One of the shortcomings of the fundamental approach to investing is that it does not focus on the levels of entry and exit. That is where technical charts come in handy. They are based on the assumption that all chart patterns tend to repeat themselves. As a result, one can extrapolate the future by studying the patterns emerging from past charts. Let us understand some key types of charts used in technical analysis and how to interpret them from a practical standpoint.
- Line charts
Line charts are the simplest form of technical charts. They measure the period in the X-axis and the price and the volumes in the Y-axis. The volume chart is normally shown as a subset of the price chart so that the price movement at any point in time can be directly correlated with the volume chart. This is important as it underlines how reliable the trend shown by the price chat is. A rising price chart supported by rising volumes is considered more credible evidence of a bullish market. Similarly, a sharp fall in price accompanied by a sharp increase in volumes indicates a more credible downtrend. However, line charts can be used to decipher very simple trends like price trends, price supports, price resistances etc. For more complex forms of charting, we need to move beyond the pure line charts.
- Bar Charts
Structurally, a bar chart is almost similar to a line chart. The only difference is that the bar chart is able to capture and explain more data points within the same chart. Hence if you are looking to identify more complex and abstruse trends then a bar chart may be more suitable. So, how is a bar chart different from a line chart? While the line chart only captures one price point, the bar chart captures 4 price points for each unit. It captures the open price, the close price, the intraday high and the intraday low for each point. That not only makes it more comprehensive compared to the line chart but also makes it a better measure of the volatility of the stock. One can capture the relative heights of these points and get a clear idea of whether the volatility range of the stock is narrowing or broadening. Therefore, the bar chart also captures the aspect of risk, which is normally ignored in a line chart. That is because volatility is the best proxy for the risk inherent in a stock.
- Candlestick Charts
In a way, candlestick charts are an extension of bar charts. They cover the same data points as a bar chart the only difference is that data is presented in a better and more elegant manner. Instead of the bar chart representing the Open, low, high and close as points, the candlestick chart represents these various points in the form of closed rectangles. The open and close are captured as the limits of the rectangle whereas the highs and lows are captured as lines from the rectangle. As mentioned earlier, the data coverage is exactly the same as the bar chart but the presentation is more elegant and therefore it offers an easy interpretation. The candlestick also uses colors and shading to capture the trend of the stock. So, if the close of the stock is higher than the open then the chart will be unshaded and if the close of the stock is lower than the open then the chart will be dark shaded. In between, the relative gap between the open and the close price can be understood with the help of various degrees of shading. The candlesticks are pictorially a better way of representing volatility risk and give a better idea of risk-adjusted returns on the stock.
- Point and figure charts (PFC)
Point and Figure charts (PFC) used to be in vogue in the old days but people are gradually reducing their usage of these charts. Firstly, the chart is too complex to understand. It is more like an Advance / Declines chart with the difference being the chart is depicted after deciding upon a range of expected volatility. The chart uses X and O to decipher various points on the chart. For example, the number of times the stock rises by a certain percentage is represented by an X while the number of times the stock fell by a certain percentage is represented by an O. While the concept is quite elegant, it is quite difficult to put into practice. That is one of the reasons why this chart is not popularly used in practical technical analysis by the traders and analysts.
Apart from these 4 broad categories of charts, there are a number of sub-categories of charts also available. Charts play an important role as they are an elegant and easy representation of data. It is much easier to see patterns in charts than in 6raw numbers. For a trader in the stock markets, these charts form the basis on which trading decisions are taken!