Basic Chart Analysis: Trends, trading ranges, and support and resistance
If you’ve read The Technician’s Basic Tool: The Price Chart, you’re probably familiar with the more popular chart types and how they display price information. But knowing the difference between a bar chart and a candlestick chart is only the beginning. Obviously, what’s important is making sense of the price patterns that develop over time.
| To many, the term “chart analysis” brings to mind images of traders poring over price charts, deciphering hidden patterns in much the same way a fortune teller would read tea leaves |
Chart pattern myth vs. reality
To the general public, the terms “technical analysis” and “chart analysis” usually bring to mind images of traders poring over price charts, deciphering hidden patterns in much the same way a fortune teller would read tea leaves.
Actually, despite the sometimes colorful names given to chart patterns, chart analysis has a very common-sense goal: to locate price trends, congestion areas, and points where trends are likely to reverse. “Patterns” can consist of a single price bar or dozens, and can trigger trades that last a few hours or a few months. To start, we’ll focus on a few major price patterns that illustrate the most important principles of chart analysis.
Keep in mind that many, if not most of the concepts we will discuss here are equally applicable to intra-day, daily, weekly, or monthly charts. However, certain patterns, especially those that revolve around the open or closing prices, will be relevant only on the daily time frame.
Trends
| Catching the precise beginnings and ends of all trends is unrealistic; fortunately, you do not need to |
- Identifying trends after they have developed and trading in their direction (buying into the beginning of an uptrend or selling into the beginning of a downtrend)
- Entering trends after they have begun on corrections (or pullbacks)
- Identifying reversal points where trends seem likely to end and trading in the opposite direction (selling into the end of an uptrend or buying into the end of a downtrend)
Of course, catching the precise beginnings and ends of all trends is unrealistic; fortunately, you don’t need to. But as a technical trader interested in finding profitable price moves, you are always concerned with price trends on a certain level, whether they last a few hours or several months.
It is easy to intuitively understand what a price trend is: a continuing series of daily (or hourly, weekly, monthly, and so on) price advances or declines. A standard definition of a trend is a series of higher price highs and price lows (for an uptrend) or lower price highs and price lows (for a downtrend). The daily bar chart in Figure 1 illustrates this definition of an uptrend.
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| Figure 1. Sun Microsystems (SUNW), daily. Uptrend preceded by trading range and punctuated by corrections, or pullbacks. Source: Omega Research.
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It is obvious from this example that even though the market is clearly in a strong overall uptrend, the rally is punctuated by occasional counter-trend downswings (corrections, pullbacks–pick your term), the most notable occurring between January and February 1999. (This correction happened to take the form of a triangle, a pattern we will discuss in a future article.) A trading range, or congestion period (see next section) preceded the uptrend.
Points A, B, C and D correspond to some of the more notable highs and lows throughout this uptrend, the largest of which (C and D) are referred to as relative (or “reaction,” or “swing”) highs and lows. Figure 2 shows a downtrend on a 15-minute chart. A, B, C and D mark some of the relative highs and lows on this chart.
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| Figure 2. America Online (AOL), 15-minute. Downtrend and relative highs and lows. Source: Quote.com.
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Of course, trends are relative, depending on the time frame you consider. Figure 3 shows a somewhat random market that drops dramatically toward the end of a roughly three-month period on a daily chart. While this might not qualify as a downtrending market (until the steep sell-off at the end), it is definitely not an uptrend.
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| Figure 3. Cisco (CSCO), daily. Sideways price action ending with sharp break. Source: Omega Research.
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This underscores the importance of putting market action in context by consulting different time frame charts. Price action on a weekly or monthly chart may determine whether or not you establish a position on a daily chart; behavior on a daily chart will similarly influence how you