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How do stocks work?Another way to ask "how do stocks work?" is: What makes stock prices move? This is a general understanding that is needed for a trader. He can’t plan his actions without it. The "how do stocks work" chapter will analyze what force moves the stock price and then further our understanding of how to apply it to real trading. We usually say that the buyers move the price up and the sellers move it down. It seems obvious but many still ask the following question: Since every trade is a buy and sell at the same time, why does it affect the price? The difference is, which market participant was actively trading. Only active market participants can really move the stock price. If the buyers are active, they are hitting the ask, bidding a stock up and chasing it higher. In this case, we would expect the stock to move higher. If the buyers are passive, they are sitting on the bid, willing to buy only if the selling is not too active and ready to drop the bid lower if selling increases. This type of buying won’t cause the stock to move higher. The same applies for the converse case of selling. If active selling came about where sellers were hitting the bid sizes while lowering their ask price, the stock would most likely move lower. Therefore, price movement is a matter of confidence and beliefs in different market participants that determines the supply and demand ratio. Obviously, stocks do not go straight up or straight down! Therefore a trader needs to learn how to determine the points, when the stock will reverse in direction in order to capitalize on such an event either with an entry or an exit. Suppose a stock price started to rise because the buyers strongly believe it represented good value at the current level and should trade higher. Sellers consequently are willing to lift their offers because they are convinced by increase in buying pace that the current price level is too low and the stock can be sold higher. At some point, we can see how this set of beliefs changes. The buyers start to doubt that a stock still has a significant upside and want to take their profits. The sellers doubt they can sell a stock higher and start to increase selling pressure. As a result, the stock is showing a possible turn. So how do stocks work? What affect how high or how low they go you ask? A number of factor affect the amplitude of the price per share variations and two very important concepts are: Price resistance/support and Volumes We will start by looking at price resistance and support: There are many different forms of support and resistance: -Historical highs and lows -Price moving averages -Fibonacci retracements -Moving averages ( especially the 200 MA ) -etc... Those are all technical forms of support and resistance. There is another very important form of support and resistance: The support/resistance thru whole numbers in the stock price, i.e. $0.5, $1, $5, $10 etc. This form of support/resistance is of psychological nature. Image you are buying a stock at $55 and it is going to almost $100; wouldn’t you be very inclined to take some of your profits there? I am using whole numbers as areas where I take profits and areas where I place my stop. Sometimes I even consider them more relevant than technical stops, i.e. I buy a stock above $50.75 and my technical stop is at $50.25; in this case I would rather set the stop to just below $50, because chances of getting stopped out are much smaller than with the technical stop. Make sure to also consider $0.50 steps especially in stocks priced under $20. Now the "how do stocks work" chapter will dive into a very important concept: Price volume studies: There is a close connection between price and volume. It is important for every trader to understand at least the basics. Generally speaking, increasing volume indicates a trend continuation and decreasing volume indicates the end of a trend or a reversal. Lets have a look at some more detailed scenarios: 1. A price advance with steady increasing volume indicates continuing upward momentum. As the price is climbing, more and more buyers are getting attracted until the stock gets into a stage of euphoria that usually indicates the end of the price advance. 2. A slowing pace of buying with decreasing volume indicates that the top is near. This is also referred to as buying, that is drying up. It has two possible outcomes: a) Sellers realize that the top might be near and start selling, causing the stock to reverse lower. b) The stocks starts consolidating and gets supported by strong bids, which indicates that a move higher is likely later. 3. A relatively big volume increase during the price advance with lower volume on the pullback indicates a continuing uptrend. The lower volume during the pullback indicates that there are not enough sellers in the market to drive the stock down. 4. Big buying volume without the price going higher indicates distribution, which means resistance. A big seller is likely in the market. There is no way to tell yet if the buyers will win this battle and are able to drive the price higher, or if they will give up and the stock eventually reverses. 5. A slow and steady movement upward with consistent volume indicates continuing upward momentum. There might be a buyer in the market, who is steadily buying shares, trying not to get too much attention. 6. An extreme acceleration in the price advancing (an almost vertical movement) is usually not sustained and indicates the end of this stage of the move (euphoric stage). This is a very common scenario. The best example is the NASDAQ market itself in the beginning of 2000; you all know what happened. Those stages of euphoria are very important exit signals. They can also present very interesting entry points especially after a stock had a panic sell off. Once again, as promised, I will keep it simple and not bother you with unnecessary fluff and end this chapter about "how do stocks work" now. Now let's move on to the next chapter entitled: momentum trading. 
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