Reading a Chart

Tea leaves or charts? I prefer to drink tea and read charts rather than trying to read tea leaves. Like all reading tasks, we can make this as simple, or as complicated as we wish. We can read a popular novel, serious literature, or a scientific paper. The reading skills are the same but the subject matter changes. We read a chart of price action in four different ways.

• As a record of the price paid for a stock. The graphic chart display makes it easy to compare today’s price with prices paid in the past. Once we see 260 days of price behaviour we also immediately observe certain pattens of price behaviour.
• As an emotional record of the crowd of buyers and sellers. Their emotions change over time as they grow to like, or dislike the stock. Quite simply, this emotional record appears on the price chart as trends. Uptrends reveal when the market falls in love with a stock. Down trends tell us when the love affair has ended. These trends are easily seen. We look at two ways to define them in the remainder of this article.
• As an exact record of crowd behaviour. We look for repeated chart patterns. These point the way to high probability trading events such as a rally from a triangle pattern. We look at this in the next article.
• As a translation of price activity. This is closer to literary criticism. We take the text – prices – and interpret the information. A moving average line is a simple indicator  that provides technical analysis or interpretation of price data. We look a these in the last articles in this series.
  

Price trends are exciting because we can see the opportunity to make money if we buy stock at the bottom of a downtrend and sell it at the top of an uptrend. It is easy to find these turning points on a chart of price history, but much more difficult to do in real time. Rather than trying to identify turning points, another useful approach is trend trading. This is covered in more detail in my book, Trend Trading.

The objective is to find a strong, established trend several weeks or months after it has started. Then we ride the trend until it has proved that it has ended. The trend may last weeks, months or even years. The trend in Fleetwood started in early 2002 and finally slowed in 2004, returning around 400%

If we ride the trend we need to know when to get off. We use a chart based signal to make this decision. One of the most effective is a straight edge trend line. This is a line plotted along at least two, and preferably three rebound points as shown in the diagram.

A correctly plotted line appears to have an uncanny ability to define the trend. Prices move away from the line, then fall back to the line, hit it, and bounce away again. Some people see this and believe that a good trend line is able to predict what will happen. Not true. The line predicts what we will do when particular events happen in the future but it does not predict how price will behave. The trend line is a trade management tool.

The trend line simply tells that prices are still moving up-hill in a rising trend. When prices drop below this line they tell us there is a strong probability that the up trend, as we defined it, has ended. Stay with this stock and we could start losing money and profits. 

We use a trend line to tell us what we are going to do in the future when the trend changes. We know the trend changes because prices drop below the trend line. The line is like a safety railing on a mountain road. Cross over it and there is a strong chance we will plunge down the cliff. Used in this way the trend line captures around 85% profit from First Australian Resources. Sure, we could use an example that does not suddenly drop below the trend line, but even after the drop, a 85% return is still a good result. Many traders make a very good living using just this technique.

Trends are the clearest evidence that prices in the market are not random. What we pay for a stock today depends on how we feel about prices paid in the past. Are we paying more than average, or less than average? The moving average line on a chart helps answer this question. Modern charting software do all the calculations in a  flash and plot the moving average line on a chart.

A 10 day moving average line shows the average value of prices over the past 10 days. Each day this value is recalculated and a new value added to the old line. Rather than show a series of dots this is usually shown as a line. 

We all feel good when we buy a stock for less than its average price over the past 10 days, but this does not help us understand when a  trend starts, or ends. Using two moving averages does help. When the average of price for the past 10 days is higher than the average of price for the past 30 days it suggests an uptrend is in place because prices are rising.

Plot these two averages on a chart display and we see  crossover points. These are created when the shorter moving average moves above the longer moving average. This may signal the start of an uptrend. The reverse may signal the end of an uptrend.  This is particularly useful information because it is an easy and convenient way to identify up-trends almost as soon as they start. Using First Australian Resources  again and applying this technique delivers a 80% return. The exit signal comes after the crossover, so the actual exit price is around $0.085.

This automatically calculated indicator is also easier to use than a straight edge trend line. There is no guessing about where to place it. The values are mathematically calculated. All we have to read is the crossover point and then make a decision. Like the trend line, the two moving averages are a tool for managing the trade. They do not predict the future, but they do tell us what we will do in the future when certain events happen.

Reading a chart using a straight edge trend line or moving averages is like reading an instruction manual. The additional information delivered by the trend line, or the moving average indicator flash a signal when we need to make a decision about a change in the trend. We may choose to act on the signal, to look for another signal to confirm it, or ignore the signal completely.

Reading the chart helps us to recognise the difference between an uptrend and downtrend and this helps us to make better decisions about when to buy, or sell. In the next article we do some close reading to understand the exact emotion of the crowd.

The next article on charting will appear in the October edition of the ASX Investor Update newsletter. 

Daryl Guppy is a full time trader and author of Trend Trading, Trading Tactics and Better Trading. He runs trading workshops in Australia, Asia, China and the US. He can be contacted via www.guppytraders.com.

© Guppytraders.com Pty Ltd ACN 089 941 560. All rights reserved 2004. This article has been prepared by Guppytraders.com Pty Ltd and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice.

ASX is interested in your thoughts, please email any comments or feedback on this article.