How the Market Works- Part 3
Price Action
Price behavior is the result of all the information a market absorbs. Novices use price to predict price which is why price action trading has been given a bad, really bad name. But in reality, once you understand how prices react, price action can give you clues as to what is taking place. For example, Violent/Monster/Large/Elephant-like bars formed after narrow ranges, meaningless zig zag behavior say something. If formed at a prior turning point, the bar might actually be a great signal. Again, if formed after some important news flow such as results, economic or govt. announcements, the same bar can lead to a complete different behavior for the stock. The thing with price action is that whenever something drastic takes place, it almost always has the signs of a few predictable patterns. The most important advice that we have for all market participants- be it traders or investors- We don’t view a chart searching for patterns, we monitor stocks that we’d like to buy and we pull the trigger when a pattern emerges.
Risk Levels
Definitive price action- one that is identifiable, happens frequently enough and has predictable behavior help any trader to note a risk level i.e. a level against which shares can be bought and should the level hold, the trade remains active. This price level is always on the opposite side of the entry. For example after a lateral base a large bar which closes at an all time high one massive volume usually suggests that as long as the low of this bar isn’t violated, everyone is looking at a near term gain on the stock. We bring forth this principle to our investing as well. Since we determine where the sentiment of the stock would change i.e. say from bullish it becomes neutral or tepid, we set exit points to book a small loss or in more popular parlance a ‘stop-loss’. Having a stop-loss hit allows that capital to be freed up to take another bet/investment which might appear. There is only a limited amount of capital one has and portfolio returns are based on how well you have allocated such capital.
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The other aspect about risk levels comes again from trading. Lets assume a stock starts going upwards without a halt, or perhaps towards the moon. Unless you know where your risk level is, you’ll run the risk of buying blindly and in most certainty realize that the major move has taken place and the market doesn’t have much left. It is exactly why “pullbacks” are popular ways to enter because the market creates a level to risk against. Without a risk level you’ll be investing not knowing if and when to exit if things go wrong. A $100 stock can crash to $10 and you wouldn’t have known when to have ditched the investment. Risk levels help determine objectively when to exit gracefully and not in panic. When sizing an investment, a risk level helps to determine how much to buy of the said stock. The closer the stoploss, the more you buy. Conversely, you buy lesser with a wider stop. If you had to risk $100 you’d risk 50 shares if the stoploss were $2, 33 shares with a $3 stop and 100 share with a $1 stop. Your position sizing aka no. of shares to buy is determined simply by
No. of Shares= (Risk Amount ‘R’)/(Dollar Amount of SL)
