How to Read Stock Charts

Once you get the hang of reading stock charts, technical analysis allows you to observe a stock's history in a whole new way.

For example, dry bulk shipper Dryships (DRYS) ran up over 1200% from the middle of 2007 to 2008 peaking at $131.48 on 10/29/08. The stock then fell 96% and returned to single digit levels. By applying simple technical analysis, the stock offers a wealth of knowledge valuable for investing in the future.

Commodities were red hot throughout 2006 and 2007 and analysts believed every investor should have exposure to this trend. Like all trends though, the party eventually ended and many market leaders were crushed alongside the overall market.

Referencing the following chart of DRYS, here are five crucial concepts to understand about technical analysis and investing in trends:

1. Trends are fast moving and powerful – The run from under $10 in June 2007 to $131 in October 2008 (1200%+) was no coincidence. Institutions were heavily accumulating this dry bulk carrier as commodities continued to soar. Catch a trend right and the profits can be staggering. Furthermore, never fight the trend.
2. Some technical patterns are prone to failure – This “W” shaped pattern for example was considered a faulty base because the 2nd dip was not lower than the first. This is important as it allows the stock to shake out any uneasy holders before moving back up in price.
3. Heavy distribution or accumulation identifies new trends – The two heavy distribution weeks in May and June 2008 were key turning points for the stock. These reversals signaled the end of DRYS’s rally.
4. Tight price consolidation often signals a big move is coming – For over two months DRYS and other stocks in the same group (GNK and EXM for example) traded sideways in a fairly predictable price range. Once the stock broke down below this range though heavy selling quickly followed. Price consolidations can work in both the bulls and the bears favor.
5. Know when to sell and walk away – Any investors holding onto DRYS shares thinking the stock was going to comeback were in for serious trouble. Buying even at $80 would leave the investor down 90%+ now three months later. Either use stop losses or be disciplined enough to walk away from losers before they get too big.

For another example, this one shows the rise and fall of Travelzoo (TZOO) stock. The stock ran from $20 to $103.80 in less than eight months, then over the next five fell all the way back to its initial price levels around $20.

1. Travelzoo (TZOO) jumped off an impressive earnings release. This was one of the main catalysts that really strengthened the number of institutional investors holding the stock. These institutional investors only further fueled the price rise in future months. Note that TZOO broke out of a four month base in September 2010 (not shown) which was its original foundation.
2. A mini inverse head and shoulders breakout which lead the stock on its parabolic move higher. Key point here was the formation of the head. Notice how the stock broke under its December lows and marked "lower lows". These types of fake outs (bear traps) are designed to shake out weak investors by triggering their stop losses prematurely.
3. The climax top comes as the stock gaps on record volume (up to that point) to fresh 52-week highs. Massive gaps like this one are often marked as exhaustion gaps as they very typically come right before or at the top of parabolic moves. Note, however, there are many other common topping formations; this is just one example.
4. TZOO breaks out of a nice 2.5 month consolidation in expectation of strong earnings, but once released, the stock gapped heavily to the downside on record volume. This was more or less the beginning of the end of TZOO.
5. As the stock declined, you can see how lowers lows kept coming into play and previous support became resistance. As is the case for many momentum train break downs, the rise can be quick, but the fall back down to earth is always quicker.