Commentary (Page 439)

For the past couple weeks (and for the next several weeks) I am publicly reviewing my Watch List. This is an important task that all investors should do on a regular basis. Analyzing your investments to make sure they are performing to your standards is essential to your success as an investor. While I am not as popular at Jim Cramer, I do like to follow his advice and announce when I change my mind on a stock.

This week, I removed Caterpillar [stckqut]CAT[/stckqut], Chipotle [stckqut]CMG[/stckqut], and Carbo Ceramics [stckqut]CRR[/stckqut].  For different reasons, each of these companies was not performing to my expectations. If you want to understand this logic, you should read my book, The Confident Investor.   You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.

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A stock exchange is similar to an auction house. If you collected rare coins and saw that a leading auction house had coins to sell, you could attend the auction. You would compete with other interested buyers for the coins. The buyer who agreed to pay the highest price would acquire the coins.

Probably a bit more relevant to your everyday experience is when you buy something on eBay (NASDAQ:EBAY). With eBay, you can set the minimum and maximum you will pay for the item. As other bidders enter the market, they can bid against you with eBay’s automatic bid tool until one of you reaches your personal maximum; the most that you think the item is worth. At that point, one bidder will be the current leader and others will have to bid against the leader.

At any time during the auction, an interested bidder on eBay could value the item more and increase the bid to be the leader. The winner of the item is the person with the largest bid at the end of the auction deadline set by the seller.

The stock market is larger and more efficient than eBay!

The auction example doesn’t quite hold for stock price, though, as there are no deadlines. Also, buyers may immediately become sellers. It is similar in that the stock price is set by the number of people who want to sell their shares at the current price and those who want to buy the stock at that price.

If an investor wants to sell shares of a company, he looks at the current share price and determines if it is in his best interest to sell the stock. If it is, he will sell it. If he needs a higher price to sell the shares to meet his goals, he will hold on to the stock. If no investors want to sell their shares at a given price, then no buyers will be able to buy shares. This will cause the price to increase until some investor somewhere thinks the price is high enough to sell.

The converse is also true. There are times when potential investors believe that a stock’s price is too high to be a suitable investment. At the same time, there are shareholders who want to sell the stock. In this case, the price will go down until some investor wishes to buy the stock. Most stocks huge volume changing hands in any given day so there is little delay between the buying and selling of a stock.

This makes the market extremely efficient but a little chaotic. Every investor has a different way to analyze the company and determine if it is wise to invest. Also, every investor has separate outside influences in spending money, which includes other investment options. With the diverse range of influences and opinions of thousands or millions of investors, the market may be quite volatile. Prices can change a few percentage points each day on the most stable of days and move even farther on days when there is a significant amount of activity.

The good news for you, the individual investor, is that you do not need to understand all of this background theory. You simply need to understand that when you want to buy a stock you can buy it. The price may be better or worse tomorrow though so it is important to try to buy the stock at a discount. This is where my book, The Confident Investor, can help. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.

You may have seen this ad by Prudential. I am not receiving financial payment for putting their ad on my site, I am using this great video to communicate the same basic idea that Prudential is suggesting. My question is the same as theirs,”Who is the oldest person that you know and do you have enough money to live that long?”

It is a simple enough question. If you know someone that is 90, shouldn’t you expect to live to 90? If you know someone that is pushing 100 (especially if that person is in your family) doesn’t it make sense that you might live to be 100? If you are planning to retire at the young age of 65, that means 35 years of living off of your savings!

How much do you need to live on when you are retired?  Some say a fairly conservative number that will pay their bills and leave them sitting on the porch for 35 years. I actually want to enjoy my retirement life. I want to Retire in Luxury!

I don’t care if you want to use Prudential as your broker. That is a personal decision. You probably shouldn’t just give them your money and trust that they will maximize your investment. You should probably use your brokerage account at Prudential (or any broker that you choose) to invest in the stock market according to my book, The Confident Investor. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.

Editors Note: I frequently get asked on Twitter or via my Contact page why a certain stock “gapped up” or “gapped down” and if the investor should react to it. It is important to understand the nature of gaps and Zachary does an excellent job of explaining the basics.

