Technical analysis, when understood and applied correctly, is a powerful tool for understanding market psychology and the interplay of supply and demand. These are the fundamental forces that drive stock prices. Let’s take a look at the chart of Amazon.com, Inc. (AMZN), a company that offers a prime example of some key technical analysis concepts.
The $180 level served as a support point for Amazon’s stock price in July. However, the same level has now transformed into resistance. This transition from support to resistance is a common occurrence in financial markets and is often attributed to the actions of regretful buyers. Some investors who purchased Amazon at the support level might have felt remorse when the stock price dropped shortly after their purchase. These buyers, hoping to avoid further losses, may have sold their positions when the stock rallied back to their initial buy price. If a sufficient number of such regretful buyers place sell orders at the previous support level, it can effectively turn it into a resistance level. This is precisely what happened with Amazon.
The Amazon chart also provides a valuable lesson on reversal patterns. Reversal patterns emerge on charts when the market’s leadership shifts from bears (sellers) to bulls (buyers), or vice versa. While these shifts can occur gradually over a prolonged period, they can also happen abruptly within a single day. The Amazon chart exhibits two such one-day reversal patterns. These patterns, known as ‘bearish engulfing patterns’ in Japanese candlestick terminology and ‘outside reversal days’ in Western terminology, are characterized by a dramatic reversal of momentum within a single trading day.
The key to understanding these patterns lies in recognizing the trading dynamics that give rise to them. On the days these patterns formed, the initial trading activity suggested a continuation of the recent uptrend. The opening price was higher than the previous day’s closing price. However, by the end of the day, the sellers overpowered the buyers, driving the price significantly lower. The stock ultimately closed at a price lower than the previous day’s open. This ‘engulfing’ of the prior day’s trading action by the current day’s activity is the defining characteristic of these patterns.
New traders often get caught up in the specifics of pattern identification, focusing on whether a pattern is ‘real’ or not. However, the names of these patterns are secondary. The real value lies in understanding the trading activity that generated them. Experienced traders, unlike beginners, are less concerned with the names and more focused on the underlying market dynamics. This is precisely why they are consistently profitable.
