Charting and Technical Analysis: Meaning and Types of Chart Used

Our previous chapter focused on choosing a stockbroker for stock trading and investment. Once that aspect is sorted, the next step is choosing the securities you wish to trade or invest in. 

Have you ever wondered how some traders and investors are more successful than others? Or what securities should you buy at what time to grow your investment significantly? 

Well, it is not as straightforward. There is no secret list of securities or a cheat sheet to aid these decisions. It requires careful research and analysis to make the right decisions at the right time.

Enter technical analysis! 

Stock market investments are popular because of their ability to reap attractive returns. However, they are often associated with risk and uncertainty. It is also regarded as a dynamic space because it evolves continually, and opportunities emerge and fade in the blink of an eye. Understanding market trends and making informed decisions is thus quintessential to ensure that you profit from your investments and don’t lose your hard-earned capital. This is possible through technical analysis, which enables investors and traders to sail through the tides of market fluctuations with confidence and ease.

Among the primary building blocks of technical analysis are charts. They are pictorial representations of market trends and data and equip investors with sufficient data to base their decisions. Apart from representing past and present price movements, they become the language of communication of the market, thereby bringing to the forefront aspects like demand, supply, fear, greed, and other facets of the collective market sentiment that drives price movements.

In this chapter, we will talk about various types of charts in the stock market and their significant role in technical analysis. 

What is Technical Analysis?

Traders and investors need to understand the underlying factors behind price movements in the market to make investment decisions. These include how the market has responded to certain events and how prices change in response to the overall economic climate. A thorough understanding of these aspects helps forecast the future direction of securities prices. These analyses are usually done by looking at charts and focusing on trading volumes and price movement. This is known as technical analysis and is different from fundamental analysis, which involves arriving at the intrinsic value of securities by evaluating companies' financial data and market conditions.

At its core, technical analysis is based on the belief that historical trading activity and price changes of securities can be valuable indicators of their future price movements. Technical analysts, or "chartists," scrutinise charts of price movements. They then use various analytical tools to identify patterns and trends that can suggest future activity.

Charts are helpful in analysis because they offer a visual representation of the price movements of a security over time. Analysts use them to observe recurring patterns and formations that point to the potential direction of market prices. By interpreting various types of charts in the stock market, technical analysts can identify buying and selling opportunities along with the ideal entry and exit points.

Types of Charts in Technical Analysis 

Most of us think of zigzag lines or bar graphs at the mention of charts. However, there are several other types of charts that analysts look at to forecast the prices of securities and the direction of the market. Each type of chart offers a different way to look at stock prices and makes it easier to understand how and why they change. Whether you're interested in quick changes or long-term trends, a chart can help you assess that. 

• Line charts:

A line chart is like drawing a line in a notebook that zigzags up and down, connecting the dots from one day's price to the next. It's a super simple way to see how the price of something, like a stock, changes over time.

Imagine you're tracking the price of your favourite video game stock over a week. You mark the price at the end of each day and then connect those marks with a line. The chart you get shows you the game's price journey throughout the week.

• Bar charts:

Bar charts are like building a city skyline where each building or bar shows you how the stock's price moved during a single day. Each bar tells you the highest and lowest prices and where the day started and ended.

Think of a bar for a day when a new game was released. The bar might be tall if there was a lot of excitement and the price moved a lot, with the top and bottom showing the highest and lowest prices for the stock that day. However, it didn’t garner adequate excitement, and the bar will be shorter.

• Candlestick charts:

Candlestick charts look similar to bar charts but are more detailed. Each "candle" shows the same price information as a bar chart but also uses colours to show if the price ended up higher or lower than it started.

For instance, if a candle is green, it means the price of the stock, like for the gaming company that we have been discussing, went up that day because a lot of people were buying the game. If it's red, the price went down, maybe because the game had bad reviews.

• Point and figure charts:

These charts depict big moves in price irrespective of time. They use X's to show when prices are climbing and O's when they're dropping. This way, they focus only on the changes that matter.

