Chart patterns offer a framework for analyzing the battle raging between the bulls and bears by providing a complete pictorial record of all the trading action in the market.
A chart is the pictorial representation of a stock's demand and supply over a period of time. The time frame can be minutes, hours, days, weeks, months, etc. The high and low of the price range of any time frame is recorded as a vertical bar where the top is the highest price and the bottom is the lowest price.
This bar is drawn with the use of the chart's x-axis and y-axis. The x-axis (horizontal axis) represents time and the y-axis (vertical axis) represents price. The increase in the number of bars over time leads to the formation of some typical patterns which chartists make use of in forecasting future trends and prices.
A chart, therefore, has three parameters - time, price, and the resultant pattern. A good trader can use charts to make forecasts of the future trend. Stock prices move in cycles. Chart reading skills are acquired over time by studying how prices behaved at certain junctures of earlier cycles; for example, by noting price action at earlier market tops and market bottoms.
Studying the time periods of past cycles and price actions at specific times within past cycles provides an indication of future price action. By studying past price cycles and patterns a trader may thus be able to make an accurate forecast. Any security with price data over a period of time can be used to form a chart for analysis.
Time frames for charting
Charts can be formed by using different time frames so that one gets a history of the price pattern over a reasonable period of time. Traders can use these time frames to their advantage whether for day trading or swing trading. Generally, the time frames used are intra-day, daily, weekly, monthly, quarterly or yearly.
A daily chart is made up of the intraday price range that has been com-pressed to show each day as a single period. A weekly chart is made up of daily price ranges that have been compressed to show each week as a single period.
Traders usually concentrate on charts of daily and intraday data to fore-cast short term price movements.
While long on detail, short term charts can be volatile and contain a lot of noise. Large and sudden price movements, wide high-low ranges and price gaps lead to volatility and can distort the overall prediction.
Investors, on the other hand, usually focus on weekly and monthly charts to spot longer term trends for forecasting long term price movements. Because long term charts cover a longer time frame with com-pressed data, price movements do not appear as extreme and there is often less noise.
You can also use a combination of longer and shorter term charts. Long term charts are good for analyzing the big picture and to get a broad perspective of the historical price action. Once the big picture has been analyzed, a daily chart can be used to zoom in on the latest few days or weeks.
Broad classification of chart patterns
The tug-of-war between the demand and supply of a particular security gets reflected as patterns - or formations - on price charts. Such patterns, if read correctly, can be used by a shrewd trader to his or her advantage. These patterns are graphical depictions of the fear and greed present in the market. Remember, chart patterns are the footprints of the bulls and bears of the stock market.
Charts pattern can be analyzed by looking at support, resistance and trend lines. Traders all over the world use chart patterns to identify trends. An old stock market saying goes: "The trend is your friend." Accordingly, traders attempt to recognise the trend early by analyzing chart patterns.
Chart patterns can be classified into three general categories, namely:
- Reversal patterns,
- Consolidation or continuation patterns, and
- Trend patterns.
These are patterns that show imminent tops in bull market and bottoms in bear market and are analysed by also taking into account the volume of trade. Some of the well known reversal patterns are head and shoulders pattern, rounded bottom / top pattern, double bottom / top pattern, wedge top, diamond reversal pattern, etc.
Consolidation or continuation patterns
These patterns indicate an indecisive tug of war between bulls and bears. These patterns reveal a temporary pause in the advancing, or declining, price and indicate that the market / security is taking a breather before starting its next move. Volume is usually low during periods of consolidation. Some common consolidation, or continuation, patterns include symmetrical triangles, ascending and descending triangles, wedges, flags and pennants, rectangles, etc.
Trend patterns highlight the areas of support and resistance. Some of these patterns are fan lines, gaps, trend lines and channels.
Some chart patterns have a high rate of success in trading. Chart patterns are useful gauges of momentum, support and resistance, and other indications of strength or weakness in a security. Chart patterns also help traders determine market direction and in timing their entries and exits.
A trader must be able to correctly identify chart patterns. They are your road map in the jungle maze that is the stock market. If you can read your map correctly, you can find your way to success. Chart patterns provide us a concise picture of all the buying and selling forces active in the market.
Have you ever watched the replay of any cricket match on television? When you watch the first replay, it will only give you limited information but if you watch it again and again you will notice the strength and weaknesses of individual players, and you will also be able to figure out at what point the match slipped away from the losing team.
You will be able to see some characteristics of a particular player; for example, the strength of Sourav Ganguly in timing balls pitching around the off stump. Similarly, if you watch your charts again and again you will be able to recognize the various patterns and different trends and you will find that different charts have different characteristics.
Chart patterns provide a framework for analyzing the battle raging between the bulls and bears by providing a complete pictorial record of all trading.
The first pre-requisite for chart analysis is the use of your visual faculty. You should first train your eyes. Most often we fail to see the obvious which is right in front of our eyes and look for complex things instead.
As we all know, Sachin Tendulkar is one of the greatest batsmen we have ever had. But to strike the ball he has to see it first - and also see it early. Only then will he be able to strike. That should be your objective too; train your eyes to see the charts. Charts speak to you. Look at the charts to understand their language; if you are able to decipher it properly you will be able to decide your trading strokes, otherwise you will be out of the game.
[Excerpt from Ashwani Gujral's bestseller (www.visionbooksindia.com/details.asp?isbn=8170947219) How to Make Money Trading with Charts. Published by Vision Books]
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