No matter what your approach is to the market, you've undoubtedly taken a look at the chart of a stock or an index. But the information you take away from that chart does depend heavily on your approach. While many people see simply a line representing price history, technical analysts see much, much more.
Technical analysts study past price movement for the purpose of understanding what future prices may look like. They review charts of a particular company or index's price action and examine the changes in price over a particular period of time.
If you want to think more like a technical analyst, this report is a good place to start. However, it's not meant to be an exhaustive examination. Its intent is to provide a basic introductory overview for people unfamiliar with chart-reading and hopefully spark their interest. That said, there is a lot more to learn about each aspect presented here, so I'd encourage anyone interested to pursue it further, and
is a good resource to use. Now, let's move on to the charts.
Start With the Charting Basics
The first two things you need to know about reading charts are also the most important: price and volume. These are the building blocks that make up a chart's foundation; all of the other indicators and overlays which, while helpful and revealing, are ultimately secondary. Let's start with price.
is represented in several different ways, depending on the type of chart you're using. There are bar charts, in which price is represented by a bar, as you can see on the left graphic below; candlestick charts, in which price is represented by what resembles a candlestick, as you can see on the graphics in the middle and the right; and line charts, where price is nothing more than, well, a line.
Let's look first at a bar.
As you can see on the graphic, the line on the left represents the opening price of the trading day. The bar's length, or the center vertical line, represents the day's price range, with the top of the bar indicating the day's high and the bottom representing the lowest. The small horizontal line on the right is the closing price for the day.
Much of the same information is reflected in the candlesticks. It too features the open, high, low and close for price that time period. The primary difference between a bar and a candle is reflected in the body, with the length of both the body and the wick, or shadow, representing the type of activity -- heavy selling or light buying, for example -- that took place. In the graphic, the white candlestick represents an up day, or a day when a stock's price increased, and the black candle is a down day, when the stock's price fell.
Many analysts prefer candlesticks to bar charts because they feel that more information is presented. The reason for this is that the color and shape of the candlestick, relative to the previous candlesticks, gives an immediate visual snapshot of the day's trading and its relationship to the past. Price bars relay much of the same information, but its relationship to previous price changes is not considered as complete by itself in comparison. Volumes have been written about candlestick charting, so for the sake of brevity here, we'll concentrate on bar charts.
is represented on a chart by a single bar directly below the price bar. It is adjusted according to quantity, meaning the number of shares that changed hands that particular day.
On the chart below, you can see both price bars and volume bars. The time axis, meaning the amount of time represented by the chart, is on the bottom line -- in this case, in days. The price axis runs up the upper right side, and it is the scale, in dollars and cents, by which we measure the stock. Through these, you can see the open, high, low and close of a stock's price on any particular day, plus its volume that day.
Since I've mentioned the subject of time scale, this would be a good time to talk about time frames. Charts can be made for any number of time frames, from long term, such as annual, quarterly or monthly, to more intermediate term, such as weekly or daily, to extremely short term, meaning intraday in anything from one- to 120-minute increments. In each case, a single bar represents the chart's time period; for instance, on a daily chart, which is the most common chart, one bar equals one day.
Now let's take a look at these two things in action and get a very basic idea of what chart analysts look for.
First, technical analysts look at a chart to determine whether a stock is in an uptrend or a downtrend. This isn't a complicated process; in fact, one of my former colleagues said it was simple enough for his 5-year-old daughter to identify.
Looking from left to right, is price going up or going down? Or is it just choppy? Simply take a pencil and draw a line from one swing point to another, and you'll have your answer.
What is a swing point, you ask? As you can see in the graphic, a swing point is when one price bar (or more than one with the same high/low price) is surrounded by two others that, in our graphic, are higher or lower than the high/low of the center bar(s).
So you find two swing point lows or highs, draw your line, and that's your trend line. Now you have a visual representation to show which way a stock is moving.
This brings us to the question of whether a trend line serves any purpose other than showing us something we probably already knew, namely the direction of the stock. The answer is yes.
