In this second installment on how to chart stocks, we’ll discuss ceilings and floors. These are patterns of interest to those who chart stocks, and therefore have an effect on the psychology of the market. To see the start of the series, go here.
The first pattern is a ceiling. When a stock attains a price point and then falls from it – particularly when it stays at that upper range for a while – it is called a ceiling. The longer the stock stays in the upper range, the stronger the ceiling becomes. The significance of a ceiling is that it becomes an effective upper limit for the price of the stock. The reason is that people think the stock is expensive if it approaches the ceiling price because last time it traded there it sold off. In addition, if there are a lot of people who bought shares at the ceiling price, they may sell off if the stock gets near that price again because they feel like they are getting their money back. The longer the stock stayed at that level, the more people bought at that price, and therefore the more people who are ready to head for the doors if the stock reaches that level again.
An example of a ceiling can be seen in the late July/early August period on the candlestick chart for BJ’s Restaurants, International. Note that the stock reached a new high of about 56, then fell back down to the low 40’s. A ceiling then existed at around $56 per share. Note that when the stock rebounded several months later, it touched the ceiling and then fell back.
A floor is the exact opposite of a ceiling. It is a price at which the stock traded for a while before moving up in price. Once again, the longer the stock stays at that price, the stronger the floor becomes. This is because people begin to think of the floor price as a fair price for the stock. After all, if it traded there for a long time they are used to it being at that price.
To look at a non-market example, think about the price of a can of Coke in a vending machine. For a period of at least 15 years the price was 50 cents per can. People therefore expected a can of Coke to cost 50 cents in a vending machine. If the price is higher, people would feel it was expensive (like a $1.50 Coke at a Disney World hotel). Likewise, if the price were less than 50 cents, people would see it as a bargain.
Stocks are just the same way. If GE normally trades between $20 and $25 per share, people would think of that as a fair price. If the stock falls to $18, it would be seen as a bargain and people would be ready to scoop up some shares.
Looking at the BJRI chart again, notice that the stock hit about $40 per share, then bounced back. It did this two more times before finally moving back up. A floor of about $40 therefore exists for the stock. Note also that whole numbers of dollars and especially round numbers like $40 are especially powerful price points because people tend to set values at whole numbers. Think of the $7.99 meal.
If a stock moves above a ceiling it becomes a new floor, and likewise, if it falls through a floor it becomes a new ceiling. If BJ’s were to fall below $40, that would be a good indication that the stock was suffering a serious selloff and was likely to go much lower. Looking further back in its price history, it looks like the next floor is at around $35 per share. If you were short the stock and saw it drop below $40 per share, putting in an order to cover the stock at a little about $35 would be a good idea. (Here again, remember that people like round numbers, so if you put in a cover order at $35.26 you would be more likely to be the only one at that price and therefore ahead of the crowd than if you put it at $35.25 or even worse, $35 even.)
So, let’s see how to put this knowledge to work. Let’s say that you had $5000 to invest and were interested in getting into BJ’s restaurants. (First of all, you would look at the PE of 50 and say “Whoa, that’s way to pricey,” but let’s say you aren’t one to worry about the fundamentals.) Looking at the 6-month chart, you would see that the stock created a bit of a recent floor at around $48 per share, and a larger, more stable floor at $40 per share.
If you were really excited about getting into the stock, or you didn’t feel like spending a lot of time waiting, you could place a limit order to buy 100 shares at maybe $48.17. Make the order “good ’til canceled,” and the order would stay there until the stock retreated enough to hit your limit or 30 days passed and the order was cancelled. If you were less eager to get in, you could place a buy order at $41.32 or $40.62 and wait a bit longer, hoping that Greece will threaten default again and cause the stock to sink.
In the next post in the series, I’ll discuss trends.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
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