Using charts as criteria for buying and selling stocks is foolish. Charts give a lot of information on where you are but give little information on where you are going. Humans innately look for patterns even where there are none, and just because a pattern resulted in a certain price movement in the past does not mean it will repeat the same way again. Good stock selection starts with good fundamental analysis of the company. Still, there is some merit to using charting once you have selected a stock to buy for setting a buy price. The same techniques can also be used to determine a good exit point if the fundamentals of the company you have purchased begin to change or you just need to raise cash for some purpose.
Continuing the series of posts on how to use charting in your stock trading, today I’ll discuss how to use charting to determine how to set a buy or a sale limit price for a stock. To see the start of the series on charting, go here.
In previous posts I discussed floors and ceilings, as well as trends. As said, floors tend to offer support for the price of a stock, particularly if the stock price has bounced off of that floor several times. The reason is that people trying to value the stock tend to see the fact that the stock tends to trade no lower than a certain price to indicate that the floor price is at the low range for the stock.
Likewise, if a stock has traded within a given range for a long period of time and then drops in price, a lot of people will have bought the stock while it was trading within the upper range. these individuals will sell the stock as it gets back to that price again since they’ll want to get out without a loss. They also will begin to think that it is unlikely to go past the ceiling price because it did not in the past.
Realize also that there is a fair market price for a stock at any given time. This price is based on the expected return which is a function of future earnings and the risk of the company not meeting those future earnings. If a stock drops too far in price below that fair market price, it will be bought up by value investors who recognize the bargain price. Likewise, if a stock moves too far above that fair market price, value investors will sell the shares, rightly seeing that the potential return on the stock is no longer worth the risk.
To use a floor in setting a buy price, first determine a round number around the average price of the floor. No calculators are needed here – just eyeball the chart and round to the nearest 1/2 dollar.
Next, pick an odd amount somewhat above the average price. For example, if the floor price is $21 per share, you might pick $21.07 as a buy limit price. The reason to pick an odd value goes into the way order are executed. If a trader enters a sell order at the market, the brokerage house will match it with a corresponding buy order with the highest offer price. If there is more than one order at a given price, the first order at that price is executed first.
If you were to set a limit price of $21 even, there would probably be a lot of other buy orders at that price. Even though the stock trades at that price, your order may not be executed. By setting an odd number for a limit, it is unlikely that there will be other orders at the same price. By setting a price above the floor price, it is more likely that yours will be the high offer.
Placing a sell price is exactly the same except you would set a price just below the ceiling price. Use caution, however, when setting a sell limit because if you miss it, you could see a lot of your profit evaporate as the stock falls in price. When it is time to sell, it is often wise to simply enter a market order and get out.
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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.