10 Tips for Reading Tape

This column was originally published on RealMoney on Feb. 14, 2008 at 11:22 a.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Pure chart reading can get you into a ton of trouble if you don't take the time to read short-term price action before committing to a new position. Those short-term bursts of buying and selling pressure expose underlying forces that often mean the difference between a vertical breakout and a gruesome failure.

Of course, I'm talking about tape reading, a curious and misunderstood concept in our fast-fingered electronic markets. Despite the strange aura surrounding this subject, all traders with tape-reading experience recognize it's a more valuable tool to their profitability than the most perfect pattern. The reason is simple: the tape never lies.

Sadly, there are few shortcuts in learning this essential skill, so be prepared to spend a very long time building up your tape-reading prowess. Why are there so few good books on the subject? Unfortunately, it's almost impossible to render down years of ticker watching into a few simple observations.

In fact, when students ask me for seminars on tape-reading mastery, I usually tell them to just sit down, pull up a notepad, and watch the numbers for a decade or two. They think I'm kidding, but I'm not. Literally, it takes 10 years or more staring at the shifting numbers to decipher the games played by Wall Street and other ticker-tape participants.

Fortunately there are great ways to speed up this steep learning curve. Start with these 10 tips and techniques to improve your tape-reading skills.

1. The Level II screen tells lies because the vast majority of market size is hidden from public view. But it's still a good place to start your examination of the tape flow. However, when you're tired of staring at the paint job, turn it off and focus exclusively on a simple display that shows only the last price and bid-ask spread .
2. Skilled tape reading depends on a single key observation: Professionals move markets in whatever direction yields the greatest volume . To this end, the most basic order flow manipulates price against the crowd's emotions.
3. The ticker tape already knows the chart. Market insiders push prices toward support and resistance levels to test the waters, trigger the stops and see how much interest they can generate with the public.
4. Filter the tape's message through index movement and market breadth. Look for the ticker to react with surging volume when the indices break out or break down. Recognize that a strong tape rings a loud bell in a weak market, while a weak tape rings the same bell in a strong market.
5. Rapid bursts of activity on the ticker tape reveal greed and fear under the surface. They show you where other traders are committing to the market or getting out in disgust. Look for nervous prints above the offer price during breakouts and desperate prints below the bid price during breakdowns.
6. The bid-ask spread engine expands and contracts as it reacts to shifting market conditions. Look for spreads to widen when neither side wants to make a commitment to the current price.
7. Liquid stocks move in channeled ranges, driven by computerized market-making systems. Ignore oscillations in the middle of these zones, but focus undivided attention on the tape's quality when prices reach the upper or lower boundaries.
8. Look for stock prices to move in lockstep with the index futures at least 75% of the time. The percentage rises during the midday doldrums and drops in the first and last hours of trading.
9. Watch the relationship between the current price and the daily range . This single number, often referred to as "percent in range" can track the progress of an entire watchlist in just a few seconds.
10. Know the fish you're swimming with. Most volume comes from scalpers who push prices in both directions for a few pennies. It's your job to find the whales beneath these minnows that are in real control of the underlying trend.

Finally, here's an observation that will add considerable power to your tape-reading expertise. Look for price action to move in three distinct phases just above resistance or just below support.

1. Excitement driven by the break.
2. The fade against the break.
3. Resolution that confirms the break or triggers a failure.

Most traders focus their attention on the excitement of the break, jumping in when the ticker bursts with buying or selling activity. But this is a good way to lose money. In contrast, tape readers step back and examine the quality of this three-prong conflict, which tells them if the embryonic move is bona fide, or a nasty trap waiting to be sprung.

This column was originally published on RealMoney. For more information about subscribing to RealMoney, please click here.