So far in this chapter you will have seen how charts can be used to present financial data and help to analyse it. However, one further important use for charts is to use them to spot patterns and trends.
As we have seen, the financial markets do not merely move at random and there are many situations where one event or action can give rise to another. Analysing chart trends is another way in which you can spot trends and make predictions. Chartists – those who use charts – claim that charts are the perfect way to predict markets. They argue that, since markets usually change gradually, yesterday’s market prices are the perfect guide to tomorrow’s likely market prices and that charts are the best way to spot patterns and trends as they develop.
Whatever market you are interested in always get into a habit of plotting its performance on a chart. As I said, many financial websites provide you with ready made charts for many markets, and there are various computer software programmes that can be used to draw up charts at a few clicks of a button. If you don’t have access to the Internet and/or a computer it doesn’t matter. Charts drawn up on graph paper with a pencil and ruler are just as effective, if not more effective since you have to study the data as you plot it.
For many successful spread betters, chart reading forms a vital part of their strategy. This process is known as technical analysis. Charts depict the movement in price of a specific instrument over a period of time. For example, we may be looking at the change in price of Amazon stock over the last 3 months, or how GBP/USD has moved over the last week. By showing us what has happened historically, charts give us clues about what might happen in the future. It is for this reason that they are indispensable.
Trends
Price movement over time can be categorized as being bullish (rising in price), bearish (falling in price) or flat (no significant change in price). Knowing the trend of the stock allows us to place higher probability bets. For example, if a stock is bullish, then a long position is more likely to profit than a short position. Conversely, if a stock is bearish, then a short position is more likely to be profitable.
Instruments never move perfectly over time, but instead depict a series of peaks and troughs. So how do we read a chart to tell if it is bullish or bearish? You use those peaks and troughs to point out highs and lows. A bullish chart will show a series of higher highs and higher lows. A bearish chart will show a series of lower highs and lower lows.
We can profit from a bullish trend by buying retracements. Price moves up significantly as buyers outweigh sellers, and then retraces as those buyers take profits. When price begins to move back up again we can enter the market for a lower risk long position. We hold the position as price moves up again. If the price fails to move upwards then we exit for a small loss. The reverse set up is true for a short in a bearish trend.
History may tend to repeat itself, but how can we profit from that? Here are a couple of aspects of reading charts that you can use in your strategies:
Support and Resistance
Support and resistance represent significant historic price levels. Resistance is a ceiling that the instrument has struggled to break through in the past. Support is a floor on which price has bounced in the past.
We can use support and resistance to profit when we monitor price action at those levels. When price moves up to resistance and breaks through that level with momentum, then we are likely to see that move continue and can profit from a long position. If price moves weakly up to resistance and fails, then we could potentially profit from a short position.
The converse is true for support. When price moves down through support with momentum that move is likely to continue and a profitable short position may be likely. If price bounces off support a profitable long position may be available.
How To Profit From Reading Charts
The impact on your bottom line depends on how you put these ideas to work for you. The world of technical analysis is full of different tools which have varying degrees of utility. Tools like candlesticks, gap analysis, Elliott wave, Gann and Fibonnaci all have something to offer in theory, but the most important question is how they can boost your profitability in practice.
It is important to note that in technical analysis, there is no one infallible tool. It is the combination of trend reading, support and resistance, volume analysis, chart patterns and other tools that will add to your edge. Increasing your edge increases your probability of profits.
Once you have drawn up your chart you can begin to look for trendlines and chart patterns. We will discuss the main types of trendlines and patterns and what they can tell you by reference to real-life examples :