Discussion 10: Volume Sparks Interests

As most of us know, technical traders do not rely solely on Candlestick Patterns. Usually, there are more than candlesticks that are plotted on the charts. In my previous Discussions, I have repeatedly stressed the importance of Volume in confirming Candlestick Patterns.

Volume is the number of transactions that took place during the day. It should not be confused with Open Interests (which applies only to futures and options). A transaction involves a buyer and a seller. One buy and one sell, in this sense, constitutes to one volume.

So, why is volume so important? Volume shows the amount of interests in a certain movement. In other words, increases in volume means traders/investors are agreeing to the stock price, and therefore, they are more interested to transact at that price. Interests start to decline when traders/investors think the stock price is no longer attractive. At that time, volume starts to decrease.


VOLUME AND PRICE TREND

Volume Divergence

In a price uptrend, if the Volume does not increase with the Price (we say Price Action is inconsistent with Volume, or sometimes, Volume Divergence), then most likely the movement lacks interests from the traders/investors. In this sense, as smart traders, we will begin to tighten our stop losses, and take partial or all profits.

This is also true during a price decline. Theoretically, if Volume does not increase during a price drop, then the drop are lacking interests from the traders/investors, and very likely, a reversal would be taking place soon. However, due to fear prevails over greed, prices fall of its own weight! Established traders/investors would therefore pay more attention to volume decline at the top, and volume increase at the bottom, of a prevalent trend.

The table below shows different convergence and divergence combinations of Volume and Price:

Price	Volume	Remarks
Increase	Increase	Trending, with Conviction
Increase	Decrease	Trending, but losing Momentum
Decrease	Increase	Trending, with Conviction
Decrease	Decrease	Trending, but losing Momentum



Illustration (i) : TCHONG - Volume Divergence


Volume Behaviour in Trending Market
In an uptrend, prices tend to move up and then retraces to its support before making another leg of ascent. The reverse is true for a downtrend. Volume tends to make a hike when the price is trending, and then reduced when the prices consolidated or retraced to its support/resistance, and then makes another hike when the price continues its trend. A trend is usually broken when volume made consecutive highs in a retracement, and the price unable to make another higher low.

Illustration (ii) : KNM - Trend Broken

In illustration (ii), KNM was in an uptrend since end of November 2010. We can see that with each retracement, volume decreases. Volume then increased when the price trend resumed upwards.

In an uptrend, the tendency is to have the price making a higher high and higher low. Therefore, on 11/01, the new low created at RM3.01 was a support that KNM was expected to rebound off, if the uptrend were to continue. Unfortunately, on 21/01, the support was broken on a Gap Down, coupled with successive higher volume. Unable to make another higher low, the uptrend is confirmed to have been broken.

The price then hovered within the box, with the previous support of RM2.80 (created by the previous retracement low) and resistance of RM3.01 (support turned resistance). Both support and resistance were tested on numerous occasions, before the support was broken on 23/02. The drop on 24/02 in high volume was halted by the prior support of RM2.37 (created in previous Gap Up).

Taking a step back, you could already have seen this coming way back on 23/12. Since then, the volume has been making consecutive lower highs, while prices making higher highs. This constituted to a Volume Divergence, which signals the end of the uptrend is imminent, before it took place on 21/01 (approximately a month before it happened!)


VOLUME AND CANDLESTICK PATTERNS

Candlestick Patterns can be a Reversal, or Continuation Pattern. Volume plays an important role in further strengthening the signals derived from Candlestick Patterns. In seeking a volume confirmation, we always expect to see a convergence of Price Action and Volume.

For Candlestick Reversal Patterns, Volume on the candle itself or the next few candles is crucial to confirm the strength of the signal. We tend to look for high volumes in Candlestick Patterns as a strong signal confirmation. Subsequent price movements will most likely follow the direction of what traders/investors are more interested in. If the reversal candles receive more interest than the prior candles (high volume), then most likely, the bullish or bearish reversal signals generated are genuine ones.

Illustration (iii) : WCT - High Volume Confirmation

For Candlestick Continuation Patterns, Volume is almost associated with breakouts. Upon breakouts, high volume would confirm the success of the signal, with very little chances of the price falling back to the support/resistance.

