The Best Way to Read a Chart

stock chart

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  • Chart reading has been the subject of analysis for almost 100 years. The first book on the subject was likely published in 1930. Richard W. Schabacker published Technical Analysis and Stock Market Profits, that year. It was originally a series of lessons but was in a book form by 1932.

    Schabacker covered reversal patterns, continuation patterns, trend lines, support and resistance, how to develop price targets from chart patterns and how to trade the patterns. It’s all been explained for many years yet many traders still struggle with charts.

    Buffett’s View on the Subject May Not Be Right

    Many investors follow every word of the great investor, Warren Buffett. And, there is a reason for that. Buffett is brilliant with a long term track record of success. He has strong opinions, such as his one on charting.

    Buffett is not a technical analyst. He once said, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” This confirms the view of many academics who say that charts are random and not valuable to investors.

    This view has been proven wrong. In a 2012 study called “Are Price Charts Useful for Investment Decisions?” a group of MIT economists found that:

    “Although some anecdotal evidence has suggested that humans cannot even distinguish price charts from charts generated via a synthetic random walk, to our knowledge the above question has not previously been addressed scientifically.”

    They set out to study that question and found:

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  • “statistical evidence that subjects can distinguish between actual and randomized price charts. These results show that temporal charts of asset prices convey to investors information that cannot be reproduced by summary statistics, and call for more research on the usefulness of making such representations available to investors.”

    This means charts can be useful. But, investors may still struggle to determine how to make sense of the charts. This is due to the variety of chart styles and complexity of patterns that some analysts have found in the data.

    As with many complex tasks, it can be best to start with simple ideas. For chart readers, these simple concepts can be profitable.

    The First Step in Chart Reading

    To begin with, it can be helpful to look at the simplest chart possible. This would be a simple line chart with no indicators or other information. An example is shown below.

    SPY daily

    This chart shows an up trend, a pull back and a consolidation. The first step is that simple. With that information, we can form a specific plan for more detailed analysis.

    We see that the up trend ended almost six months ago and the pull back was steep. But, there was no follow through to the down side. This indicates the bulls have enough power to prevent a further decline. That is noteworthy and worth keeping in mind.

    Now, let’s drill down to a more detailed view. The next chart covers the same time frame. It is a bar chart so we see the highs and lows which can sometimes provide additional insights. The consolidation in the chart above is highlighted. And, a 200 day moving average (MA) has been added.

    SPY daily chart

    Let’s start this review by noting that the 200 day MA has stopped the decline on two occasions and seemed to provide a level of support on the initial sell off. That indicates the bulls are buying when they see an opportunity.

    In this chart, the lows break below the main price action twice, that tells us, again, that bulls are coming into the market on weakness.

    So far, we see that there is support and a bullish breakout is possible. This is confirmed with a look at the lows. The lows are progressively higher.

    Schabacker taught that the chart should be analyzed as a battle between bulls and bears. So far, we have seen that bulls take an upper hand in this market. The blue consolidation shows that bulls are struggling to break out.

    This analysis doesn’t rely on pattern names because the pattern names are irrelevant. We could call this consolidation a rectangle, or an ascending triangle since the lows are rising and support is nearly horizontal. But, some analysts will find reasons that those patterns are not correct.

    Since all patterns use a similar measuring formula, the name is truly not important. In all patterns, the depth of the pattern provides a target for the subsequent breakout. The next chart illustrates this point.

    SPY trading pattern

    In the chart, both up side and down side targets are shown. The depth of this consolidation is about 21 points from high to low. The up side target is found by adding 21 points to the high of the consolidation and the down side target is 21 points below the low of the pattern.

    This rule applies to rectangle patterns, head and shoulders, or any other pattern that could be named. Because the measuring or price projection rule is the same for all patterns, there is no point, from a trading perspective to naming the pattern.

    From a trading perspective, the goal is simply to identify a pattern of some time. Then, wait for a break out and place the trade.

    Now, since we entered this consolidation or trading range after an up trend, and then see evidence of bulls in the way the lows formed and the MA held, we should expect the break out, when it comes to be to the up side.

    As with anything in the financial markets, we can make chart analysis more complex than this. Or, we can apply a simple and profitable approach.

    This approach shows the importance and potential profitability of research.

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