Ways of Using Charts

Now it’s time to get an overall idea of how charts fit in to the world of technical analysis and the many ways that you can use them to help in your trading. They are an essential device for the trader to spot opportunities, but you don’t just work from what you have seen so far in this introduction to charting. There are many other devices and tools that have been discovered or invented over the years to make it easier.

But first, understand that you do not want to get overwhelmed with the different ways that you can use charts to find trades. You want to know about the varieties, but once you have decided on a way that works for you, and that fits your risk profile, you will only regularly use two or three tools. It is easy to get carried away searching for the ‘perfect’ way to trade, and never become proficient at any one simple method. There is no perfect tool or indicator for trading, and believe me, many people have searched for it for many years! When you trade, your task is to put the odds on your side and enjoy the results, and not worry if some trades don’t go where you think they should.

Using Trends and Patterns to Control Risk

The basic chart, as you have seen, shows price over a period of time, and includes volume information which at a minimum should be used for confirmation. Some technical studies just deal with the natural cycle of prices to see where the current level is and how it relates to where it may be going. Looking at the curve of the price information can give some clues about whether to trade, but there are many more devices available. In the module on candlestick charting, we will look more at patterns that can be formed by different shapes and arrangements of candlesticks, and what they have been interpreted to mean.

There are also some ways to add lines to the charts, and these can give price targets or other indications. A common version is called trendlines, and they come up in the next module. You can draw, either on paper or on the computer, other lines which you place from various rules or ideas, and they can help you see how the price may go. Module 6 about moving averages shows you how powerful this easily calculated set of lines can be, and there are yet more ways to add lines at various levels and angles to a chart to help in decision making.

All these aids are added in the main part of the chart, and relate directly to the position of the price line, showing you levels of pricing.

We’ve also seen already that you can have a separate graph at the bottom of the chart, giving more information. The volume and the open interest are examples of these. They are plotted separately, as the actual levels shown do not relate to the price level directly. You just see what the volume is doing, and look directly above to see the price related to it.

Now, there are a whole family of indicators and ‘oscillators’ that can also be plotted under the main price chart, and we talk about them in detail in Module 7. The idea behind many of them is that they show you when a stock is ‘overbought’ or ‘oversold’. This is a very important concept that underlies many trading systems and decisions.

When a stock is overbought, as the name implies, there has been a lot of buying activity which may be ‘irrational exuberance’. It suggests that the demand has been too high, forcing up the price, and the stock may be due to lose value. This corresponds to the later stages of the ‘distribution’ phase which Dow Theory talks about. Typically a trader will look for this as a signal to sell a stock short, to profit from a decline in value.

The opposite of this is when a stock is oversold. Generally coming after a decline in price, this suggests that people have been hasty to get rid of their shares, to the point that the price has dropped below the level that it should really settle to. This may represent a buying opportunity for the trader. It relates to the distressed selling of the Dow Theory.

An oscillator varies or oscillates between high and low values which give a measure to the degree of overbought or oversold. Different oscillators will not give the same results, as it depends how they are calculated, but they will probably agree on the general feeling of the market. When you get an indication from the oscillator of a buying or selling opportunity, you can relate it to the price chart above and make your trade.

So in summary there are three basic concepts that traders can employ in using charts for their trading –

  • Look at the pricing information for patterns and cycles that would indicate the future price movement
  • Draw chosen lines on the price charts to determine the likely price movement
  • Add an oscillator below the chart to suggest the sympathy of the market, and hence the expected future direction.

Here’s a chart with some of these indicators added. You will learn about using them in the later modules.

Technical Analysis Indicators

 

You can see that there are several lines, both straight and curved, added on the price chart. Some may represent targets for the price to move to, and the action of others can give signals to trade. Below the volume we have the MACD (pronounced Mac-dee) which gives further trading guidance, as we’ll see in the module about oscillators and indicators.

You don’t have to choose just one of these methods. Usually you will want at least two confirming signals or indications before making a trade, and you can combine the different ways to get your confirmation. But you should make it as simple as possible, consistent with getting the results you want. When you pick the two or three ways, it’s a good idea to make sure that they are based on different values – for instance, you may have one based on price and one on volume – as they are more likely to give a balanced picture of the market.

Do Chart Patterns have to be Complete?

Using Charts to Trade

Some spread betting providers like IG Index will allow you to trade directly from the charts. These trading platforms usually show the entry level, stop and limit orders as horizontal lines on the chart and normally you can tweak them by simply dragging the lines. This makes it easier to visualise positions and also makes risk management simpler in a way as the chart will serve as a reminder of your original trading plan.

Summary

  • Line charts just show closing prices
  • Bar charts and candlestick charts show you the four prices – open, high, low and closing – for each period
  • Candlestick charts are easier to interpret
  • Most charts allow you to see the volume of trading, which is important to indicate the strength of any move
  • You can use arithmetic or logarithmic price scales – log is sometimes better on the long term charts
  • Technical analysis can be applied to any timeframe of charting
  • Futures charts include open interest information

At the end of each module there is a quiz. You can take a quiz at any point, but we suggest you view each module before taking the quiz. When you’re ready to start the quiz, click the take quiz ‘Start’ button below -:

The Masters Certificate in Technical Analysis - Module 2

Questions – Module 2
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