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Intro to Chart Analysis

by | Nov 24, 2021 | Strategy, Uncategorized

Intro to Price Charts

Stock charts are simply a collective visual representation of all participants in the market and their actions displayed through supply and demand of the underlying stock. Since price does not lie, then understanding how to read a chart and analyze its behavior is a great way to evaluate what the stock is trying to do and thus the emotions of all trading participants in the market overall. Trends can be revealed simply by drawing trendlines or using moving averages on a chart and whether it is minute chart, daily, weekly, or monthly chart you can analyze a chart pattern the same way because it tends to repeat over time. Fear and greed are two emotions that are as old as the markets themselves and by looking at a chart to depict the angle and velocity of a trend you can determine what is likely coming next. 

Finding Your Timeframe

The chart timeframe you focus on should depend on what kind of trader or investor you are. I think it’s important to look at multiple timeframes no matter what. Traders usually focus on daily charts and intraday charts to determine short term trades. However, the shorter term the chart timeframe, the more susceptible it is to noise. Being able to understand the big picture trends to the short term wiggles separates the best traders from others. The forest from the trees approach is a good way to say it. The larger time frame trend dictates the short term moves in markets. Investors usually will focus more on the weekly and monthly charts to spot trends and participate in long term price moves. With weekly and monthly charts, there is only one candlestick formed per week or month. This cuts down on the noise factor and often results in cleaner trends and decision making on the part of the investor. Combining multiple timeframes is also a good method to use for drilling down from long term trend to shorter term patterns within the trend. If you are a longer term investor, focusing on the monthly charts for trend and then zeroing in on the weekly chart is a good way to pinpoint entries and exits within that long term trend. If you focus more on swing trading several days to a few weeks then perhaps taking your trend signals off the daily chart works and watching the 60 minute or 2 hour chart for more of a swing trading entry point timeframe. 

Types of Charts

There are many methods of charting out there but a few of the most popular are line charts, bar charts, and candlestick charts. The latter of which is what I prefer and have used for many years. Many investors consider the closing price the most important because that is the final price of that time period that buyers and sellers agreed on. There is a lot of noise intraday with volatility and wiggles in price but the close is where the rubber meets the road. By focusing on the closing value of a stock, intraday swings can be ignored if you are more of a longer term trader. For this data it can be beneficial to use a line chart which only plots the closing price of each period.

Line charts are useful more for if you only care about the closing price of a product or a comparative chart. For example if I wanted to set up a pairs trade between the Nasdaq and the Russell I might look at a chart of the QQQ-IWM. This pair would look too noisy using a candlestick chart so a simple line chart might be cleaner. Or comparing gold to silver with a ratio chart could be useful to look at using a line chart. The QQQ chart below shows that a line chart simply plots a continuous line based on daily closing values.

Bar charts are similar to candles but they just form thinner vertical bars and essentially show the same information, the open, the high, the low and the close for the time period. The high and low are shown by the top and bottom of the bar and the open price is displayed on the left of the bar with a hash mark while the closing price is on the right side of the bar. A bar chart is a more minimalist way to display price action and takes up less space on the chart as well. Also you can often make the colors of these bars neutral so the trend of the bars is what stands out more. Being able to see how a bar chart is shaped or where it closes in relation to its open is a useful way to gauge how the market traded that day. 

The candlestick chart is probably the most popular and has many uses. As shown below, the candle has a body which is either solid or hollow depending on where the open and closing price is situated. If price closes above the open, then most charting software will paint a hollow candle or sometimes filled with green. If price closes below the open then there will be a solid candle or red in color showing that sellers took control of price during the session and closed below where it opened. The high of the candle is shown with the wick of the candlestick at the high and similarly the low price of the day is shown by the price low in the lower wick of the candle.

In the AAPL chart below you can see how these candles form a price chart which visualizes the trend of the stock over a specific timeframe. These daily candles tell a story. Specifically in mid September 2021 where the arrows show a large body candle that opened higher but was sold lower throughout the day creating a solid body red candle. Sellers were clearly in control on this day driving AAPL lower in price and closing on the lows. Many traders think that candlesticks are easier to read at a glance and especially in relation to the open and close price levels because the body of the candle is a great visual. The rectangular body portion of each candle essentially illustrates who was in control of prices during that time period. If the body of the candlestick is wide and long ranging it was a day characterized by trending action from the open till the close. If the body is more tight and narrow, often called a doji candle, then the day was range bound price action and buyers and sellers played a sort of tug of war since prices stayed sideways. Using inside candles is another way to identify when a stock was quiet and inside of its previous day’s range. That topic is for another post but in general smaller range candles show indecision between traders while wide range candles depict a more agreed upon price expansion since its moving in one clear direction during that time period, whether it be the day, week or month.

Price Scaling

The final basic concept to cover in regards to chart analysis is price scaling and whether the chart’s y-axis  is using an arithmetic price scale or a logarithmic scale. This just simply means how the prices are displayed in the space provided. An arithmetic scale shows 10 points of range as the same vertical distance no matter the price level. If a stock rallies from 20 to 100 in 1 year, the move from 20 to 30 will show up the same as the move from 90 to 100 was. Even though the point move was the same, the percentage move is very different.  Arithmetic scales are useful for short term charts and swing trading smaller price movements. Log scales are more useful when the price has moved significantly as they put large movements into better perspective. 

Often for longer term charts or large advances in price its best to use a log scale chart which measures moves in percentage terms. A move from 20 to 30 in a stock represents a 50% advance. A move from 50 to 100 also shows a 50% increase. Even though these moves have different price total movements the percentage moves are the same. Since they are the same percent moves they would show up the same way on a log scale chart. The charts below show the same stock of TSLA and its wild advance throughout 2020-2021. You can see the arithmetic chart shows the absolute price movement and each 100 point move looks the same but in percentage terms the moves were quite different. The second chart shows the logarithmic scale chart which takes into account the percentage change and the weight of a move from a lower price is more significant since it results in a larger percentage gain. It’s up to the trader and personal preference on which to use but it comes down to timeframe. The longer term focused you are, the more beneficial a log scale chart will be since most of the time returns of a stock are judged based on the percentage it returns during a specific timeframe.

 

Takeaways:

  • Many different chart analysis methods are available out there but finding the one that works for you and sticking with it is the best course of action. 
  • The way a chart is displayed does not matter as much as how the analysis of the price action is performed by the trader. Successful traders keep an objective view of all chart analysis and understand that anything can happen at all times. 
  • Finding your timeframe that works for your goals and personality is important as then you can focus on dedicating your knowledge to continued development.
  • Once you find a charting method that fits you, sticking with it and not going back and forth between methods or timeframes and indicators will promote consistent habits.