO turns downwards (from a peak).

William's Accumulation-Distribution
Williams' Accumulation-Distribution tracks the buying pressure and selling pressure.

Overview
Williams' Accumulation-Distribution (WAD) tracks buying pressure (accumulation)
and selling pressure (distribution) on a security.

With accumulation, most of the volume is associated with upward price

movement.
With distribution, most of the volume is associated with downward price
movement.

The pressure is determined by where the close sits within today's true range.

Interpretation
Williams' AD is a running sum of positive accumulation values (buying pressure) and
negative distribution values (selling pressure).

If today's close is higher than yesterday's close, WAD is increased by the

distance of the close from today's true low (the lesser of today's low and
yesterday's close).
If today's close is lower than yesterday's close, WAD is decreased by the distance
of the close from today's true high (the greater of today's high and yesterday's
close).

Signals
Divergence between Williams' AD and the price produces the signals. As with most
indicators, WAD leads the price; or in other words, when a divergence occurs, the price
usually changes accordingly. For example, if the indicator is moving up and the security's
price is going down, prices will probably reverse (as shown in the example above).

A buying opportunity is signalled by falling prices and a rising WAD

A selling opportunity is signalled by rising prices and a falling WAD

William's % R
Williams %R has proven very useful for anticipating market reversals.

Overview

Williams %R is a momentum indicator

identifies overbought or oversold markets.
It is plotted on an inverted 0 to 100 scale.

This oscillator, a version of the stochastics oscillator, was developed by Larry

Williams. < >

In the example above a strongly uptrending market it shown with the Williams %R
indicator plotted below. The primary buy signals are shown in red. More cautious
investors wait for the %R to form a definite low below 90% and then bounce back
through this level before acting on the buy signals.

Interpretation
Mr. Williams indicates that the essence of his trading system is based on interpreting
readings of %R. He states that, "Generally speaking, readings below 95% give a buy
indication - during bull markets. A reading above 10% gives a sell signal during bear
markets." He goes on to say that "the %R index will not work if you insist on acting on
the buy signals during a bear market." He emphasizes strongly the need to isolate the
dominant trend - whether it is a bull or bear trend. Then he tracks price movements with

%R and waits for the signals. (See his book, "How I made One Million Dollars... Last
Year... Trading Commodities" by Larry R. Williams.)
To determine the long term trend for commodity or futures markets, Mr. Williams
advocates the use of a 10-week moving average. The indicator is now popular in most
markets and has proven itself useful with stocks.
Like other momentum indicators, Williams %R is not very useful in a sideways
market, or trading range. The market needs to be trending up or down for the signals to be
reliable.

Signals
Mr. Williams bases his system largely on the use of the following two signals (once
again notice that the signal is reliant on the direction of the underlying long-term trend):

Buy when %R hits 90% to 100% and the trend is up.

Sellwhen %R hits 10% to 0% and the trend is down.

Some traders use readings below 80% to indicate oversold markets and readings above
20% to indicate overbought markets. These levels can also be used as early warning
signals.
In a blow-off market, where prices have undergone a very steep rise, Mr. Williams
suggests waiting before responding to %R. For example, he suggests acting on buy
signals (assuming the long term trend is up) only after:
1. %R has hit 100%,
2. Five trading days have passed since the 100% reading was hit, and
3. %R again falls below 95%.
Mr. Williams assures us that not all signals will be correct; there are no perfect indices.
"Yet," he continues, "%R remains the best timing tool I have ever used for determining
overbought and oversold markets."
Williams %R has proven very useful in anticipating market reversals. The indicator
almost always forms a peak and turns down a few days before the price peaks and turns
down. And vice versa for bottoming markets.

References
1.
2.
3.
4.
5.

BurtonMalkiel's "A Random Walk Down Wall Street"

http://www.investorguide.com
http://www.vectorvest.com/research/marketmyths2.htm
http://www.prenhall.com
http://www.chartfilter.com

6.
7.
8.
9.

NYSE website at NYSE.com

New Concepts in Technical Trading Systems
Technical Analysis of the Financial Markets
New Strategy of Daily Stock Market Timing for
Maximum Profits
10. Technical Analysis of the Financial Markets