Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Brice

The Technician’s
Basic Tool: The Price Chart

By Mark Etzkorn

 

Whether you trade short-term or long-term, discretionary or systematic, your
goal as a technician is always the same: to find profitable patterns in price
behavior.

To accomplish this, technicians use a number of methods to identify the
prevailing price trend, or to identify points at which a trend is about to
reverse (the time scale, of course, can vary). These basis for these techniques
can be roughly divided in two categories: chart analysis and technical
indicators.

Because basic chart analysis is the backbone of technical trading, we’ll
explain the most popular chart types, what they tell you, and where chart
analysis fits into an overall trading plan. In future articles, we’ll go into
more detail about specific chart pattern and trend analysis.

Elements of a price chart

Price charts can depict price action in any number of time frames or styles.
In almost all cases, though, the horizontal x-axis of the chart represents time
and the vertical y-axis represents price. Before discussing the different types
of charts, though, there are a few simple, but important concepts you need to
understand.

 

• High. The highest price of a given trading period, be it an hour,
  day, week, or month.
• Low. The lowest price of a given trading period.
• Opening price (or open). The price at the beginning of a trading
  period (usually a day). For stocks, the open is the price of the first trade
  that is recorded after the market opens; for futures, the opening price
  represents the average price (approximately) of the first minute of the
  trading session.
• Closing price (or close). The last price of the trading session
  (for stocks) or the representative trading price of the last minute of the
  trading session for futures. The closing price takes on special importance
  because it functions as a representative price for a particular trading
  session–the price the market arrived at after a day of trading. The closing
  price is the most commonly used in technical indicator calculations.
• Range. The difference between two specific price levels, most
  commonly the high and low of a given period. For example, the daily range is
  the difference between the high and low prices of the day, the weekly range is
  the difference between the high and low prices of the week, etc.
• Volume. The number of shares or contracts traded in a particular
  market in a given time period (usually day).
• Open interest. The number of open trades in a particular market.
  Both volume and open interest provide measures of liquidity, i.e., the
  amount of trading activity in a market, and thereby the ease with which you
  can get in and out of it. Liquid markets are generally less risky and easier
  to trade than illiquid markets because they are less prone to wild swings or
  gaps between prices. (However, some traders use strategies specifically
  designed to profit from the volatility in illiquid markets.)

The bar chart

The most popular type of price chart is the daily bar chart, which summarizes
the price action of a trading session as a vertical line, or bar, ranging from
the high price to the low price. The closing price appears as a horizontal hash
mark extending out from the right of the bar and the opening price appears as a
horizontal hash mark extending out from the left of the bar (sometimes the
opening price is omitted).

 

  Figure 1. A price bar from a daily bar chart.

Figure 1 depicts a typical price bar. A daily bar chart, for example, would
represent each day’s trading with an individual bar: The high of the bar would
be the high price of the day, the low of the bar would be the low price of day,
and the left and right hash marks would be the opening and closing prices of the
day, respectively. The price bar succinctly summarizes the day’s trading
activity: the daily range (from high to low), where the market opened, and where
it closed. Figure 2 shows a daily bar chart for Dell computer.

 

  Figure 2. Daily bar chart, Dell Computer.

Time frames

Price charts can be constructed in virtually any time frame: minutes, hours,
days, weeks, months, quarters, years, etc. A weekly bar chart, for example,
would be constructed exactly the same as the daily bar chart except that it
would use the high and low prices of the week rather than the high and low
prices of a day.

The opening and closing prices for a weekly chart are simply the opening
price for the first trading day of the week (usually Monday, unless there is a
holiday) and the closing price of the last day of the week (usually Friday,
unless there is a holiday).

 

  Figure 3. Weekly bar chart, Dell Computer.

Similarly, each bar on a monthly bar chart would use the opening price of the
first day of the trading month and the closing price of the last day of the
trading month. Figure 3 shows a weekly bar chart that also encompasses the time
period captured in the daily chart shown in Figure 2. Figure 4 shows a monthly
bar chart for the same stock.

 

  Figure 4. Monthly bar chart, Dell Computer.

An hourly chart, by comparison, uses the high and low prices of each hour of
a trading session to define price bars, and a five-minute chart uses the high
and low prices of each five-minute period. For such intraday charts, opening and
closing prices are often omitted (since, obviously, there are no official opens
or closes reported), or the first recorded price of a particular period might be
used as the opening price and the last recorded price of the period as the
closing price. Figure 3.5 shows a five-minute chart.

 

  Figure 5. Five-minute bar chart, June ’99 T-bond futures. Note: Bars are tightly compressed.

The smallest time frame chart that can be constructed is a tick chart, which
creates a data point for every trade reported in a market. (Tick refers to the
minimum price move in any market.)

Looking at price charts of varying time frames allows you to focus on as
short or long a time period as you want. Longer-term price charts also enable
you to provide a context for the price action on shorter-term charts. A trade
signal generated from a pattern on a short-term chart may be supported or
negated by the activity on the long-term chart. A short-term buy signal might be
ignored, for example, if the long-term chart shows a strong downtrend is in
force.

