GENERAL PRINCIPLES OF CHART READING
Charts are powerful tools for traders, but it is important to think deeply about what a chart is and what it represents. Though it is possible to trade by focusing on simple chart patterns, this approach also misses much of the richness and depth of analysis that are available to a skilled chart reader.
Top-level trading combines traditional left brain skills of logic, math, and analytical thinking with the intuitive, inductive skills of right brain thinking. Charts speak directly to the right brain, whose native language is pictures and images.
Part of your edge as a discretionary trader comes from integrating these two halves of your being; charts are a powerful tool that can facilitate this integration and foster the growth of intuition. Modern software packages are a mixed blessing for traders.
On one hand, they have greatly increased the scope and breadth of our vision. It is not unusual for a modern trader to examine 400 or 500 charts in the course of a trading day, sometimes more than once, quickly assessing the character of a market or a set of related markets.
This would not have been possible in the precomputer era, when charts had to be laboriously drawn and updated by hand. However, charting software also encourages some potentially harmful habits. It is so easy to add various plots and indicators to charts and to tweak and change settings and time frames that some traders are forever experimenting and searching for the holy grail of technical indicators.
Other traders bury price bars behind a barrage of moving averages and other indicators, thinking that complexity will lead to better trading results. Simplicity is often better than complexity. A chart is nothing more than a tool to display market data in a structured format.
Once traders learn to read the message of the market, they can understand the psychological tone and the balance of buying and selling pressure at any point. When it comes to chart setup, there is no one right way, but I will share my approach.
Everything I do comes from an emphasis on clarity and consistency. Clean charts put the focus where it belongs: on the price bars and the developing market structure. Tools that highlight and emphasize the underlying market’s structure are good; anything that detracts from that focus is bad.
When you see a chart, you want the price bars (or candles) to be the first and most important thing your eye is drawn to; any calculated measure is only a supplement or an enhancement. Consistency is also very important, for two separate reasons.
First, consistency reduces the time required to orient between charts. It is not unusual for me to scan 500 charts in a single sitting, and I can effectively do this by spending a little over a second on each chart.
This is possible only because every one of my charts has the same layout and I can instantly orient and drill down to the relevant information. Consistency is also especially important for the developing trader because part of the learning process is training your eye to process data a certain way.
If you are forever switching formats, this learning curve becomes much longer and steeper, and the development of intuition will be stymied.
Keep the same format between all markets and time frames, and keep the setup of all of your charts as consistent as possible. Chart Scaling: Linear versus Log The one exception to the principle of keeping charts consistent might be in the case of very long-term charts spanning multiple years, or shorter-term charts in which an asset has greatly increased in value (by over 100 percent).
In these cases, the vertical axis of the chart should be scaled logarithmically (called “semi-log” in some charting packages) to better reflect the growth rate of the market. The idea behind a log scale chart is that the same vertical distance always represents the same percentage growth regardless of location on the axis.
On a very long-term chart, linearly scaled charts will often make price changes at lower price levels so small that they disappear and they are completely dwarfed by price changes that happened at higher levels. The linear scale also magnifies the importance of those higher-level price changes, making them seem more violent and significant than they actually were.
Compare Figure 1.1 and Figure 1.2, two charts of the long-term history of the Dow Jones Industrial Average (DJIA), especially noticing the differences between the two charts at the beginning and end of the series. They seem to tell completely different stories.
The first chart shows a flat and uninteresting beginning followed by violent swings to tweak and change settings and time frames that some traders are forever experimenting and searching for the holy grail of technical indicators.
Other traders bury price bars behind a barrage of moving averages and other indicators, thinking that complexity will lead to better trading results. Simplicity is often better than complexity. A chart is nothing more than a tool to display market data in a structured format.
Once traders learn to read the message of the market, they can understand the psychological tone and the balance of buying and selling pressure at any point. When it comes to chart setup, there is no one right way, but I will share my approach.
Everything I do comes from an emphasis on clarity and consistency. Clean charts put the focus where it belongs: on the price bars and the developing market structure. Tools that highlight and emphasize the underlying market’s structure are good; anything that detracts from that focus is bad.
When you see a chart, you want the price bars (or candles) to be the first and most important thing your eye is drawn to; any calculated measure is only a supplement or an enhancement. Consistency is also very important, for two separate reasons.
First, consistency reduces the time required to orient between charts. It is not unusual for me to scan 500 charts in a single sitting, and I can effectively do this by spending a little over a second on each chart.
This is possible only because every one of my charts has the same layout and I can instantly orient and drill down to the relevant information. Consistency is also especially important for the developing trader because part of the learning process is training your eye to process data a certain way.
If you are forever switching formats, this learning curve becomes much longer and steeper, and the development of intuition will be stymied. Keep the same format between all markets and time frames, and keep the setup of all of your charts as consistent as possible.
Chart Scaling: Linear versus Log The one exception to the principle of keeping charts consistent might be in the case of very long-term charts spanning multiple years, or shorter-term charts in which an asset has greatly increased in value (by over 100 percent). In these cases, the vertical axis of the chart should be scaled logarithmically (called “semi-log” in some charting packages) to better reflect the growth rate of the market. The idea behind a log scale chart is that the same vertical distance always represents the same percentage growth regardless of location on the axis.
