People have drawn up charts for as long as they have used numbers. A chart presents information in a way that is instantly understandable; it is a pictorial description of a numerical reality.
And, of course, a chart can illustrate trends, either up or down, in the price of a financial security.
This would be of interest to traders and investors under any circumstances. But it is vitally important for those traders who use charts to guide their market strategy and even more so for those whose strategy is dependent on taking action, either buying or selling, informed by charts.
Trends are key
But while a swathe of traders agrees on the key importance of charts, there is rather less concord about the optimum types of trading charts to use, and still less about the best way to interpret what the charts seem to be saying.
For the beginner seeking to learn trading charts, this can appear a bewildering world of “candlestick charts”, the “evening star” and “reverse flag patterns”. But there is no reason to be daunted by what can be a fascinating and rewarding field of study.
Begin with the most basic type of chart imaginable, a straightforward graph created by linking a series of dots. The vertical axis measures the price of the security in question while the horizontal axis gives the time period over which the price movements occurred – hourly, daily, annually or whatever best suits the trader’s purpose.
Usually, the price points will mark the price at which the security closed, this being the most relevant figure in terms of gauging what was the result of the day’s activity.
In a word, trends. Simply stating that, for example, sterling ended the week at $1.30 gives no indication of the direction of travel. Has it surged from $1.20 or tumbled from $1.40?
Virtue of simplicity
Now, there is a school of thought that states that it doesn’t matter, that the pound has no “memory”, does not know where it has been or where it is going. But it is fair to say that any trader holding such a view would probably not spend too much time with trading charts.
Those in the business of understanding trading charts will be looking, at the most elementary level, for evidence of momentum, whether upwards or downwards. They will be looking for both floors and ceilings in terms of the price, the former being the level at which the security finds support in the market and the latter referring to the level at which the security runs into resistance from investors and traders.
This very basic chart has the virtue of simplicity. But it has one big drawback, which is that, by employing only the closing price in each time period, it tells traders nothing about how the security behaved during the trading session.
For that reason, many traders prefer one or other of two more sophisticated types of trading charts: “bar” and “candlestick”. Both are designed to contain valuable information about the price action during each trading session, rather than simply at the end.
Of the two, bar charts tend to be the less complicated, thus are popular with very many traders. The “bar” will display the following information: where the price opened, where it closed, its low point during the day and its high point.
By definition, if a bar chart shows a closing price that is higher than the opening price, then the security made gains during the trading session, and vice versa.
Candlestick charts are very similar but can seem a little overwhelming to those seeking to have trading charts explained. In part, this can be traced to their physical appearance, complete with colour coding.
A candlestick chart, as the name suggests, depicts the price performance of a particular security using a design shaped like a candle. If the security gained in price during the trading period, the closing price will be at the top of the candle and the opening price at the bottom. If it has fallen in price, the close will be below the opening level of the security.
At either end of the candle there can be a “shadow” that looks a little like a wick, representing the highest and lowest prices seen during the trading session. There will be no lower shadow if the security closed at its low point and no upper shadow if the close was at the high point.
In cases where the security gained during the session, the candle is usually coloured either green or white and when the security has fallen it is usually coloured red or black.
For the novice trader, all types of chart-watching can seem complicated and involved, but candlestick charts may come over as especially so, not least because of the jargon employed to explain what the chart is telling us. Thus the “evening star” mentioned earlier describes a three-session pattern in which the security makes gains in the first session, initially gains in the second but loses ground in the third.
Whatever type of chart you choose – line, bar or candlestick – the big question has to be whether any of them actually works in terms of improving trading outcomes. After all, if they were sure-fire guarantees of trading success, surely everyone would be using them?
There is certainly a school of thought that says they do not work other than in that, if a lot of people believe that other market players will use them, then the chart patterns can become a self-fulfilling prophecy. And it is true that the past – or even, in the case of more sophisticated charting software, the present – is not always a reliable guide to the future.
Defenders of charts point out that they show how real traders behaved with real securities, as opposed to how financial analysts and other experts thought they ought to have behaved. Furthermore, they say, there are trading patterns and these can be understood.
On that note, good luck with your charts!