Suppose the price of a stock jumps up a lot because the company announced a cool new game; the graph will show a bunch of Xs. If the price drops significantly later, maybe because the game had glitches, you'll see O's.

• Renko charts:

Renko charts use blocks to show price movements. A new block is added only when the price moves a certain amount. This helps you see the big trend without getting lost in daily ups and downs.

Using the same example as above, if a game's stock price steadily climbs over a month because it's super popular, you'll see a neat line of blocks moving up. This will depict the trend without all the daily noise.

• Kagi charts:

The primary focus of Kagi charts is direction. They draw a line that moves up or down when the price changes by a certain amount. This helps to spot where the price might turn around.

For example, if the price of our gaming stock goes up because a new model is announced, the Kagi line will climb. On the contrary, if the price drops because of production issues, the line will turn and go down.

• Heikin-Ashi charts:

Heikin-Ashi charts are similar to candlestick charts but smoother. They use average prices to make the chart less choppy. This makes it easier to see the overall trend.

For instance, if the game's stock has a lot of quick price changes because of mixed reviews, a Heikin-Ashi chart will facilitate seeing the bigger picture, i.e. if the overall trend is still positive despite the ups and downs.

• Mountain and area Charts:

These charts are like line charts but with the area under the line filled in. This filling makes them look like a mountain and helps you see how much the price has moved over time.

For example, if you're looking at the long-term growth of the gaming company, a mountain chart can show you how the stock price has climbed over the years. This helps assess the overall increase.

Charts Based on Time Frames

When you look for charts online, you will get an overwhelming amount of information and charts with huge volumes of historical data. So, one of the first decisions you'll need to make is about the time frame you're going to look at. Think of a time frame like choosing a magnifying glass to look at a map. Depending on whether you're trying to find a street in your neighbourhood or planning a cross-country trip, you'll need a different level of zoom. It's similar to chart time frames, which can range from super zoomed-in (like intraday charts that show you what's happening minute by minute) to way zoomed-out (like charts that show you trends over many years).

Below are the types of charts based on time frames

• Intraday charts:

Intraday charts show you what's happening in real-time or close to it, with updates every few minutes or even seconds. These are great if you're trying to catch quick price changes. Day traders use these extensively to look for opportunities to buy low and sell high within the same day.

• Daily, weekly, and monthly charts:

Daily charts give you one picture per day. They show how the stock moved from the opening to the closing. Weekly and monthly charts zoom out even further and condense each week or month into a single snapshot. 

• Yearly charts:

Zooming out further, yearly charts look at a historical timeline. They help you see the big picture, like how a company's stock has responded to major events over time. These events include new product launches to economic recessions. This long view can be really helpful for making decisions about long-term investments.

Choosing the right time frame is very important because it helps to align your analysis with your trading or investment goals. 

Trends and Trendlines in Chart Analysis

Trends are helpful for traders in deciding when to buy and sell securities. Market trends can move in three main directions. These include up, down, or sideways. Different types of charts offer unique perspectives to decipher trends. For example, a line chart can help you quickly spot the overall direction the stock is moving in. Bar and candlestick charts, on the other hand, offer more detail and information about the highs and lows of each day or trading period. This can help you see the smaller ups and downs within a larger trend.

Once you've got a rough idea of the direction of the market, trendlines find application.  These lines aren't just random but are visual representations of the stock's momentum and sentiment among traders. The longer a trendline holds, the more significant it becomes. However, remember, no trendline lasts forever. Market conditions and trends change sooner or later.

Chart Patterns for Predictive Analysis

Chart patterns serve as visual cues in technical analysis. They fall into two main categories. They are continuation patterns and reversal patterns. Continuation patterns suggest the likelihood of an ongoing trend persisting, whereas reversal patterns indicate a possible shift in the direction of the current trend. These patterns are important because they reflect the collective psychology of market participants. However, relying solely on chart patterns without considering other technical indicators or fundamental analysis can be risky. Consider mastering chart patterns, as it can significantly enhance trading strategies and enable more informed decision-making based on anticipated market trends and reversals.

This brings us to the end of this chapter. We will learn about market microstructures in the next chapter.