On a very long-term chart, linearly scaled charts will often make price changes at lower price levels so small that they disappear and they are completely dwarfed by price changes that happened at higher levels. The linear scale also magnifies the importance of those higher-level price changes, making them seem more violent and significant than they actually were. Compare Figure 1.1 and Figure 1.2, two charts of the long-term history of the Dow Jones Industrial Average (DJIA), especially noticing the differences between the two charts at the beginning and end of the series. They seem to tell completely different stories. The first chart shows a flat and uninteresting beginning followed by violent swings
near the right edge of the chart, while the second, the log scale chart, shows more consistent swings throughout. Over this long history, the log scale chart is a much more accurate representation of what market participants would have experienced at any point on the chart. Remember, as a rule of thumb, there are two times when log scale charts should be used: any time you have greater than a 100 percent price increase on a chart, and for any chart showing more than two years of data, whether on daily, weekly, or monthly time frames.
THE TWO FORCES: TOWARD A NEW UNDERSTANDING OF MARKET ACTION
Price action is a complex and imperfectly defined subject. There are many traders who believe that price action is something nebulous that cannot be quantified.
To other traders, trading price action means trading the patterns of price bars on charts, without the addition of indicators or other lines. In this book, price action simply means how markets usually move, which, frankly, is, usually randomly.
Be clear on this point: markets are usually random and most of the patterns markets create are also random. However, we can sometimes identify spots where price movement is something less than random and is somewhat more predictable, and these less-than-random spots may offer profitable trading opportunities.
Price action is the term used to describe the market’s movements in a dynamic state. Price action creates market structure, which is the static record of how prices moved in the past. Think about a finger tracing a line in the sand.
Market structure is the line left in the sand; price action describes the actual movements of the finger as it drew the line. In the case of a finger, we would talk about smooth or jerky, fast or slow, and lightly or with deep pressure into the sand. In the case of actual price action, we would look at elements such as: How does the market react after a large movement in one direction?
If aggressive sellers are pressing the market lower, what happens when they relax their selling pressure? Does the market bounce back quickly, indicating that buyers are potentially interested in these depressed prices, or does it sit quietly, resting at lower levels?
How rapidly are new orders coming into the market? Is trading one-directional, or is there more two-way, back-and-forth trading? Are price levels reached through continuous motion, or do very large orders cause large jerks in prices?
All of these elements, and many more, combine to describe how the market moves in response to order flow and a myriad of competing influences. In the past, many authors have used a wide range of analogies to describe financial markets. Ideas and models have been borrowed from the physical and mathematical sciences, so terms like momentum, inertia, vectors, and trajectories have crept into the vocabulary.
More recently, some thinkers have applied the tools of digital signal processing to market data, so we have a new vocabulary that includes cycles, transforms, and waves. Markets are confusing enough in their natural state; some of the analytical frameworks traders use add to the confusion.
I propose a simpler model: that market action appears to be the result of two interacting forces: a motive force that attempts to move price from one level to another and a resistive force that opposes the motive force.
These forces represent the sum of all analysis and decision making at any one time. The normal state of existence in most markets most of the time is equilibrium. The two forces are in balance. Buyers and sellers have no sharp disagreement over price; the market may drift around a central value, but there are no large trends or price changes.
Market action in this environment is highly random; if we were to analyze this type of action statistically, we would find that it conforms very closely to a random walk model.
This is also precisely the type of environment that technically motivated traders must strive to avoid, as there can be no enduring statistical edge in a randomly driven market. Markets in this state of equilibrium will have varying degrees of liquidity and ability to absorb large orders.
Eventually, there is a failure of liquidity on one side, and the market makes a sudden, large movement in one direction. Perhaps this movement is in response to new information coming into the market, or it can simply be a result of a random price movement setting off further movement in the same direction. No matter the reason behind the movement, in theoretical terms, the motive force has, at least temporarily, overcome the resistive force.
In the parlance of technical analysis, this type of sharp movement is called an impulse move or a momentum move. From this point, there are basically two options. In many cases, the resistive force is quickly able to overcome the motive force, and the market finds balance again.
This may be at a new level, or prices may immediately retrace their course and return to the pre-shock levels. Psychologically, market participants have chosen to view this large price movement as a temporary aberration, and new liquidity comes into the market that will dampen any future distortion.
However, it is possible that the large price spike will lead to continued movement in the same direction. In this scenario, a feedback loop develops where the market makes a large movement, which, in turn, provokes another large price movement, and the market trends.
In most cases, the market structure of this trending movement will be a series of directional moves alternating with nondirectional periods in which the market essentially rests and absorbs the previous move. In the bigger picture, the motive force has overcome the resistive force, but there is still a subtle interplay of balance and imbalance on shorter time frames.
Prices trend because of an imbalance of buying and selling pressure. (This is often, but not always, indicative of nonrandom action, as trends exist in completely random data.) Once prices are trending, at some point they will have moved far enough that the resistive force is once again able to balance the motive force, and the market again finds a new balance.
This interplay of motive and resistive forces, from a very high-level perspective, is the essence of price action and the root of technical analysis. The patterns we see in the market are only reflections of the convictions of buyers and sellers.
They are useful because we can see them, trade them, and use them to define risk, but always remember that they are manifestations of deeper forces in the marketplace.