[Note: We will discuss more on Candlestick Continuation Patterns in future Discussions]


VOLUME AND SUPPORT & RESISTANCE

As the price approaches support and resistance, most trader/investors will buy, or sell the stocks accordingly. While prices tend to range within the support and resistance, there are instances where such supports and resistances are broken, and the price then goes on a rally or dip. Volume acts as a useful indicator to hint such potential breakouts.

Due to the fact that support and resistance are hard to break, it is understandable that in order to break them, huge convictions must be in place. When a lot of traders/investors are interested in a price surge or dip, the probabilities of such support and resistance of being broken are greatly enhanced.

Illustration (iv) : WCT - High Volume Resistance Breakout

VOLUME AS CRYSTAL BALL

Volume, being magical as it is, may bring early signals of an imminent huge movement. This is particularly important when it happens on the intra-day chart. When traders/investors see a sudden volume spike in the charts (be it intra-day or daily chart), and there are no significant Price Actions on that candle, then traders/investors must be prepared for a potential big movement. It could mean that someone could be accumulating at that point of time, knowing that the price may surge or decline soon.

As the saying goes, "Volume Precedes Price".

Illustration (v) : FKLI 5-minute - 23/02

Illustration (vi) : FKLI 5-minute - 24/02

Illustration (v) and (vi) shows FKLI futures 5-minute intraday chart. The futures index made a sideway move. A significant spike in volume occurred but there were no significant Price Actions (candlesticks showed a doji). This gave a signal that the sideway trend was about to be broken and a huge movement is following up soon. True enough, FKLI futures made a breakout in the next few candles. This indication showed us a signal minutes before the breakout happened.


VOLUME BLOWOFF!

In a trending market, a sudden spike of volume may not necessarily signal trend continuation. Most of the time, when the volume spikes to an extreme high, accompanied by significant Price Actions, it may signal the end of the trend. Let me show you an example. Study the illustration below.

Illustration (vii) : OSK - Volume Blowoff

OSK made a sudden high on 06/01 with and unexpected surge of volume. Following that, the price went on a downtrend. This is due to the fact that during the extreme volume hike, those who wanted to buy the stock have already done so, now leaving only the sellers. Therefore, with supply more than demand, the price fell off its balance and made its way south.


In addition to candlesticks, traders/investors must also utilize Volume to assess the reliability of signals disseminated from the candlesticks. Volume, on its own, may not tell us much. Candlesticks, on the other hand, lack reliability. Combining volume and candlesticks would complement both tools' weaknesses, and at the same time, forging yourself a strong weapon for your trading success.

Happy Charting for the week ahead! Thank you for patronizing tlsinvestor.blogspot.com!

C.ky Series 4 : Proof of the Pudding is in the Eating

Proof of the pudding is in the eating. This idiom means that something can only be judged when it is tested or by seeing its results. So I am going to share with readers one of the successful fundamental techniques in investing used widely by many well-informed, professional investors.

There are many methodologies one can use to pick stocks. One of the methods that I am using is called the Top-Down Approach.

This method believes that the economic environment and industry performance influence the share price and its return. So, in picking shares, we first analyze the economy, then choose the industry and finally, select the company.

In October 2010, emerging markets were recovering well after the world’s economy was battered by the subprime loan crisis originated from US. As the economies in East Asia were recovering faster, it was a good time to invest in those countries. During this period of time, I had some funds to be invested. I started to analyze which industries will perform better with the economy cycle on the upswing in Malaysia. I narrowed down the industries into a few and one of them was the oil and gas sector.

 

The oil price dropped sharply (from the high of U$145 per barrel to US$30.28) during the economic crisis and investment activities in this sector also slowed down. However, when the economy picks up, the demand of oil and gas will rise and the price of oil will start to rise too. Companies will invest more in oil exploration activities as it’s more profitable to do so as compared to when the oil price was lower. These investments will create multiplier effects and benefit oil and gas related companies that provide support services.

 

There is a number of oil and gas related companies in Malaysia. I did some analysis and finally picked the Dialog Group Bhd, one of the leading specialist technical services providers to the oil, gas and petrochemical industry. I invested in the shares at RM1.20 in October 2010. I hold some shares for long term investment and some shares for short term trading purpose.

