Investment: Technical Analysis basics 2

Introduction to technical analysis (for beginners)
Thanks to http://stockcharts.com/

Introduction to Charts

Technical analysts use charts to analyze securities and forecast price movements. For beginners, “securities” refers to any tradable financial instrument or index such as stocks, bonds, commodities, futures or market indices. Any security with price data over a period of time can be used to form charts for analysis. Because charts provide a graphical representation of a security's price movement over a specific time period, they can also be of great useful benefit to fundamental analysts, not just technical analysts. A graphical historical record makes it easy to hereby spot the effects of key events on a security's price, its performance over a time period and if it is trading near its highs, lows, or in-between. The time frame used depends on the compression of the data: intraday, daily, weekly, monthly, quarterly or annual data are the major time frames.

Daily data is made up of intraday data that has been compressed to show each day as a single data point, or period. Weekly data is made up of daily data that has been compressed to show each week as a single point. Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the time frame and the less compressed the data is, the more detail that is available. Short-term charts can thus be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can affect volatility, which can distort the big picture.

Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts, typically 1-4 years, cover a longer time frame, price movements do not appear as extreme here and there is often less noise.

Some use a combination of long-term and short-term charts. Long-term charts are good for analyzing the larger big picture to get a broad perspective of historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months, and can thus provide perspective.

It seems that the most popular charting method is the bar chart. The high, low and close are required to form the price plot for each period of a bar chart. Bar charts can be displayed using the open, high, low and close. Bar charts can be effective for displaying a large amount of data. For instance, line charts show less clutter, but do not offer as much detail. The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars. If you are not interested in the opening price, bar charts are an ideal and useful method for analyzing the close, relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker.

If you are interested in opening price, candlestick charts offer a better alternative. Candlestick charts are quite popular nowadays. For a candlestick chart, the open, high, low and close are all presented here. Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and close.

The beauty of point and figure charts is their simplicity. Little or no price movement is irrelevant and not duplicated. Only price movements that exceed specified levels are recorded here. This focus on price movement makes it easier to identify “support’ and “resistance” levels, “breakouts” and “breakdowns”, which will be dealt with in later posts in this blog on technical analysis.

“There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points as the same vertical distance no matter the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 80 over a 6-month period, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80.”

“A logarithmic scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale.”

Key points on the benefits of arithmetic and semi-log scales here:

Arithmetic scales are useful when the price range is confined within a relatively tight range. Arithmetic scales are useful for short-term trading. Price movements are shown in absolute dollar terms and reflect movements dollar for dollar.

Semi-log scales are useful when the price has moved significantly, be it over a short or extended time frame. Semi-log scales are useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective.

Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book, hence it makes sense to analyze price movements in percentage terms.

Conclusions

Even though many different charting techniques are available, one method is not necessarily better than another. The data is the same but you can see that each method will provide its own interpretation, with its own particular benefits and drawbacks. Again, the data is the same and price action is what matters. It is the analysis of the price action that separates successful technical analysts from unsuccessful ones. The choice of which charting method to use will depend again on personal preferences and trading/investing styles. Once you have chosen a particular charting methodology, it is best to stick with it and learn how best to read the signals. Switching back and forth may cause confusion and undermine the focus of your analysis, giving rise to faulty analyses.