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Technical analysis primer: Charting Basics

Carl Capolingua Carl Capolingua 23/05/2022
Technical analysis primer: Charting Basics Technical analysis primer: Charting Basics
Technical analysis primer: Charting Basics Carl Capolingua
Technical analysis is growing in popularity with investors due to its broad accessibility, and when it is used correctly, its accuracy in predicting market timing signals. In this article, we introduce the concept of technical analysis, and also provide readers with a primer on the basics of setting up a chart.

Highlights:
  • Benefits of technical analysis compared to fundamental analysis
  • Chart types (Line, Bar, Candlestick)
  • Periodicity (time scale)
  • Zoom
  • Arithmetic scale versus logarithmic scale


Benefits of technical analysis over fundamental analysis

Put simply, technical analysis (TA) is the study of how the price of a stock or a bond or a cryptocurrency changes over time. Price is probably the purest and least ambiguous input for any analysis. This is because price is derived from the interaction between demand and supply for a security. Demand and supply sets the price, and then the shifting balance or imbalance between the two over time causes the price to change. 

The price represents the sum of all fears and all hopes held by investors and potential investors in the market for a particular security (for this article, let's assume we're talking about stocks).  If we truly believe that the market is always right, then the study of price is the most logical place to focus our analysis efforts.

Now, not everyone feels the same way! Those smarty pants fundamental analysts, with their protractors and pocket protectors, not to mention half an alphabet after their name on their business cards, believe that the market is not always right. Rather, they believe they can use their giant brains, and even gianter spreadsheets, to find hidden gems in the market that no one else is smart enough to see!

Power to the people!
This is perhaps the biggest benefit of technical analysis compared to fundamental analysis, that is, you don't need three degrees and a fancy spreadsheet to use TA to pick good entry and exit points in the market. I love TA because it's so egalitarian! 

Price data is made available to all market participants, either free or for a modest price by securities exchanges. Therefore, it's a level playing field for all participants. The wealthiest and most powerful individuals in the world have absolutely no advantage compared to the smallest traders when it comes to obtaining the price of a stock.

Can the same be said about fundamental analysis? Does everyone have the same access to company information? Despite the best efforts of securities exchanges and government regulators, not all market participants transact based upon the same information, and not all market participants get their market information at the same time. This means some investors have a significant advantage over others.

Company insiders obviously have the best information regarding companies and how they are performing. There are specific times when these company insiders can legally transact in the shares of their companies and all transactions must be fully disclosed to the exchange. In a perfect world, the proverbial buck would stop here, but those who are close to company insiders including family and friends often benefit from leakage of price sensitive company information. This can often be the source of rumours and tips which can spread quite a way through the investment community.

Next best informed are the nerds over at the big research houses and broking firms. As part of their daily routine they will talk to company insiders, visit company operations, and analyse in painful detail any information released by the company to the market. These clever guys and gals crunch the numbers to determine the "intrinsic value" of every stock in their investing universe. The cheapest stocks get the nod, and the most expensive stocks are either turfed out of clients' portfolios, or avoided altogether. 

It is probably fair to say that both of the above parties have a major advantage over the average "mum and dad" investor when it comes to accessing and capitalising on fundamental information. But, there is a way mums and dads can piggy back the superior analysis of each of these groups of investors.

When an insider or a client of a broking house wants to act upon their information, they must transact. They'll buy if they believe there's an opportunity to turn a profit, or sell to avoid or limit a loss. And it's this exact buying and selling that causes the demand and supply which sets and moves stock prices. Prices therefore reflect all of the information available to all participants, official or unofficial. Using price to make one's investing decisions effectively levels the playing field in terms of expertise and access for mum and dad investors. 

Put most simply, if there is greater demand than supply for a stock at a particular time, its price will rise. Alternatively, if there is greater supply than demand, its price will fall. And finally, if demand and supply are equal, the stock's price will stagnate. It's that simple! In the coming weeks, this TA Primer will cover various aspects of using charts to spot sound entry and exit signals. For today, we're going to start with the most basic aspects of TA, setting up your chart.
 

Chart types 

A chart is simply a schedule of price versus time. Price is plotted on the vertical axis and time is plotted on the horizontal axis. We will talk in detail about each of these factors in this section and investigate how traders can use clues from price and time to predict where price may be headed in future articles. 

There are four important elements of the price which are regularly represented on charts, they are: the opening price, the high price, the low price, and the closing price, or Open (O), High (H), Low (L), and Close (C). This data is logged for a certain period we wish to analyse, and then gathered for all previous and subsequent periods to make a price schedule, or "chart".

There are a number of different ways to represent price on a chart:

Line Chart

technical analysis line chart

In this type of chart, each period's closing price is connected in a continuous line. Line charts ignore other elements of price data such as the open, high and low, and only focus on the close. This cuts out much of the volatility which can occur intraday and therefore also a great deal of "noise" within the price action. Line charts are great for getting an overall picture of the trend of a stock. The trend is the most important indicator of potential future price movement.
 

Bar Chart

technical analysis bar chart

In this type of chart, each period's closing price is represented as a line or a "bar". The bar's high point will match the highest price the security trade at during the period and its low point will be the lowest price the security traded at during the period. It is common for bar charts to also have horizontal dashes to represent the opening price (drawn to the left of the bar) and the closing price (drawn to the right of the bar) for the period.
 