Guest Post by Zachary D Brethauer

Gaps occur because something has significantly changed the forces of supply and demand for a particular security. When price gaps up, sellers are no longer willing to part with shares at the currently traded price or the closing price from the day prior. When price gaps down, buyers are refusing to exchange shares of the currently traded price or closing price from the day prior. Both of these events usually stem from pertinent news about the immediate past or future of the security in question, and since the market is considered a leading indicator, the largest gaps come from changes in the future guidance of that particular security.

Let’s take a look at a quick example, XYZ Inc. in its most recent earnings report comes out with a new product that is slated to considerably improve the company’s future earnings and possibly create a brand-new market segment. The lucky people who have the shares are now unwilling to sell them at the prior days close and one in extra three dollars to part with their shares. Demand for the shares pick up as buyers, wanting to be a part of the company’s burgeoning growth potential, happily pay the extra three dollars for the shares. When the market opens the next day a gap up occurs for exactly 3 dollars. This type of gap may end up being what’s called a breakaway gap, where price has lain dormant for some time but this fresh news’s barks at torrent of new demand for the shares. There are also three other kinds of gaps that will discuss in the coming section and those are common gaps, runaway gaps, an exhaustion gaps.

Common Gaps
Common gaps also referred to as an area gap or trading gap, occur with no real catalyst about the future of the security in question. These types of gaps usually occurred during uneventful times and most commonly when volume for a particular security is low, referred to as being thinly traded. An example of a common gap may be a security that has an upcoming ex-dividend date where volume falls off and inexperienced market participants are willing to pay whatever price is being offered. These types of inefficiency gaps are usually “filled” very quickly, meaning that price will retrace to the close of the day prior to the gap. When this happens it is known as “filling the gap”. Sometimes you’ll hear traders say that Gaps HAVE to be filled, but this is mainly due to an old methodology of thinking or marketing experience.

Breakaway Gaps
Breakaway gaps occur during exciting times in a security’s life and are usually accompanied by high volume. For a gap to be considered a breakaway gap, the security’s past price data has to of been going sideways for a while, this is also referred to as an area of congestion where price move sideways usually within a defined range continually bouncing off support and resistance. For price to move sideways, key support and resistance lines are usually horizontal with buyers coming in when price touches the support line and sellers dumping shares at the resistance line. Price can remain in this range for weeks, months, and even years, and as time passes the support and resistance lines become even more entrenched making it harder for price to escape. Fresh market enthusiasm, usually accompanied by spike in volume, is necessary for price to finally escape this range and the resultant gap usually occurs because traders accustomed to the range will have to quickly cover their positions to mitigate losses. This is one of the reasons why these gaps can be some of the largest.

Runaway Gaps
Runaway gaps are also caused by an increase in market enthusiasm for a particular security, but have one main difference from breakaway gaps in that they usually occur during a well-defined up or downtrend. A runaway gap to the upside usually represents market participants who waited on the sidelines during the initial trend, sitting on their laurels waiting for a pullback to get in too long positions. But there’s only one problem, price steadily continues upward and all the sudden the anxiety of missing the move becomes too much to handle. In a rush to get in, buyers are falling over each other paying whatever price sellers are demanding resulting in a runaway gap to the upside. Runaway Gaps commonly have significantly higher volume on days before and after the gap. Getting into positions after a runaway gap occurs can be difficult due to increase price volatility as market participants with early entry book profits.

Exhaustion Gaps
Exhaustion gaps are the evil cousin of runaway gaps in that they occur at the end of a long-standing trend and may signal a reversal of the trend. Exhaustion gaps are commonly identified by massive spikes in volume that can be many multiples of the securities average trading volume. Exhaustion gaps are the most profitable gaps to trade because there’s so much emotion involved in the last gasps of the trend that people who were waiting on the sidelines for the trend to end, come in guns a blazing securing a premium spot for their stop losses.

I hope that you enjoyed my analysis of “The Big 4” Gaps in trading. If you would like to learn more about technical analysis as well as how to apply it in Day Trading please visit my website where I teach Day Trading Strategies in video webinar format. Here’s the best part… It’s free! Enjoy

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