MODULE 5 - TECHNICAL ANALYSIS: CHARTING
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- Introduction to Charting
- Candlestick Charts
- Open Interest
Introduction to Charting
Charts are an invaluable tool for traders. Indeed, I would say that any time that you as a trader spend studying price charts will be worthwhile. Chartists study the recurring patterns that occur in market prices, because these tend to repeat time and time again.
Why are charts so important?
Charts are prices. Period. Don’t care what’s driving them. They are prices. And they move up or down which is why they are so relevant to us traders. Charts can be a very useful and influential aid to intelligent trading. Not only can charts help to highlight the present direction and stage of a trend but they are also useful for planning trade entry and exit price levels. Charts can also help you to identify levels of resistance i.e. points on a chart where the price has stalled in the past or points of support i.e. points on a chart where the price has stopped falling. Becoming familiar with how charts function, and with what they show, will enable you to fully harness the advantages that they offer.
Charts are Fractal, which means that they are equally valid over all time frames. Imagine looking down on a map showing only the natural physical shape of a section of coastline not knowing the scale. The wavy shore line could be of a 1 mile section or a 100 mile section. Patterns and trends of prices are as frequent in all time frames. Therefore consider moving out of your comfort zone and trying different chart scales. We can pick whatever timeframe we choose to argue what the direction we are going. Ten years, two years or three months all give a different story. I believe the main trend that matters is the one you are currently trading.
A visual inspection of any stock chart will reveal that over time, prices do not always behave in a random or chaotic way but rather move about in stages, trends, congestion zones and sometimes repeating patterns. As buyers and sellers fight for control of the share price, the daily market forces of supply and demand shape the behavior of prices on a chart.
Certain patterns have a habit of re-appearing, time and again. The same patterns have been used by professionals to safely trade the market for over a hundred years. These patterns will continue to appear on charts because they are a manifestation of the basic underlying human psychology that’s always present in the market – the emotions of fear, hope and greed.
All successful trades begin with well timed entries. When’s the right time to buy? Only the market knows. Therefore, perhaps the best way to time your entries into the market is to use the market itself as your timing tool.
Chart patterns can signal a time to either buy or sell a stock. They provide the trader with a simple and straightforward way to enter the market, often with minimal risk. One advantage you have when trading patterns is that you can accurately measure both your risk and the expected profit target before entering the trade. Knowing these factors allows you to make informed planning that is a vital component of successful share trading.
Introduction to Charting Chart Patterns
Candlestick charts are in fact a Japanese invention which dates back to the 18th century when candlesticks were originally used to track deals on the rice market and hence for predicting rice prices in Japan.
There’s some jargon associated with candlestick charts. The rectangular part of the symbol is called the ‘real body’. The lines above and below the real body are called the shadows or wicks. Overall, the shape is often reminiscent of a candle, with the shadow being the wick, hence the name. The names candlestick charts and candle charts are used interchangeably.
In a similar way to bar charts, a candlestick chart can be used to help you identify trends. If the price of a stock rose during the period under consideration, then investors were bullish about the stock. If the price lost ground during the period, then investors and speculators were bearish. Both bar charts and candlesticks are highly popular and both provide plenty of detailed identical information. However, some people tend to feel that candlesticks make it easier to read charts at a glance, especially in cases where there has been a considerable overall price shift between the open and close and whether the entire period’s trading has been within narrow or broad trading confines.
When we discussed market action in the first module, price was only one of the factors. The second factor in most trading is the volume, and it is important for technical analysis that we have a way of examining that. If you remember, Dow was interested in volume as a confirmation that an apparent trend was valid. It makes sense that if hardly anyone is buying, the price might be distorted, but if there is a lot of buying and selling going on, it indicates that the price is soundly established. Another way of putting it is that volume is a confirming indicator of a price move.
Volume is the total amount of trading that has gone on during the day, whether it is the number of stocks that were bought and sold, or the number of futures contracts traded. It is usually shown on a chart by a line of vertical bars, shown separately at the bottom.
It seems obvious when you think about it that a lot of buying and selling action is more inclined to produce a “real” or solid price. If there are many buyers and sellers, these in effect represent votes for the price at which they are trading with each other, so you are getting many more people agreeing to the level that the security is priced at.
Each vertical volume bar lines up with the candlestick for one minute, and shows the trading for the afternoon. The height of the volume bar shows the amount of volume on that trading day.
You should remember from Module 1 that open interest is another type of trading volume. It is used for futures contracts, and is a count of all the outstanding futures contracts that are out there. It is simply defined as a count of the total number of long positions, or of short positions. It is not the sum of these, because for every long position there must be a short position, so if you added them together you would be doubling the number of contracts.
Note also that it is different to the contract volume traded on any particular day, and somewhat unrelated. Open interest is a running total of contracts that exist, no matter when they were taken out.
When futures are traded, the contract may be a new one, which would add to the open interest, or the trades may include traders liquidating their open positions, which would have the effect of reducing the open interest that is outstanding. In fact, one trader might be opening a position, and the trader on the other side is closing his position, so open interest would not change. Just from seeing the number of futures contracts traded on any day, you can’t really say what effect they have on the open interest. All you can know is that open interest cannot increase or decrease by more than the number of contracts traded, even if the transactions were all of one type.
Volume and open interest for futures and options contracts are not as straightforward as volume is on shares. The Dow Theory about volume was based on observation of share trading, and the addition of another variable with technical analysis of futures and options changes the obvious relationship of trading volume confirming a trend.
When both volume and open interest are increasing, along with an increasing price, it is a strong confirmation of the trend. Weak volume and open interest tend to confirm a declining price. But if open interest increases greatly in a sideways market, the market is likely to move lower as it is a sign that commercial interests are taking out more short contracts, as pointed out by Larry Williams in his book, How I Made $1 Million Trading Commodities Last Year. I’ll get into more detail about the differences with futures markets later.
September 7, 2019