Technical Analysis An Introduction to Chart Reading

Two of the questions that excite traders the most are "When to buy?" and "When to sell?”. The main tool used to discover the answers are Charts. Graphs and charts provide information about the exchange rate and equity prices, debt and derivative instruments. They allow us to study market trends, to observe signs of reversal or continuation of a trend and that helps us make predictions about what is happening in the market.

The most used types of charts are "bar chart", "line chart" and “candlestick chart”. They provide information about the prices of opening and closing trends, as well as the highest and lowest prices for the reference period.

Technical analysis is the art and science of reading a price chart to determine who is stronger, and who may win the struggle in the future.

Chart Types




Line charts:


The Line Chart is the simplest form of charting and it depicts the changes in the price fixed at regular intervals. Values are placed in a coordinate system. It also displays the closing price for any given time period. However, it does not tell you very much about the opening price or price fluctuations during that period.

The disadvantage of Line Charts is that they provide information averaged for the specified period of time. Analysis of Forex trading requires data on the behavior of prices during the time period. To this end, much more useful are "bar charts", and "candlestick charts."

Bar charts:

Bar charts provide a wealth of information on prices in an easy to understand and illustrative way.

In bar charts, the vertical bar displays the extremes - the highest and the lowest prices reached during a particular period. The short ticks on the sides of the bar chart depict where the period opened and closed. The bigger the bar, the wider the range of the struggle. The smaller the bar, the more agreement and consensus there was on the price. You can also see if the open and the close of the period occurred closer to the lowest price, the highest price, or somewhere in the middle.

Candlestick charts:


Candlesticks charts, as suggested by their very name are created in the "Land of the Rising Sun". Initially, they were used for analysis of changes in the price of rice. Their use of the financial markets in Europe and the United States began in the 80s of the twentieth century, where they quickly became popular.

In this type of charts information is provided by figures that look like candles. Each candle is made of a rectangular body (called jittai) and upper and lower wick. Upper wick is called the upper shadow and the bottom - lower shadow.

The wick depicts the extremes, that is, the highest and lowest prices during that period. The candle body displays the opening and closing prices. Additionally, the color of the candle depicts who ultimately won. Green candles represent a higher close than open, while red candles represent a decline in the closing price from the open.

In the example on the right, you can see that the most recent candle opened at 1.4830, then dropped as low as 1.4820. It then went on to rise as high as 1.4860, and finally settled at the present closing price of 1.4850. This is 20 pips above where it started its journey.




In this manner, each candlestick tells us a complete story of what happened in the power struggle between bulls and bears during that particular period of time. Also, candlestick charts give us clues about who is growing stronger and who is weakening.

There is a special kind of candle called a “doji” – this is a candle where the open and closing price were the same, leaving the candle without a body at all. These candles look like a “+” and represent a moment of consensus – an agreement between buyers and sellers in the market, but also a moment of indecision as to the next direction.

In the chart to the left, you can see the bulls gradually losing strength as the rally comes to an end at the top, as evidenced by the shrinking candle body. Then a doji prints and we begin to see the bears slowly overpower the bulls as price begins to move back downward.





Timeframes

Each candle or bar on a chart represents a specific time period - 1 minute, 5 minutes, 15 minutes, 30 minutes, an hour, 4 hours, a day, week, or an entire month. The timeframe refers to the amount of time it takes to print one candlestick on your chart.

Both of the charts on the right show the same time period, and the same price movement from 1.4710 up to 1.4840

The first chart is a longer timeframe, where each candle takes 1 hour to form. The second chart is a shorter timeframe, which shows the same move, but in 5-minute increments.





The timeframe you choose to use depends on the type of trade you want to execute. A long-term trend follower is likely to use a longer timeframe, a swing trader something in the middle, and a day trader or scalper more likely to choose one of the shorter timeframes.

Trading with Multiple Timeframes

One strategy for trading is to use multiple timeframes. In order to do this, you need to first identify the best chart to use for your particular style of trading. This will be your lower time frame. Then choose another chart for the higher one. The goal is to choose two charts that are far enough apart (a factor of 5 or as close to that as possible).

A long-term trader who uses a daily chart as the lower timeframe, for example, may occasionally glance up at a weekly chart as the higher one (since there are 5 days in 1 week). A day trader who uses a 5-minute chart as the lower timeframe would most likely use a 30-minute chart for the higher one (since a 15-minute chart is only a factor of 3, and may not provide a different enough perspective).

On the higher timeframe, you can decide if you wish to be a bull or a bear in regards to that particular currency pair (or you can also decide to stand aside and look for another pair if the market is sideways and showing no clear direction). Then you can switch to the lower timeframe and take entry signals as normal, but only in the direction you decided upon in the higher timeframe. A bull would be looking for long signals in order to buy, while disregarding any short signals. A bear would be looking to sell short and would disregard any long signals.

Trends do change direction eventually, but generally they tend to do so gradually. You can change your mind and choose a different direction, but only on the higher timeframe, not on the lower one. The idea behind multiple timeframe analysis is to reduce the number of false trades and to avoid the temptation to trade randomly in both directions at once.

Next Article: Support Resistance and Moving Averages
 

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