Other types of charts

Bar charts are the most widely used chart type, but they are not your only
choice as a technician. Other chart styles give you different perspectives on
price action.

Line (close-only) charts

The line chart plots only the closing prices from each trading session,
essentially creating a simplified version of the standard bar chart. Figure 6
shows a close-only version of the price data from Figure 2. Some charting
software will allow you to create line charts using the high price, low price,
or average price from a particular bar instead of the closing price, but the
closing price is most commonly used in technical analysis.

 

  Figure 6. Line chart, Dell Computer.

Candlestick charts

Candlestick charts, which originated in Japan, are very similar to bar
charts, although they pre-date them by a number of years.

Instead of a bar for each day (or week or month, etc.), the candlestick chart
uses rectangles that range from the opening price to the closing price of each
trading session. The rectangle is dark (usually black) if the closing price is
lower than the opening price (a down day), or light (usually white) if the close
is higher than the open (an up day).

The high and low price extremes extend as vertical lines above or below these
rectangles, forming “wicks” to the bodies of the candles represented by the
rectangles. Of course, if the high and low of the day are identical to the open
and close, no wicks will exist; conversely, if the open and close are the same
price, no rectangle (body) will exist. Like bar charts, candlestick charts can
be constructed on any time frame. Figure 7 shows the candlestick version of the
price data from Figure 2.

 

  Figure 7. Daily candlestick chart, Dell Computer.

Some technicians feel candlestick charts highlight certain price patterns
standard bar charts do not. There are numerous elaborately named candlestick
patterns, ranging from one “candle” to several, which supposedly portend price
reversals or trend continuations depending on their context. (Most tests of such
patterns, however, show little success in the way of systematic application.)

There are also several candlestick chart variations, like renko and kagi
charts, but an in-depth discussion of these charts and their interpretation is
outside the scope of this article. Because candlestick charts use exactly the
same price data in exactly the same time frame as a corresponding bar chart, the
preference for one chart over another can only be considered a matter of taste.

Point-and-figure charts

The point-and-figure chart differs from other price charts in that its time
axis is not constant–prices are not plotted day by day or week by week, etc.
Instead, point-and-figure charts use columns of ascending Xs and descending Os
to portray up moves and down moves (of a certain magnitude), respectively, in a
market.

For example, every X might represent a .5 point rise (referred to as the “box
size”) in the stock’s price. Price declines would only be denoted by a column of
Os if price fell, say, 1.5 points (three boxes, referred to as the “reversal
amount”). In this case, if the stock rose from 25 to 25.5 to 26 to 26.5, you
would add three Xs to your column of Xs, one for each .5 point rise from 25 to
26.5. If it rose only a quarter point or a half-point, or declined only a point,
you would do nothing. Only when price dropped by 1.5 points or more would you
stop adding ascending Xs and start a column of descending Os immediately to the
right.

The larger the box size and reversal amount you use, the less sensitive your
chart will be to smaller price fluctuations. Because a one-point move (or
whatever increment you use for your box size) may occur in one hour or two days,
the price action depicted in a point-and-figure chart is independent of time.
Point-and-figure practitioners feel these charts provide a clearer picture of
the tug-of-war between supply and demand in a market. Figure 8 shows a
point-and-figure chart of the same price data shown in Figure 2 using a box size
of .5 points and a reversal size of 1.5 points.

 

  Figure 8. Point-and-figure chart, Dell Computer.

Volume and open interest

Many price charts includes figures that track how many stock shares or
futures contracts have traded during a certain time period (volume) and how many
open positions exist in a market (open interest). Because volume and open
interest can only be calculated after the end of trading, these figures are
usually released one day after the day they represent, i.e., Wednesday’s volume
is not published by the exchange until Thursday.

Volume and open interest indicate how liquid a market is–how much trader
interest and activity exists. High volume and open interest accompany active,
healthy markets, and some traders look for high or rising volume and open
interest to confirm trends and other price moves.

Volume and open interest often are plotted at the bottom of price charts as a
line (for volume) and a histogram (for open interest). Figure 9 shows a daily
chart with volume and open interest included at the bottom.

 

  Figure 9. Daily bar chart with volume and open interest, continuous Japanese yen futures.

What charts tell you

Regardless of what type you use, all price charts communicate the same
information: where prices have been, a clear picture of market trends,
significant historical high and low prices, and an idea of the volatility in a
market. Such information can suggest both what kind of trading approach might be
appropriate and which markets may be suitable for trading.

The most basic form of technical analysis involves identifying specific price
patterns (longer-term top and bottom formations like head-and-shoulders
patterns, or continuation patterns like triangles and flags, etc., as well as
one-day patterns like spikes and gaps) and exploiting their probabilities.

Basically, charts allow you to identify trends and inflection points. Chart
analysis is a visually based, subjective skill that nonetheless can yield
excellent results when approached realistically, and offers an alternative to
mechanical, indicator-based techniques.

Finally, historical charts and price data allow you to test your ideas before
you actually trade them. Luckily, computers and the Internet give you a great
deal of power and flexibility in researching and analyzing charts and price
data.