Technical analysis, in which traders read the stock charts and graphs of a security’s past price levels, is one of those techniques that divides opinion. Adherents insist the price history can be used to identify trends, which, in turn, can be used to predict likely next movements. Charts, they say, show the real state of supply and demand for the security in question.
Critics, many of whom prefer “fundamental” analysis of a security’s prospects, such as a company’s earnings, rather than previous price performance, allege that chart analysis amounts to little more than joining up the dots on a price chart and drawing pretty patterns.
What, perhaps, can be agreed upon is that price data shows the results of decisions that have been taken by real traders using real money. Technical analysts say that patterns can be detected in this data from which conclusions can be drawn.
Spotting the trend
Should you, as a trader, agree, the question is: how to read stock charts and graphs?
The first point to bear in mind is that how you go about reading stock charts and graphs depends to an extent on what sort of chart or graph they are.
The simplest type of chart is one that would be familiar to most people from their schooldays – the line chart. A series of prices is plotted, and a line is used to join them. The prices in question are usually those at which the security, or the , closed, this being the “last word” on the security’s performance for that particular day.
Sad to say, most charts will prove rather more difficult to analyse. What would need to be done is to screen out the “noise” in the chart and focus on the underlying trend. For example, a security may well have put in an apparently-storming performance over the last week, but how does that fit into the bigger picture?
If its recent peak is well below its previous recent high, and the trough that preceded it was deeper than the previous trough, then a strong downtrend would appear to be underway.
The same, obviously, is true of a line in which a recent dip forms part of a generally upward trend, in which each peak surpasses the last and each trough is shallower than its predecessor.
But always bear in mind that shorter-term trends form part of the longer-term variety. Just as last week’s “storming” performance looked rather less impressive when put in the context of a medium-term downtrend, so that downtrend will itself fit into a longer market cycle.
Looking for patterns
How long, or short, ought your reference period to be? That is largely a personal decision, but remember that an excessively short period would deprive you of valuable price data while an over-long period could well load you with too much out-of-date information that could cloud your judgment.
Two, however, may be useful for you. Perhaps the best-known is the “head and shoulders formation”. This describes a reversal of a bullish market trend, as the price is set to come down from the “head” to the far “shoulder”.
Then there is the “reverse flag pattern”, when a price drops sharply, then drifts a little and then partly rallies.
Bars and candlesticks
These two examples underline a key aspect of chart analysis, the spotting of a change in trend. Great efforts are made to use the past performance patterns of a security to alert the trader to the imminence of a change to either an uptrend or downtrend.
Detecting such changes is, of course, a key component of a successful chart-trading strategy.
One such is, confusingly, called a bar chart, but has little in common with the type of graph, whose name it shares, in common use to display information of all types in a series of rectangular boxes, usually of different colours from each other.
A bar chart uses a richer set of data than the basic graph, with opening as well as closing prices and the highs and lows of the day’s trading.
A more elaborate version of the bar chart is the Incorporating the same information as the bar chart, it provides a more graphic depiction. The “body” of the candle is made up of the opening and closing price, while the highs and lows of the day’s trading are the “wick”.
Should the security have closed higher than it opened, the “high wick” will tell the trader how near was the closing price to the high, thus giving an insight into market sentiment. The same, of course, is true of a lower closing price in relation to a low wick.
Should a security close, either up or down, after a trading session in which both the high and low wicks are notably long, it would be fair to suggest the security experienced a volatile trading session.
The value you place on such patterns when you read graphs and stock charts will depend on the significance you attach to intra-day data. Some prefer to stick to closing prices, these being the “settled” value of the security in question. Others believe intra-day activity contains valuable clues to future movements.
In the jargon, is intra-day data part of the “signal”, or simply part of the “noise”?
As with the original decision to employ chart analysis, the answer to that question is, ultimately, a personal one.