 

Why did I pick the Dialog Group Bhd? The main reasons are:

1. It is not a neglected stock (It’s popular with analysts and fund managers). Neglected stocks are good companies that are not in the radar of most investors thus it’s harder for the price to move up.
2. Excellent past management track record. 
3. Good financial results, these include good ROE for the past 3 years (2008: 19.9.3%, 2009: 20.87%, 2010: 24.42%), high Altman’s Z-Score, reasonable gearing (low financial risk) and good liquidity, amongst many other indicators)

So, with economy improving, the rising oil price, increasing investment in the oil and gas industry, and a slew of positive news and contracts awarded, it’s not surprising that Dialog Group Bhd share price increased almost 100% in just four months. I made some handsome realized gain and substantial unrealised profit in the past 4 months. (The price on 18 Feb 2011 was RM2.31)

 

This company is one of my most successful stock picks in recent months based on the Top Down Approach. Though the price has almost doubled, I am still holding some of the stocks as I think there is further upside potential.

 

 

[Disclaimer: This article serves an educational purpose and in no way, constitutes to a recommendation to buy Dialog Group Bhd shares.]

Discussion 9 : Engulf the Trends!

Have you ever heard of this man named Munehisa Homma? Allow me to briefly introduce him to my readers in these opening few paragraphs of this Discussion.

If we study the history of Japanese revolutions, we would definitely come across writings relating to a 100 year which the revolutionists and historians call the "Sengoku Jidai", which literally means, "Age of Country at War". Unifications of over 60 provinces under one power (government) took place during that time (years 1500 - 1600).

After the "Sengoku Jidai", Japan is under the rule of Tokugawa Shogun. The country, at this time, is said to be in the Tokugawa era. With the centralization of feudal systems led by Tokugawa, Japan gained economic stability and had then resulted in growth of the agrarian economy, as well as improving ease of domestic trades. This introduction forms a national marketplace and, by the 17th century, replaced the conventional isolated and local marketplace concept.

As there was no currency standards in place at that time, rice became the de facto medium of exchange. The Dojima Rice Exchange was institutionalized in late 1600s in Osaka. The exchange deals with actual rice until 1710. After 1710, rice coupons were issued by rice warehouses. Since then, rice coupons were used as medium of transactions. Later, rice coupons were raised for crops that weren't even harvested yet! This, somehow, became the first kinds of "futures contracts" in the world!

In 1724, Homma was born to a wealthy family in Sakata, and inherited his family business in 1750. It was during that time that he developed a technique to trade in the local rice exchange, and subsequently amassed a huge fortune enough to trade "rice futures" in the Dojima Rice Exchange in Osaka. Using the same technique, he then moved on to conquer the regional exchange in Edo (now Tokyo). After making 100 consecutive successful trades, he retired and joined the government as a financial consultant. He was then later honoured with the title of 'samurai' before passing on his life in 1803.

The technique Homma used to achieve this huge financial success is none other than the Candlesticks that we use in Technical Analysis (TA) nowadays. Up to approximately 25 years ago, this technique was unknown to the western hemisphere until Steve Nison, the father of Candlesticks, wrote the book "Japanese Candlestick Charting Techniques".



ENGULFING SET
One of the candlestick patterns that I introduced to my readers in Discussion 4 (Part 2) is the Engulfing Set. As we know, the Engulfing Set consists of Bullish Engulfing and Bearish Engulfing. They are illustrated as one candle eclipses or engulfs the previous day's candle in opposite colour. Please see illustration (i).


Illustration (i) : Engulfing Patterns



PSYCHOLOGY
Consider the example below:

Illustration (ii) : Bearish Engulfing - John

John bought a stock at RM0.70. The price then went on an uptrend. On the 4th day, the price opened at RM0.90 and closed at RM0.95. On the 5th day, the stock price opened at RM1.10 (this is what we call a price Gap Up). Then, he sold his house and car and buy more into this stock, thinking that it is bullish. At the end of the day, the stock price closed at RM0.85. This completed the Bearish Engulfing Pattern.