Candlestick Chart

technical analysis candlestick chart

A candlestick chart is similar to a bar chart in that it considers the opening, high, low and closing prices for each trading period. But, candlestick charts represent this standard data in a slightly different way. Each period's price action is represented by a combination of coloured boxes and lines. The box part is formed by measuring difference between the opening and closing prices for the period. If the price has fallen for the period, the box is coloured black. If the price has risen for the period, the price is coloured white.

If the price rises or falls outside the range between the opening and closing prices, then the movement is represented as a line protruding from the box part of the candle. Another name for the box part is the "body" of the candle. The lines protruding from the real body are known as "shadows" or "wicks". We will go into further detail on candlestick charts later in the primer.
 

Periodicity (time scale)

The time scale, or "periodicity" used on a chart is extremely important. This will determine whether we are looking at data representing minutes, days, weeks, or months of price data. We can adjust the chart so that one period represents any of these timeframes on our TA platform. Other popular periods include 5 minutes, 15 minutes, hourly, four-hourly, and there are many others, both shorter and longer.

As a rule of thumb, the time scales we use will determine how long our trading horizon is. For instance, if we are looking at a 15 minute chart, we would expect to enter trades which would last in the order of magnitude of hours. An entry based upon an hourly chart may see a trade last days, and an entry on a daily chart may see a trade last weeks, and so on. By definition, we call longer time periods "higher" periodicities and shorter time periods "lower" periodicities.
 
technical analysis periodicity_daily

We can see here that the daily chart for BHP (above) looks very different from the weekly chart (below). If we measure the trend by drawing a line from the first candle to the last on each chart, the daily chart shows the trend is sideways, however the weekly chart shows a well-established long term uptrend.

technical analysis periodicity_weekly
 
We suggest picking a periodicity that suits your investing horizon, and also one which you can check each and every period. We cannot stress enough the importance of an investor being able to check his/her charts in line with their selected periodicity.

Let's say for example you really want your trades to last a few hours. This means you'd typically have to consider a lower periodicity such as a 5 minute chart. But, checking each of your charts every 5 minutes isn't going to suit most people. In this example, if you're unable to check your charts every 5 minutes, you should consider increasing your periodicity to a duration which is consistent with your ability to check do so. This is more likely to be a daily chart - but of course you'll have to accept that your trades are going to typically play out over a longer timeframe.
 

Zoom

The level of zoom you have on your chart will determine how much information you pack into your screen. By zooming in on the latest price action, you'll find that the number of price periods you have on your chart decreases as the data points on the chart become further and further apart. Conversely, by zooming out, you will find that more and more data is squashed into your viewing area.

technical analysis zoom in

This is such a simple concept, but it can have a dramatic bearing on your investing decisions. Investors often forget to consider just how much information they're actually looking at on their charts. Sometimes, they look at too few data points and fail to ascertain important trading signals such as the overall trend, and sometimes, they zoom too far out and miss the finer details such as candlestick patterns.

technical analysis zoom out

As a rule of thumb, traders should consider setting the number of periods on their chart to at least 250-260 periods by default. This represents approximately 1 year in terms of trading days. Further, it is always advised to zoom out at some stage during your analysis to get a better idea of the bigger picture and potentially to also use higher time scales (like weekly and monthly charts) to emphasise this point.
 

Arithmetic scale versus logarithmic scale

Most TA platforms will give you the option of using an arithmetic scale or a logarithmic scale. The difference between the two can be quite marked. Arithmetic charts represent price by fixing the distance in pixels on the y-axis in terms of the dollar amount moved. Log charts on the other hand, fix the distance on the y-axis in terms of the percentage amount a stock has moved.

For example, if a stock is trading at $1.00, a price moment of 10c on an arithmetic chart will be the same size vertical movement at $1.00-$1.10 as it is at, say, $5.00-$5.10. Comparatively, a log chart takes into account that a 10c movement for a $1.00 stock is +10%, but at $5.00 the same movement is only +2%.

So, on a log chart, the 10c move from $1.00 to $1.10 will be represented as 5 times larger on the vertical scale than the move from $5.00 to $5.10. Indeed, it would take a $0.50 move from $5.00-$5.50, or +10%, to show up as an equally sized vertical move.
 
technical analysis arithmetic scale chart

The difference between the two scaling methods becomes apparent when we consider that certain technical indicators such as trend lines can give very different signals under each methodology. In the diagrams above and below, we can see that the Novonix (NVX) uptrend that began in July 2021 was broken much earlier on the log chart than it was on the more traditionally used arithmetic chart.

technical analysis logarithmic scale chart
 
Traders will generally find that there is very little difference between arithmetic and log charts in the very short term. This is because share price movements over a shorter period are more likely to be very modest, and therefore in percentage terms, very similar. Over the longer term however, when price changes can be significant, log charts tend to perform better in signalling important trend changes.

There's plenty more to learn about setting up and reading charts, but that's enough for today! We'll pick up this discussion soon in future editions of our Technical Analysis Primer.

Any opinions, news, research, analyses, prices or other information contained on this website is provided as general market commentary and does not constitute investment advice. ThinkMarkets will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

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Any opinions, news, research, analyses, prices or other information contained on this website is provided as general market commentary and does not constitute investment advice. ThinkMarkets will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
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