Charts used in technical analysis are similar to those seen in any business setting. A chart is a graphical representation of a series of prices over a set time frame. The X-axis on a chart plots the periods for which prices are plotted and the Y-axis plots the value or the price of the share. The periods showing different price levels, as plotted, may range from a few hours to a few years. Thus, charts or the timelines of charts can be hourly, daily, weekly, monthly, quarterly and yearly, based on data in respective timeframes. Even minute charts are a possibility. Exhibit 1 explains the basic construction of a chart.
‘Short-term’ traders trade on the basis of daily charts as they are interested in the immediate movement in a stock price, whereas ‘medium-term’ to ‘long-term’ traders are more dependent on weekly/monthly charts as they want higher returns for which they are prepared to wait for a longer duration.
Different time frame charts and their validity:
|Daily (1-8 days)||At the end of the day||Short term/minor trend|
|Weekly (4-6 weeks)||At the end of the week||Medium term/intermediate trend|
|Monthly (4-6 months)||At the end of the month||Long term/major trend|
The three important types of charts, commonly used by chartists, are:
1. Line Chart: The closing prices are plotted on the graph and are joined to form a line
2. Bar Chart: It uses the open/high/low/close.
In Bar Chart, the open is indicated by a small dash (–) drawn on the left side of the bar and the close by another such dash on the right side of the bar.
3. Candlestick Chart: Also uses the open/high/low/close.
In a Candlestick Chart, the real body, which is a narrow vertical rectangle, shows the opening and the closing prices for a given period. Lines at the top and the bottom of the real body are termed shadows. These lines denote the high and the low for the given period. The colour of the body indicates price action. If the close is higher than the open, then it is a bullish candle, the colour of which is white. And if the open is higher than the close, then it is a bearish candle, the colour of which is black. (In some packages, green and red are used instead of white and black.)
Volume is simply the number of shares or contracts that trade over a designated period such as daily, weekly and monthly. The higher the volume the more active the security is. To determine the movement of volume (up or down), chartists look at volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded over a period, as well as show trends in the same way prices do.
Why is volume important?
Volume is an important aspect of technical analysis as it is used to confirm trends and chart patterns. Any price movement, up or down, with relatively high volume is considered a stronger, more relevant move than a similar move with low volume. Therefore, if you are looking at a large price movement, you should also examine the volume to see whether it tells the same story.
For example, if a stock jumps 5% in a trading day after being in a long downtrend. Is this a sign of a trend reversal? This is where volume helps traders. If volume is high during a day relative to the average daily volume, it is a sign that the reversal is probably for real. On the other hand, if volume is below average, it may not be a mark of enough conviction to support a true trend reversal.
From an investor’s perspective, volume should move with the trend. If prices are on an upward trend, volume should be on the rise and vice versa. If this relationship between volume and price movements starts deteriorating, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up- trading days are marked with lower volume, it is an indication that the trend has begun losing its steam and may soon die away.
However, when volume tells a different story, it is a case of divergence that refers to a contradiction between two different indicators. The simplest example of divergence is a distinct upward trend on declining volume.
How is volume related to chart patterns?
The other important use of volume is to confirm chart patterns. Patterns such as head and shoulders, triangles, flags and other price patterns can be confirmed with volume. In most chart patterns, there are several pivotal points that are vital to what the chart can convey to chartists. Basically, if volume is not there to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern is weakened.