Illustration (iii) : Bullish Engulfing - John

For the next 4 days, the price came tumbling down. On the 9th day, the price opened at RM0.60 and closed at RM0.55. On the 10th day, the price opened at RM0.40 (price Gap Down). John could no longer contain the fear inside him, and he sold off his entire holding at RM0.35 (bid price). He then jumped off the building on the same day at 5pm, after seeing the price closed at RM0.65. This completed the Bullish Engulfing Pattern.

(Note: Gaps are strong bullish or bearish signal, depending on the prevalent trend.)

Notice that in the event above, as the price rode up the trend, buyers were euphoric. The filling of the Gap Up, which subsequently went on to form the second black candle in Bearish Engulfing Pattern, tells us that the S&B Money considered the price was at the top, and that they greedily took profits. Seeing that the price moved so low to fully discount the profits earned on the first day, uncertainties strike investors.

(Note: "Filling of Gap" means the gap is closed by subsequent price movements during the day. For instance, the price closes on Monday at RM1.00 and opens at RM1.20 On Tuesday (Gap Up). During the day, the price then traded lower from RM1.20 back to RM1.00. The Gap is now filled.)

As the stock moved down, other investors started to sell in panic. As the price moved to a ridiculous low, even the most stubborn investors, such as John, began to feel defeated and started to sell in distress. The S&B Money then came back to grab at the low. This was signaled by a ridiculously high buying sentiment, moving the price higher to make up the previous day's losses (Bulling Engulfing Pattern).



ENGULFING - HOW TO USE
They are rather easily recognizable. One candle must eclipses or engulfs the candle of the previous day with an opposite colour.


What is the Trend?
Again, you must identify that the Engulfing Pattern in play is a Bullish or Bearish one. Remember that Bullish Engulfing appears only at the BOTTOM of a downtrend, while Bearish Engulfing appears only at the TOP of an uptrend.


Seek Confirmations
Most of the time, the second candle would have already acted as a signal confirmation. The first candle will most of the time be a single candlestick reversal pattern such as Hammer or Doji, or part of a three candles reversal pattern such as Three Black Crows or Three White Soldiers.

The question here is how strong the confirmation is. I usually look at three things : Volume, Support & Resistance, and Momentum Indicators (MIs).

Volume: Preferably high, but volume may not be high for Bearish Engulfing.
Support & Resistance: Engulfing Pattern should form at or near, Support or Resistance.
MIs: Prices should preferably be trading in overbought or oversold region.

What if the confirmations of the second candle aren't convincing? Wait for another day then!


Illustration (iv) : GAMUDA



Illustration (v) : SALCON



Illustration (vi) : MAYBANK

Illustration (iv) and (v) show recent movements in GAMUDA and SALCON that featured the Bearish Engulfing Pattern.

Illustration (vi) backdates MAYBANK to late May and mid August 2010 which showed a requirement for another day of confirmation due to the lack of strength of second candle.


Ignore Shadows in Recognition



Illustration (vii) : Western Bar vs Japanese Candles

Perhaps one of the most difficult recognition issues of Engulfing patterns is its shadows. Many Western traders recognize Engulfing when the body of the second candle engulfs the high and low of the previous day. This is due to the fact that this candlestick pattern is very similar to the "Outside Reversal Day" pattern in western bar charts that Western traders relied on prior to the introduction of Candlesticks some 25 years ago.

In Japanese Candlestick patterns, the requirement for it to qualify as an Engulfing pattern is the body of the second day engulfs the body of the first day. This makes most trend reversals to be identified quicker and timelier compared to the conventional "Outside Reversal Day" pattern. Study illustration (vii).


Gap Means Strength!


Illustration (viii) : Gap Engulfing

Some books write on Engulfing patterns to involve a Gap Up or Gap Down in price when the day opens. In my opinion, such gaps are essential to measure the reliability of a reversal signal. When a Gap occurs, it shows that the market sentiment is either very bullish or bearish, depending on the prevalent trend. When such gap is filled and then subsequently closed lower/higher than the previous day's close/open, it sends out an even stronger sentiment that trend reversal is now taking place with conviction.

However, this doesn't mean that a Gap is a must! An Engulfing Pattern is formed when the second candle fully eclipses or engulfs the body of the previous candle with opposite body colour. A Gap only strengthens the signal further!

(Note: We will cover more on Gap Analysis in future Discussions.)


