The study of charts is an important aspect of technical analysis. The main reason for this is that charts are a user-friendly and an easily understood method of presenting price movements over time. By indicating price information on a chart, it is easy to identify and analyse movements, tendencies and patterns that become visible. The study of charts forms such an enormous part of the workload of technical traders and analysts that they are occasionally referred to as ‘chartists’.
The main categories of charts used for technical analysis are line charts, bar charts, candlestick charts and point-and-figure charts. These charts are then analysed, patterns are identified and, based on tendencies, choices regarding buying and selling are made. Charts can also be used to observe volatility in various markets in order to make informed decisions concerning the placement of stop losses at various price points.
In addition to chart types, another consideration when composing charts is the scale that will be used. Scale options include logarithmic and arithmetic.
The chart type and scale are determined by the relevant information with which the analyst is concerned.
The common consensus is to position the price movements on the y-axis while plotting time on the x-axis. The two different scale options consider the differences in intervals on the y-axis.
The arithmetic (linear) scale refers to graph compositions where the intervals on the y-axis are identical.
With the logarithmic scale, there are differences between the physical and numerical values of the intervals on the y-axis. This scale will be used to analyse percentage differences rather than absolute values and thus, the movement in price indicated is relative to the relevant share price. As an example, consider the movement of price changes relative to a $10 share and a $100 share. A $2 movement on the $10 share will result in a greater percentage (and thus graphical) movement than a $2 movement on the $100 share.
The logarithmic scale representation is considered to be a more accurate and realistic method used for analysis when focusing on users emotions.
The line chart is the simplest chart and is usually used for the representation of closing prices. As closing prices are considered to be the most important price indicator, line charts are extremely handy tools for trading analysts. A number of closing prices of a relevant share are used to compose a line chart which reveals various tendencies within the share price.
However, the line chart can also be used to graphically display other price movements, such as the share price every hour, every 15 seconds or in certain instances the share price after every transaction.
Bar charts, also known as OHLC (open, high, low, close) charts, consist of a composition of price bars where one bar is usually representative of a single day (or another specified period). In turn, each bar is comprised of 4 prices, namely the opening, highest, lowest and closing prices:
- The opening price is the horizontal line pointing left and is indicative of the opening price of the day/specified period.
- The high and low prices refer to the maximum and minimum prices that were achieved during the period and are graphically represented by the top and bottom points of the vertical line.
- The closing price is indicated by the horizontal line pointing right (the horizontal lines indicating the opening and closing prices are also known as tick marks).
Source: Investopedia (2012c)
The candlestick chart has three main components: the real body, the upper shadow and the lower shadow. The real body is the wide part (the candle) that is usually shown in black or white. Out of this ‘candle’, there appear vertical lines that are known as the upper and lower shadows.
Candlestick chart: MT4
The candlestick chart considers the same four prices as bar charts (discussed above) but exposes certain patterns and tendencies in greater clarity than bar charts. The top and bottom of the real body indicate the opening and closing prices. A white or green real body will signify a closing price that is higher than the opening price, while a red or black real body conveys a period in which the opening price was higher than the closing price. The upper and lower shadows show the minimum and maximum prices achieved during any single period.
As with price bars, candlestick charts are a handy tool with which to identify patterns, especially reversal patterns such as the hammer and the hanging man which are discussed later in this section.
Point and Figure Charts
Although not popular with today’s technical traders, these charts have a rich history and were used by some of the first traders. It is speculated that these charts came into existence due to the ease with which they can be plotted. This category of charts excludes inconsequential price movements that act as ‘noise’ in trading analysis, thus making it easier to identify significant trends and determining support and resistance lines.
Point and figure charts drastically differ from other charts as they only consider price movements deemed to be of importance.
Price movements will only be considered important enough to appear on these charts if and when they exceed the box size. ‘Box size’ refers to a predetermined amount that must be exceeded in a given period and is based on share price and market volatility. For example, a box size of $5 exists for a certain market. If the share price within that market decreases with more than $5 in the given period, it is indicated on the point and figure chart with an O, conversely an increase greater than $5 will be represented by an X on the chart. If the movement of the share price, throughout the given period, remains less than $5 (either increase or decrease) the movement will be omitted from the chart.
The box size also influences the number of O’s or X’s to appear on the chart. Continuing with the previous example, a share price increase of more than $10 will be represented by two X’s, while an increase of more than $15 will result in three Xs on the chart. Thus, every time the box size is exceeded another X or O will be charted.
Source: Investopedia (2012a)
Even though the box size must be exceeded within a given period in order to make the movement significant enough to be charted, the chart itself does not indicate these periods of time. Rather, a continuing downtrend will be represented by a single column of O’s, regardless of the number of periods for which the downtrend continued. Once a reversal is experienced, a new column will be charted to the right, in which the X will appear in the row above the last O of the previous column. Thus, each column will only contain either O’s or X’s (not both) and a new column will only be charted in the event of a turnaround in the movement of the share price.
However, recently, the 3-box reversal charts have been developed where a reversal will only be indicated once a movement in the opposite direction of the current trend exceeds the box size three times. There are various patterns that become visible when making use of the 3-box reversal charts. The most well-known patterns are the double top, double bottom, triple top, triple bottom as well as the head and shoulders pattern.
Once a point and figure chart is plotted, it is extremely easy to expose and present trend lines as well as support- and resistance lines.
- Trend lines are plotted by drawing angled lines from a topmost X or a bottommost O to the following topmost X or bottommost O.
- Support and resistance lines are plotted horizontally, where a horizontal line from a bottommost O will represent a support line and a horizontal line from a topmost X will indicate a resistance line.
The charts and patterns discussed here are purely a starting point for technical analysis and there are numerous other techniques and patterns that constitute the concept of technical analysis. Most importantly, technical traders and analysts are cautioned to test the success of any theory against historical data, before making weighty decisions. It is also good practice to combine technical and fundamental analyses to ensure the legitimacy of identified trends.
- William, C.S. 2011. An Overview of Chart Types Used In Technical Analysis. [Online] Available from: http://thismatter.com/money/technical-analysis/chart-types.htm [Accessed: 2012-03-16].
- 2012a. Basics of Technical Analysis: Chart Types. [Online] Available from: http://www.investopedia.com/university/technical/techanalysis7.asp#axzz1pHbXfR6X [Accessed: 2012-03-16].
- 2012b. [Online] Available from: http://www.schaeffersresearch.com/schaeffersu/Education.aspx?id=76 [Accessed: 2012-03-16].
- 2012c. [Online] Available from: http://www.schaeffersresearch.com/schaeffersu/Education.aspx?id=68 [Accessed: 2012-03-16].