Let me tell you…
You don’t get designated as “America’s Pattern Trader” without knowing a few things about stock charts…
But are stock charts really required to be a successful trader – or are they just a waste of your time and money?
Here’s the truth…
You can chuck most of it in the garbage.
Sure, there are some charts out there that certainly look fancy, but trust me, they don’t actually provide any useful information you need to set up trades.
But there are a few that are absolutely crucial to correctly timing your entries and exits.
Here are the only three charts you really need…
The Big 3: Line, OHLC, and Candlestick
First, let’s start with the three basic types of charts – line, OHLC, and candlestick. While these charts may all look different, they each show price action.
Even though they’re all showing the same thing, each of these chart styles has their own strengths and weaknesses that make them better suited for different kinds of analysis. Here’s everything you need to know about the three basic types of price charts…
Line Chart
The line chart is the most straightforward of the three. It usually plots only the closing price for each period and then connects those points with a simple line. I’ve included an example below.
Line charts are great for uncovering support/resistance levels along with the current trend. Because they only show closing prices, they reduce noise. Too much information can sometimes lead to “analysis paralysis” or, worse, confusing/incorrect signals. A simple line chart can be especially helpful to new traders still honing their chart reading skills and learning to draw consistent indicators.
However, more advanced traders may prefer a price chart that offers more information, like the opening price, as well as the day’s high and low… which is exactly what the next two charts provide.
OHLC Chart
The OHLC chart shows the four major data points – open, high, low, and close (“OHLC”) – for each period. On a daily chart, each bar represents one day of trading activity.
Reading this style of chart is not quite as obvious as reading a line chart, but it only takes a little bit of practice. The left “arm” represents the opening price, and the right “arm” shows the closing price. (Although, sometimes chart software will make it easier to quickly tell up days from down days by making each bar either black/green or red, with black/green bars representing up days and red bars representing down days.)
OHLC charts are especially helpful for depicting momentum and volatility. For example, when the bar’s open and close are far apart, it shows strong momentum. And when the high and low for the period are far apart, it shows high volatility.
There are a number of other patterns that analysts look for on OHLC charts, including…
-bar color (more black/green bars in an uptrend vs. more red bars in a downtrend)
-bar height (a series of very tall bars shows a trend of high volatility and market indecision)
-“arm” position (can indicate trend reversals and shifts in momentum)
Candlestick Chart
A candlestick chart gives us the same information – open, high, low, and close – but presented in a more visual approach. They have a rich and long history, originating hundreds of years ago from Japanese merchants and traders.
The “body” of the candle shows the open and close; a “hollow” (or white) body shows an up period, while a “closed” (or black) candle shows a down period. The upper and lower candle “wick” shows the period’s high and low.
Below are two versions, the original black and white method (left) along with the more modern colorized version (right). Note that with the original method, it can be drawn with just a pencil on light colored paper since the bullish candle is hollow while the bearish candle is filled in – see below. In the modern version shown above, bullish candles are colored green, while the bearish candles are colored red.
Like OHLC charts, advanced analysts can find numerous patterns in candlestick charts, including reversal signals (evening and morning stars), bearish/bullish engulfing patterns, and many, many more. At times, candlestick charting can seem as much as an art as it is a science.
Over the next few weeks, we’ll dive into the most popular candlestick patterns and how analysts use them to make trading decisions.
To your continued success,
Tom Gentile
Source: Money Morning