Learn how to identify price support and resistance or how to time entries and exits. There are basic chart-reading techniques at the core of any technical trading regimen. Start yours.
Question. How do you know when a stock stops going up? Answer: When it starts going down. Or, sideways.
Ouch. We know we’re being a little sarcastic, but for good reason. There’s a simple truth in that sharp tone.
Learning about stock price behavior starts with taking a closer look at, well, stock price behavior. A price chart happens to be the first tool that every technical trader needs to learn. If you’re new to reading charts and the world of technical analysis, it’s easy to become overwhelmed with the many looks and uses of trading charts. Here, we’ll simplify things by narrowing the choices to the three most common chart types and we’ll examine the more popular techniques that traders apply.
What Are Price Charts?
Price charts derive from the trading activity that takes place during a single trading period (i.e. 5-minute, 30-minute, 1-day, etc.). Generally speaking, each period of activity consists of one or more data points, including the open, high, low and/or closing price.
Perhaps the most easily constructed price chart is the line chart, which plots a single line that connects all of the closing prices of a stock for a certain time interval (figure 1).
It’s simple to follow, but the line chart may not tell the trader much about the day’s activity. It will, however, help the trader to see trends more easily and visually compare the closing price from one day to the next, for example. Since many brokerages place the valuation of an account on the closing price, this method has some value when correlating a stock’s trend or overall performance to the market, without being too concerned about the daily fluctuations.
The bar chart is another method of charting the price activity (figures 2 and 3).
Since the bar chart helps the trader to examine the range from one bar to the next, the trader can easily see the increase in the size of the bar from one to the next, or over a range of bars. Notice how the ranges of the bars on the chart in figure 2 expand and contract between longer periods of high and low volatility. As the market becomes increasingly volatile, the bars become longer and the price swings wider. As market become quieter, it will contract into smaller bars.
A variation of the bar chart is called the candlestick chart (figure 4). Candles are unique in that they visible show either bullish or bearish sentiment for the time interval they represent by displaying distinctively wide bodies that are clear or colored, depending on whether the stock closes higher or lower than the open. The body represents the range between the opening and closing prices of the time intervals, while the high and low of the candlestick are called the wick or shadow. The candles mark bullish advances with a clear body and declines with a darkened body.
The significance here is the way that prices move in a trending market. In a normal bull market, you will typically see more clusters of clear bars than darkened bars (i.e. January to March in figure 4), while the reverse is true for a bear market (i.e. March to May). Such combinations of these bars in succession help to make up patterns that the trader may use as entry or exit signals.
Seeing Trends, Support, And Resistance
It’s one thing to know what a chart is. It’s another to actually to know how to read a chart.
As you can see from the red arrows in figure 6, stocks that move up over a range of time are essentially in uptrends; stocks that move down over a period of time are in downtrends.
Support is essentially a floor for stock prices at a point where a stock that is trending down stops moving down and reverses course. At some point, the sellers will stop selling, the buyers will take control, and the stock will start rising again. At the inflection point, the stock puts in a low price, which we call “support”. After a rally, should the stock reverse course once again and start to come back down to retest the support level, this will be an area that will likely require significantly more conviction (i.e. volume) by sellers to penetrate this level. If the stock does not penetrate support, this only strengthens this level and provides a good indication for short sellers to rethink their positions, as buyers will likely start to take control.
Resistance is the exact opposite of support, and acts as a ceiling for stock prices at a point where a stock that is rallying stops moving higher and reverses course. It is at this point that the buyers will need more conviction to penetrate this level in future rallies.
Though it’s important to understand that support and resistance are merely psychological levels, they nevertheless provide key areas to be aware of for which traders can strategize a trading plan.
Reversals And Breakout Patterns
Within a chart, there are certain repeatable patterns that appear which can provide clues to help determine where a new trend begins and ends, and thus provide possible entry and exit points for trades. One place to start is to look for at least two confirming stair steps in the opposite direction of the prior trend (figure 7 below). In other words, if a stock has been trending down, and suddenly reverses, before calling it an “uptrend” instead of merely a short “bear market rally” (also known as a “dead cat bounce”), look for some type of confirmation in the chart pattern that exhibits at least one higher high than the first and one higher low than the lowest price of the previous trend.
There are many other common “breakout” patterns that can be useful to the trader in providing entry and exit points within the trend when they surface. Those with names such as “flags”, “pennants” and “triangles” are all common patterns that traders consistently use to generate buy and sell signals (see figure 8).
Is the stock you’re looking at buying moving up or down? Who is doing the buying or selling? When is a good time to get into the trade? Using multiple indicators in combination with one another is typically how technical traders use charts. The theory behind using more than one is that in and of themselves, individual indicators will provide many false signals that could lead to poor entries and big losses. A more powerful system uses a combination of indicators together, whereby you’ll stay out of potentially harmful trades more often if there are conflicting signals between those indicators. A good start may be to learn how volume and moving averages work together with price action, and add or subtract indicators as you develop your own system.
The chart in figure 9 is a good example of a daily chart that uses volume and moving averages with price action, and how a trader might determine support and resistance levels (blue dotted lines) and/or breakout patterns (red dash lines). The volume indicator can be seen below the chart and two moving averages (10-day and 30-day) are drawn over the colored bars inside the chart.
On the left side of the chart, volume started accelerating (diagonal red line) before the blue shorter-term moving average crossed below the pink longer-term average. By the time this “crossover” occurred, a new downtrend was in place, providing greater clues to the likelihood of a continuation of that trend.
Another defining moment for chartists is when stocks break out of “basing” formations such as the pennant (red dashed lines). When two indicators confirm the same thing, it’s a more powerful signal. Just before the stock broke out of the pennant to the upside, the short term moving average crossed above the longer-term average; thus providing stronger confirmation of a new uptrend.
On the right side of the chart, the stock has been declining on a series of lower lows and lower highs, and headed for the support level notated by the blue dash line. Since the stock is halfway between support and resistance levels notated on the chart, a trader might look to wait for an entry point should the stock fall through the “long-term” support level on heavier than normal volume.
What determines an uptrend or a downtrend? It varies from trader to trader, but one place to start is by looking for at least two confirming stair steps in the opposite direction of the prior trend. In other words, if a stock has been trending down, and suddenly reverses, before you can call it an “uptrend”, look for the chart pattern to exhibit at least one higher high than the first and one higher low than the lowest price of the previous trend. This is the opposite for a new “downtrend”.
Putting It Together
There are several different types of price charts that traders can use to navigate the markets, and an endless combination of methods in which to trade each one of them. One of the key considerations in developing your chart preferences should be whether or not there is enough information on the chart to make an effective decision without having too much information that could lead to indecision. Not enough indicators can lead to poor choices and a lot of “false” signals, whereas too many can lead to “analysis paralysis” and a trading signal is never given.
In addition to the types of charts mentioned here, there are “price patterns” that traders can interpret from the data on charts to help identify potential breakouts or consolidations in the stock. The recurring nature of these patterns makes them useful for predicting future price movement.
The idea here is to keep things as simple as possible. Finding the right balance is different for every trader, so it’s important to start with the basics, and work your way into using the indicators and patterns that make the most sense to you.