Market watchers often talk about a stock meeting support or resistance. They're referring to lines drawn on a chart -- sometimes trend lines, sometimes not -- where price has established a high or low or, in some cases, has merely spent a lot of time trading around.
Support is a line below the stock's current price that serves as a floor from which price can bounce and go higher or, at least, stop going lower. Resistance, therefore, is a level that stands in the way of a stock's continued rise. In both cases, the more times a stock's price has touched a line without going through it, the stronger the line becomes. For example, if a stock went to $70 six times without ever actually going through to, say, $70.25, then $70 would be considered strong resistance, meaning price is having a difficult time going higher.
Conversely, if price drops down to $50 several times without ever going through to $49.75, then $50 would be considered strong support, meaning that price is having a difficult time dropping below it.
The importance of support and resistance is that they are easily seen lines on a chart that can give an investor some idea of what the future may hold for the stock, and consequently, the importance of breaking through one of those levels.
One other thing to remember about support and resistance is that once price goes through them, they change. If price breaks through resistance, that resistance now becomes support. And if it drops below support, that support then becomes resistance. The chart below has an example of both lines, and at the same time a trading range, as
is obviously trading between tight support and resistance before gapping down below the range on extremely heavy volume on the right hand side of the chart. That sort of break on that sort of volume is a bad sign for a stock.
With the very basic outline you've been given on chart-reading, let's take a jump ahead, as a bit of a teaser, and see a pattern, in this case, a head-and-shoulders reversal pattern, the beginning of which is actually on the right hand side of the chart above, and see the promise that technical analysis offers.
A head-and-shoulders pattern is a reversal pattern, meaning that one would look for the stock to reverse its current trend and head in the opposite direction. If there is no trend to reverse, then it's not really a head-and-shoulders. In this case, the downtrend is a short one, but it is established by the gap down. As you can see in the chart, price makes three moves: a left shoulder, a head and a right shoulder.
What happens is that a new low is formed, then price moves up, forming the left shoulder. Price then declines further, with a subsequent rise that will sometimes break the downtrend by itself. This is the head. A third trough -- preferably symmetrical to the other shoulder, but not required -- is then formed, making the right shoulder.
A neckline is then drawn from the high that makes the left base of the head to the high that makes the right base of the head. In order for the pattern to be complete, this line must be broken, and in the case of a head-and-shoulders bottom, the break must be accompanied by strong volume. A break on light volume would call into question whether or not the upward move would continue. You would also like to see heavier volume on the up moves and lighter on the down, which we have to some degree.
As you can see on the circled bar, the stock broke through the neckline on a wide-range bar and had the proper heavy volume accompanying it. The breakout spent a short time consolidating, and then took off, ultimately peaking at $31.48 after another break forward on good volume.
This example is not meant as a prediction that all head-and-shoulders patterns would have the same result. Nonetheless, it provides some insight into the way technical analysis works, which is that it gauges the market's mentality regarding a particular stock through the price bars and accompanying volume to give one an idea of whether a stock has the possibility of moving upward.
As you can probably assume at this point, I have barely scraped the surface of what technical analysis has to offer. Each of the topics introduced today is worthy of an article itself, not to mention the numerous subjects we haven't even mentioned, or barely touched on, such as chart patterns and various indicators.
Technical analysis has gained in popularity in recent years, but there is quite a bit of criticism of it, primarily from investors who study company fundamentals. They say that chart-reading has no predictive power whatsoever, representing only a company's past, not its future. Their feeling is that the only way to truly judge a company is by the numbers generated by its business.
While I believe that both fundamental and technical analysis are equally valid ways to study the market, I think that critics are missing out on valuable information by not looking at charts. For example, if a stock goes up $5 in one day on great company news, but the volume is really light, you can reasonably infer from that that investors weren't as impressed by the news as the jump in price might lead you to believe. That is not the sort of insight you'll get from a company's
Securities and Exchange Committee
Is technical analysis the end-all, be-all, one-and-only-way to look at stocks? Absolutely not. But whether looked at alone or in conjunction with fundamental analysis, the information and perspective it provides are invaluable.
In keeping with TSC's editorial policy, Meyer doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.