Engulfing Support (ES) and Engulfing Resistance (ER)
Engulfing Patterns could give birth to a strong Support or Resistance, depending on the prevalent trend. The general rule is, the longer of the shadow or body (if the Engulfing Pattern doesn't have shadows) of the two candles would be the trend's Support or Resistance.


Illustration (ix) : MAYBANK - Support & Resistance



Illustration (x) : 1 minute FKLI

Illustration (ix) shows ES and ER that occured in MAYBANK that was backdated to late October and Early November of 2010.

Illustration (x) shows the FKLI futures 1 minute intra-day chart which took place this afternoon (11 February 2011).

Although this is commonly seen in the US market, ES and ER don't seem to work very well in KLSE. They are rarely tested and are rather easily broken by price surge. Having said so, traders should nonetheless be aware that Engulfing Patterns are extremely reliable in identifying trend reversals, although they defend their Support and Resistance levels poorly.



A smart trader would always trade when the stock price is trending. Therefore, knowing how to use reversal patterns would further enhance the chances of betting on the right animal. As the legendary trader Jesse Livermore says,

"There is only one side to the market... not the bull side nor the bear side, but the right side!"

My appreciations to my readers for your attentions. May the new Rabbit year leaps your wealth higher in the stock market!

Happy Charting!

C.ky Series 3 : Shares : A Gamble, a Trade or an Investment?

Gamblers are speculators that buy shares without understanding a company. They buy shares based on hearsays, rumours, recommendations from brokers or friends, hoping to ride on some good luck to make quick profits from the stock market. They totally don’t understand share analysis techniques, the economy nor the company itself!

A trader on the other hand, would be a person who uses the shares/stocks like business inventories. He/she buys shares at a lower price and sells them at higher price to pocket some profit. Just like what a normal merchant does, buying and selling goods (in this case, the shares). A trader normally uses some kind of stock analysis techniques such as technical analysis (using charts to predict share prices) or fundamental analysis (a technique including understanding a company’s strengths and weaknesses to derive at an estimated price of the company), to trade shares.

For an investor, buying shares is investing in businesses. I don’t have the capital and license to start a bank in Malaysia, thus to get into banking business, I buy shares of banks. I don’t own land for plantation to produce crude palm oil, so I purchase shares of plantation company. I don’t have model and technology to explore oil wells, therefore, I invest in shares of an oil and gas related company. I can’t start a telecommunication company to provide broadband and telephony services, so I hold shares of such company. I don’t have the time and resources to get a KFC franchise, I opt to buy KFC shares. All these made me part owner of bank, plantation, oil and gas, telecommunication and fast food businesses.

Buying shares is very easy. The question is: What shares do you want to buy?

To an investor, the logic is simple. You don’t want to start a business where the future prospect is not good or where there is no demand for your product/service. You want to get into a business where people are satisfied in using your product/service, and will continue to buy and use your company’s product/service for a foreseeable future. Are there demands for your product/service? Will your product/service become obsolete? Will your business model become outdated? Is there a growing market for your product/service? Will your product be too dependent on a single supplier or single group of customers? These are some important questions that you need to ask and answer before you start a business. So, the same concepts apply to investing in shares.

One of the companies that I have invested in is the Axiata Group (Celcom). One of the main reasons I bought this company's shares last year is that almost everybody uses telephony services and internet. With the smart phones getting more popular and the booming of the young, technical savvy generation, there will be more demand for these services. Besides that, Axiata Group has not only well established itself in the Malaysian market (ranked second after Maxis), but also has marked its presence in the important, growing, huge market of India, Indonesia, Sri Langka, Bangladesh, Cambodia, Pakistan and Singapore. Everybody will still be using mobile phones for years to come, with phones getting smarter and smarter. Many people just can’t live without this gadget! So, the demand for telephony and internet services should be growing. It’s good to be in such business.

In short, buying shares can be a form of gambling, trading or investing. I am an investor. What about you?

The purpose of this article is to share with readers the simple logic and reasoning of investing in shares. However, there are many other factors that we need to consider before investing in a particular company. It’s my interest to continue to share with readers other investment pointers in future postings.


[Contributed by C.ky]

[Disclaimer: This article serves an educational purpose and in no way, constitutes to a recommendation to buy Axiata Group or KFC shares.]