Many articles on chart patterns are theoretical. Instead of telling us about the market, the writer provides an abstract explanation of a pattern. There is a very good reason for this. Many of those articles are written for educational purposes. The author starts with the pattern and provides the reader with a roadmap of what to look for. In this article, we are going to turn the process upside down. We will start with the chart and explain what we see. Our goal is to explain how a chart can be read, moving from theory to practice.
We are looking at the broad stock market so will start our process with a chart of the S&P 500. We will analyze the charts from the perspective of a trader. This means we need to chart something that is tradable. Indexes are not directly traded. We will use a chart of SPDR S&P 500 ETF (NYSE: SPY) because the ETF can be traded.
It might be surprising but there are often small differences between a chart of an ETF and the underlying index. Buy or sell signals often show up earlier on one chart. There is no consistent pattern in the difference. Sometimes, the index signals first and sometimes the ETF signals first. The difference is usually only one or two days and is not significant in the long run. But, because differences exist, we prefer analyzing the ETF rather than the index when developing a trading strategy.
The first chart is a simple line chart. Our goal is to determine the direction of the trend. The line chart allows us to isolate the trend. There is no extra information on the chart that can lead to confusion or alternative explanations.
An up trend is defined as a series of higher highs and higher lows. With a line chart, this is easy to spot. The blue arrow identifies a clear up trend. On March 1, SPY reached a new closing high before pulling back. The subsequent rally failed to set a new high. That sets up a potential sell signal. The trigger for the short term sell would be a lower low. The chart shows we did see a lower low.
Based solely on the chart pattern, SPY is on a sell signal.
The next step in chart analysis is deciding whether or not we should act on the signal in the chart. Instead of reacting to every signal on the daily chart, we prefer to take a “weight of the evidence” approach. That means we look at other time frames and other indicators to determine whether they are bullish or bearish. We use the direction shown by the majority of indicators, the weight of the evidence, to determine our course of action.
The next chart provides a weekly view. Here, the up trend remains intact. Prices are still setting higher highs and higher lows, for now.
With the evidence from the charts being mixed (daily is bearish and weekly is bullish), we turn to indicators. This is where many investors get confused. We need indicators that are independent and meaningful. The truth is many indicators provide the same information. The best one to use is the one you are most comfortable with.
By default, the relative strength index (RSI) and stochastics, for example, both use the same input and calculation period. Both use 14 periods in their calculation and both are comparing the closing price to the recent market action. Despite the fact both indicators are similar, many investors look at both. Not surprisingly, they tend to deliver the same signals. This is not a true confirmation of the state of the market since the indicators are not independent. To demonstrate this, stochastics, RSI and MACD are all included in the next chart.
All three are giving the same signal. Stochastics completed a bearish crossover and is slipping out of overbought territory. This makes stochastics slightly bearish. RSI is also slipping below the overbought line and is slightly bearish. MACD is falling and near the zero line. This should be considered as slightly bearish.
Although we included three indicators on the chart, it should be clear that just one is needed. Any indicator would give us the same message.
While the trend in the price remains up on the weekly chart, momentum indicators are all potentially breaking down. This is a picture of a market that is more likely to move lower that higher. The next question we need to address is how low it is likely to move. To answer this question, we can look at the daily chart.
We’ve kept all three indicators on the chart to demonstrate all three show the same thing. On the daily chart, the three indicators are all pointing in a slightly bullish direction. Stochastics and RSI are in the middle of their range. MACD is slightly negative but improving.
This all indicates the down trend is likely to be short lived. The trend line on the chart, now near $220, should be watched. A break of that line will turn the analysis to bearish. Likewise, a breakdown of momentum in the daily time frame would tilt the outlook to bearish.
Now let’s review our simple chart analysis process.
We like to focus on line charts rather than bar charts or candle stick patterns. Line charts show price action in its purest form. Patterns on bar charts are subjective and many analysts allow their bias to influence to their interpretation. Biases may be subconscious but they are impossible to avoid. This is especially true with candle sticks where it’s possible to see multiple patterns that are not very reliable. In testing, stand alone candle stick analysis is not a reliable analysis tool. Line charts, when used to spot the trend, are objective and simple to interpret. A line tells us whether prices are making higher highs and higher lows signifying an up trend, or making lower highs and lower lows dignifying a down trend.
Two time frames are often all that need to be looked at. If the trend is the same on both daily and weekly charts, the analysis is done because of the weight of the evidence is clear. When the trend differs on those time frames, an indicator should be evaluated. With indicator analysis, again, simplicity is better than complexity. Pick one indicator and stick with it. Because signals are clear and relatively frequent, stochastics or MACD could be the best tools use.
After developing your opinion, know what will cause you to reverse your outlook. In our case, a break of the trend line will shift our view from bullish to bearish.
Finally, there is the question of what to do with this information. When we are bullish, as we are now, we favor more aggressive strategies and more aggressive stocks. In a down trend, we favor conservative and allow cash to build up.
This might seem simple to some readers but simple ideas can work in the stock market, in the long run. If you are a high frequency trader or looking at day trading strategies, complex ideas may perform better. If your holding period is measured in weeks, months or even longer, a simple analysis is all that is needed. If your charts are bullish, you should be buying aggressively and when the charts are bearish you should be following more conservative strategies.